CHAPTER 11 ALLOCATING LIABILITIES AND INDEMNITIES

• Jurisdiction: United States

Oil & Gas Agreements: Purchase & Sale Agreements
(May 2016)
CHAPTER 11
ALLOCATING LIABILITIES AND INDEMNITIES
Stephen C. Szalkowski ¹
Partner
Talia G. Jarvis ¹
Latham & Watkins
Houston, TX
Yvette Schultz
Director - Legal
Antero Resources Corporation
Denver, CO

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STEPHEN C. SZALKOWSKI is a partner in the Houston office of Latham & Watkins LLP. He is a member of the Corporate Department and the Mergers & Acquisitions and Oil & Gas Transactions Practice Groups. Stephen focuses his practice on domestic and international energy transactions with an emphasis on mergers and acquisitions, joint ventures, and other strategic combinations in the domestic upstream and midstream sectors. His expertise includes negotiating and drafting asset and equity purchase and sale agreements, exploration and development agreements, participation agreements, joint venture arrangements, including associated limited liability company and limited partnership agreements, joint operating agreements, services agreements, and midstream commercial contracts such as gas and oil gathering agreements, gas processing agreements, and terminalling and storage agreements. Stephen received his B.A. in Political Science from Williams College in 2004 and his J.D., with honors, from The University of Texas School of Law in 2007. He is admitted to practice in Texas.

YVETTE K. SCHULTZ is Director of Legal for both Antero Resources Corporation (NYSE: AR), a public company engaged in the development and acquisition of oil and gas properties in the Appalachian Basin in West Virginia, Ohio and Pennsylvania, and Antero Midstream Partners LP (NYSE: AM), a public master limited partnership engaged in the operation and development of midstream assets also located in the Appalachian Basin. She is also a member of the LSU Energy Law Center Advisory Board. Prior to her current position at Antero, she worked at both Vinson & Elkins, L.L.P. (2008-2012) and Latham & Watkins LLP (2012-2015) in Houston, Texas, where her practice focused on domestic and international energy transactions, with a primary emphasis on mergers, acquisitions and joint ventures. Ms. Schultz received her Bachelor of Science degree in Computer Science from the University of South Dakota in 2004 (graduating with honors; Phi Beta Kappa) and her Master in Business Administration degree from the University of South Dakota in 2005 (summa cum laude). She went on to Louisiana State University, earning both her Juris Doctorate and Bachelor of Civil Law degrees in 2008 from the Paul M. Hebert Law Center where she graduated #1 in her class (Louisiana Law Review; Order of the Coif). As part of her B.S. and M.B.A. degrees, she worked full-time as both a technology fellow and as a graduate assistant. Raised in South Dakota, Yvette now lives with her husband in Denver, Colorado.

I. Introduction

There are three key elements of an oil and gas purchase and sale agreement (an "Oil & Gas PSA" or "PSA") that will be the primary drivers behind the determination of the overall consideration (and therefore true value) to be received by the seller ("Seller") and paid by the buyer ("Buyer") under such PSA. The first, and most obvious, element is the purchase price itself and the related purchase price adjustment mechanics. The second element, which is generally unique to Oil & Gas PSAs, is the title defect and environmental defect mechanisms. The third and final key element, which is the subject of this article, is the allocation of liabilities related to the assets or equity interests being purchased (referred to herein as the "Target Assets" or "Target Interests", as applicable) and the scope of the parties' indemnification obligations contained in the applicable PSA.

As with the purchase price and related adjustment provisions and the title defect and environmental defect mechanisms, the allocation of liabilities under a PSA and the scope of indemnification obligations contained in a PSA will have a direct impact in determining the true value of the transaction to the Seller and Buyer. Understanding the nuances of allocating liabilities under a PSA and the intricacies involved in crafting the indemnification obligations contained in a PSA are two important ways that a practitioner can add value to a transaction involving an Oil & Gas PSA and protect his or her client's interests by minimizing the client's direct and indirect risk of, and exposure to, potential post-closing liabilities under the PSA.

