CHAPTER 10 GETTING WHAT YOU PAID FOR: REPRESENTATIONS AND WARRANTIES

• Jurisdiction: United States

Oil & Gas Agreements: Purchase & Sale Agreements
(May 2016)
CHAPTER 10
GETTING WHAT YOU PAID FOR: REPRESENTATIONS AND WARRANTIES
Jolisa Melton Dobbs
Partner
Thompson & Knight LLP
Dallas, TX
Debra J. Villarreal
Partner
Thompson & Knight LLP
Dallas, TX

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JOLISA MELTON DOBBS is a Partner in Thompson & Knight's Oil and Gas Practice Group in the Firm's Dallas office. She has expertly navigated clients through sophisticated oil and gas transactions totaling billions of dollars, with a focus on acquisition and disposition transactions throughout all oil and gas plays - including the Eagle Ford, Barnett, Haynesville, and Marcellus. Jolisa's past experience as a Certified Public Accountant and an internal auditor for a major oil and gas company gives her an edge in assessing, understanding, and allocating various risks associated with oil and gas properties. In addition, she counsels clients in midstream and upstream transactions, including lending diligence and dispositions, oil and gas secured lending, joint venture and development arrangements, and acquisitions and dispositions of natural resources companies. Jolisa also has expertise in oil and gas title due diligence in acquisitions of properties, and she regularly advises clients regarding exploration and production activities, including preparation of agreements and COPAS issues, and regarding leasing issues. Jolisa is a frequent lecturer on oil and gas related topics at conferences and seminars, and has published numerous articles in prestigious industry journals. She is also a deep contributor to numerous leading oil and gas legal and accounting organizations, including serving as the current Treasurer and former Trustee and Executive Committee member of the Rocky Mountain Mineral Law Foundation. Jolisa's accolades include being honored by The Best Lawyers in America®, The Legal 500 US, Texas Super Lawyers®, and Who's Who Legal: Energy. She received her J.D., with honors, from the University of Oklahoma College of Law and her M.A. and B.A. in Accounting, summa cum laude, from the University of Oklahoma.

DEBRA J. VILLARREAL is a partner in the oil and gas section of Thompson & Knight, LLP in Dallas, Texas. Her practice focuses on the acquisition and disposition of onshore and offshore oil and gas. properties. She represents clients in strategic design, negotiations, and contract preparation for joint development and exploration activities and acquisitions and divestures of oil and gas properties throughout the United States. Ms. Villarreal holds a JD from Kansas University of Law School, where she was on the Law Review and was Order of the Coif and Phi Kappa Phi. She has been named in The Best Lawyers in America by Woodward/White Inc. (oil and gas law) for many years and was named 2014 Dallas Oil and Gas Law "Lawyer of the Year" in The Best Lawyers in America. Ms. Villarreal was named in Who's Who in Energy, by the Dallas Business Journal and in "Best Lawyers in Dallas" by D Magazine in 2014. She is a Fellow of the Texas Bar Foundation. Ms. Villarreal has two wonderful children, a seventeen year old son who is a football player, wrestler, and instigator of many a party, and a twenty-five year old daughter, who is a creative spirit thriving in the like kind environment of Seattle. Debra is a movie buff, so if you have seen a good movie recently, please let her know.

The old Russian proverb, "trust, but verify," accurately describes the transparency that purchasers of oil and gas assets seek from sellers. Representations and warranties in the purchase and sale agreement help narrow the trust gap between purchasers and sellers. After a brief review of information in a dataroom, a purchaser is asked to make an educated guesstimate as to the value of the assets. Such a bid includes a variety of assumptions concerning the assets including assumptions related to title, operations and contractual issues. Before a thorough review of the assets is performed, the purchaser must typically commit to the purchase of the assets by signing a purchase and sale agreement containing a stated price subject to defect adjustments. But not all operational and contractual issues lend themselves to the defect mechanism. Representations and warranties in the purchase and sale agreement protect a purchaser against the forced acquisition of assets at a price based on materially different assumptions.