This article surveys the various concepts, issues, and provisions that a practitioner will need to consider when structuring, negotiating, and drafting the allocation of liability provisions and indemnification mechanisms under an Oil & Gas PSA. Grasping the interlocking nature of the applicable provisions, understanding the common issues and pitfalls, and appreciating the goals (and related strategies) of a Buyer and Seller under an Oil & Gas PSA will enable a practitioner to be better informed, and therefore better able to represent his or her client, with respect to the transaction underlying the PSA.

II. Assumption and Retention of Liabilities

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A. Transaction Structure

Whether an Oil & Gas PSA contemplates a purchase of Target Assets (an "Asset PSA") or a purchase of Target Interests (an "Equity PSA"), the PSA will typically expressly set forth the agreements between the Buyer and Seller regarding the assumption and retention of liabilities related to the Target Assets or Target Interests (which, indirectly in the case of an Equity PSA, will include liabilities related to the underlying assets). Absent any such agreement (and corresponding PSA provisions), the Buyer and Seller could find that both parties may be liable to a third party for the same obligation, depending on the facts and circumstances involved and which party the applicable third party claim is made against. Although the precise allocation and retention of liabilities between the parties will depend on the facts and circumstances of the particular transaction and the negotiating power of each party, as a general matter, in determining whether to structure a transaction as an asset purchase or an equity purchase, the Buyer should consider the potential risk of assuming significantly greater liabilities under an Equity PSA than an Asset PSA.² Additional considerations, ranging from commercial points (e.g., the presence of significant consent restrictions and/or preferential purchase rights burdening certain assets) to tax treatment, will be important to parties in determining how to structure a given transaction.³

Under an Equity PSA, when the Buyer acquires the Target Interests, the Buyer inherits, by operation of law, all of the acquired entity's (the "Target Company") liabilities, past, present, and future, to the extent associated with the Target Interests, regardless of the negotiated agreements between the parties under the applicable Equity PSA with respect to the assumption and retention of such liabilities (but subject to the Buyer's indemnity rights under such Equity PSA).⁴ This outcome is in stark contrast to what occurs under an Asset PSA, where the Seller retains possession of the legal entity that formerly held the Target Assets and all obligations and liabilities associated with such entity, other than any such obligations and liabilities with respect to the Target Assets that are assumed by the Buyer pursuant to the Asset PSA. It is important to note that a party may not be able to avoid certain obligations and liabilities simply through consummating a transaction under an Asset PSA as opposed to an Equity PSA. For example, certain environmental laws provide that a current property owner will be jointly and severally liable for environmental contamination of such property, regardless of when (or under which

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party's ownership) such contamination occurred.⁵ In addition, a Buyer may have successor liability for a Seller's unfair labor practices, employment discrimination, or pension obligations.⁶ Although the Seller will commonly provide the Buyer with indemnity coverage for these types of liabilities, a contractual indemnity is not in itself a defense at law and therefore the Buyer will bear the risk of being found to be legally responsible for such liabilities in the event the applicable Seller is no longer able to indemnify the Buyer as required under the applicable PSA, for example, if the Seller were to become insolvent.

B. Assumed Obligations, Expressly Retained Obligations, and Standalone Seller Indemnities

In both Equity PSAs and Asset PSAs, the liabilities that a Buyer assumes with respect to the Target Assets or Target Interests pursuant to such PSAs, whether explicitly in the case of an Asset PSA or implicitly in the case of an Equity PSA, are referred to herein as "Assumed Obligations". In those cases where a Buyer chooses to structure the transaction as a purchase of Target Assets, the applicable Asset PSA should identify Buyer's Assumed Obligations with as much specificity as possible in order to minimize unanticipated exposure through assumption. As described above, this same consideration is not as crucial under an Equity PSA, as the Buyer will, by operation of law, assume all liabilities of the Target Company associated with the Target Interests. In the Asset PSA context, any liabilities related to the Target Assets that are expressly excepted from the Assumed Obligations and that the Seller agrees, pursuant to the PSA (and related assignment documentation), to retain are referred to herein as "Expressly Retained Obligations".

Whether or not a particular liability with respect to the Target Assets or Target Interests is assumed by the Buyer as an Assumed Obligation, it is common that Oil & Gas PSAs contain certain standalone indemnification obligations from the Seller that cover certain liabilities outside of the scope of the Expressly Retained...