REPRESENTATIONS AND WARRANTIES

A representation is a statement of fact "a statement or account made to influence opinion or action or an incidental or collateral statement of fact on the faith of which a contract is entered."¹ Whereas, a warranty is a promise that a fact is true. In acquisitions, the distinction between the two words has become practically irrelevant and will be referred to only as representations in this paper. In a purchase and sale agreement, the purchaser asks for representations from a seller to verify the purchaser's understanding of the assets being acquired. The representations are usually the most heavily negotiated element in a purchase and sale agreement. A purchaser's ability to obtain extensive representations depends in part on the market in which the transaction is occurring, the access to information afforded to the purchaser prior to signing the purchase and sale agreement, and the relationship of the purchaser to the assets. If the purchaser is paying a premium for the assets or if there are few other potential purchasers, the purchaser has a greater ability to obtain more extensive representations. If the purchaser already owns an interest in the target assets, or is the operator of the assets, the representations are typically reduced. Most transactions involve substantial asset-related representations to confirm the contractual and operational status of the assets and to confirm that the seller is not entering into the purchase and sale agreement with knowledge of issues that have an adverse impact on the assets to be conveyed, or on the purchaser's future operations as to such assets.

A seller's representations should work with the due diligence "Defect" mechanism in the purchase and sale agreement to mitigate the risk that the purchaser might receive assets other than what it thought is was bidding upon. From the seller's perspective, the purchaser has the

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responsibility to confirm the assets instead of requesting assurances from the seller. The seller typically takes the position that the purchaser should "kick the tires" prior to the sale, obtain any adjustments to the purchase price prior to closing, and not rely on representations. As a result, the seller may actively pursue a negotiation strategy based on a purchaser's extensive due diligence rights with only limited representations. This strategy is most effective when the seller has made it clear from the beginning of the transaction, preferably as early as the initial contact with prospective purchasers and in the data room, that the transaction will be an "as is, where is" deal. "As is, where is" deals are not the norm in the industry and are usually only seen when assets are sold back to a previous promoter/owner, sold at auction or sold to the operator of the assets or another party in a position of having potentially greater knowledge about the assets than the seller itself But most purchasers are not so familiar with the assets being purchased and the typical purchase and sale agreement contains a combination of seller's representations and a due diligence "Defect" process. The balance between the two is driven by the mix of assets, the client's preferences, the expected future operations on the assets and the current market. A difficult balancing act indeed.

Sellers attempt to tip the scale in their favor by arguing that purchasers should verify all assumptions and facts about the assets through due diligence and the defect mechanism. Sellers want certainty as to the purchase price (and, hopefully, the resulting return on investment from the sale of the assets) and want to limit any risk for future liabilities. As a result, sellers want to limit the representations they give in a purchase and sale agreement. Purchasers may attempt to tip the scale in their favor by including broad representations from sellers, arguing that they are unable to unearth every fact about the assets during the due diligence period and that sellers should not be able to withhold information as to known material adverse issues regarding the assets. Further, purchasers argue that the defect mechanism in a purchase and sale agreement does not provide a remedy for all types of matters covered by representations. The scope and extent of representations result in an allocation of risk between purchasers and sellers. Such allocation of risk is under careful review and of material importance, not only to the seller, but also to its private equity investors, if applicable. The exit strategy and required rate of return by a purchaser necessitates the stability of minimal ongoing risk. As a purchase and sale agreement generally includes an indemnification of the purchaser for breaches of a seller's representations, post-closing indemnification obligations are at the front of every seller's mind.

REPRESENTATION AND WARRANTY CONSIDERATIONS

Sellers seek to limit their representations in order to minimize their share of the risk. As to those representations a seller is willing to make, the seller's goal is to make a representation completely true with as much certainty as possible by either narrowing the representation and/or making adequate disclosures. Means of limiting a representation and warranty include (i) materiality qualifications, or (ii) limiting to knowledge, scope or timing.

A purchaser also makes representations in the purchase and sale agreement. The majority of such representations are not controversial but rather are a mirror image of the fundamental...