CHAPTER 12 TYPICAL AND ATYPICAL PURCHASE PRICE ADJUSTMENTS

• Jurisdiction: United States

Oil & Gas Agreements: Purchase & Sale Agreements
(May 2016)
CHAPTER 12
TYPICAL AND ATYPICAL PURCHASE PRICE ADJUSTMENTS
Michael De Voe Piazza
Partner
Willkie Farr & Gallagher LLP
Houston, TX
David A. Aaronson
Associate
Willkie Farr & Gallagher LLP
Houston, TX

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Protecting Value and Mitigating Risk: Typical and Atypical Purchase Price Adjustments in Oil and Gas Transactions

I. Introduction.¹

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In acquisitions and divestitures involving interests in upstream oil and gas assets,² there is often a period that spans several weeks or months between the parties' execution of a definitive purchase and sale agreement (a "Purchase Agreement": the date on which such execution occurs, the "Execution Date") and the closing of the transactions contemplated by such Purchase Agreement (such transactions, the "Transactions": such closing, the "Closing": the date on which the Closing occurs, the "Closing Date"). In Transactions employing such a "deferred-close" timeline (particularly those involving a pre-Closing Effective Time (as defined below)), a Purchase Agreement is an executory contract containing certain performance obligations for each of the purchaser and the seller that must be performed for the Closing to occur, absent a waiver of that performance.³ Title and the benefits and burdens of ownership do not pass on the Execution Date; however, instead, only equitable title passes to the purchaser at that time, with retroactive effect (to the Effective Time) in the event the Closing occurs.⁴

What an oil and gas asset or an oil and gas company is worth today may be different than what that oil and gas asset or oil and gas company is worth a month from today, for reasons that include changes in commodity prices (both current and forward prices), natural depletion in hydrocarbon reserves as a result of production, unanticipated new discoveries, or anticipated new discoveries that prove less promising than expected. But purchasers and sellers have to start somewhere. Purchasers' economic models pivot off of, and purchase price negotiations between purchasers and sellers settle on, an "effective time" for valuation purposes. To this end, it is customary for a Purchase Agreement to include an effective time (the "Effective Time"),⁵ which is typically a date prior to the Closing Date (and prior to the Execution Date). In our experience, it is typical for the Effective Time to be a date that occurs anywhere from one to three months prior to the Closing Date. This fixed valuation date affords the parties a sufficient amount of time to gather, examine, diligence and audit certain accounting, financial, and operational data and other information that is necessary in evaluating, negotiating and consummating the Transaction. However, because the seller is, directly or indirectly, effectively owning and, often, operating the relevant assets or target entity for the benefit of the purchaser for the period beginning at the Effective Time and ending on the Closing Date (such period, the "Interim Period"), it is typically in neither party's interest for this period to extend longer than necessary.⁶

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The incentives of the parties are aligned during this time only in their mutual desire for the Closing to occur, not because ordinary course "upside" and "downside" are shared during the Interim Period. In addition, a longer Interim Period increases the importance of purchase price adjustment mechanisms. The seller will typically prefer a shorter Interim Period for purposes of limiting its potential liability and risk exposure related to assets that the purchaser beneficially owns. With no real "upside" during the Interim Period, the seller is often motivated only to maintain the status quo and avoid unexpected contingencies and liabilities. By contrast, the purchaser, who typically possesses the "upside" and "downside" during the Interim Period, typically prefers to assume ownership (and, if applicable, operations) as soon as possible rather than leaving the assets or equity in the hands of a "contract operator" who is essentially compensated on a cost basis, without markup or profit, and who may not be motivated to optimize production results or limit contingent liabilities that could prove material.

During the period between the Execution Date and the Closing, the Purchase Agreement typically requires the seller to continue owning (and, to the extent applicable, operating) the subject assets in the ordinary course. In addition, the seller is typically subject to a suite of restrictions on its activity during this period, including restrictions on certain elections it may make with respect to the assets, entering into, modifying, or terminating material contracts, making capital expenditures, or otherwise taking (or choosing not to take) actions that could materially affect the value of the assets during the Interim Period.⁷ The purpose of these interim covenants is to maintain and otherwise protect the value of the assets or the equity in the target entity and the purchaser's benefit of the bargain expectations with respect thereto. That said, the period between the Execution Date and the Closing may or may not prove a "boring" extension of the status quo, and the suite of interim covenants cannot specifically address all issues that could affect the value of the assets or equity of the target entity during this time. To this end, Purchase Agreements typically include a number of purchase price adjustments that are taken into account when calculating the final purchase price.

This article will consider and discuss asset and equity Transactions in the upstream oil and gas industry, specifically focusing on (a) the choice between an asset Transaction and an equity Transaction, (b) typical purchase price adjustments in oil and gas asset Transactions, (c) typical working capital adjustments in equity Transactions, (d) examples of atypical purchase price adjustments in asset and equity Transactions, (e) accounting settlement processes and

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pitfalls in both asset and equity Transactions, (f) purchase price adjustment mechanisms based on changing commodity prices, and (g) protecting value through hedging.⁸

II. The Choice between an Asset Transaction and an Equity Transaction.

A significant first step towards consummating a Transaction involves selecting an optimal structure. Asset Transactions are and have been the most customary structure for upstream oil and gas Transactions for a number of reasons. Oil and gas properties are interests in land that, on a small scale, are traded, swapped and exchanged through the execution of asset-level instruments of conveyance filed in the county courthouse. These are straightforward, discreet, private trades that involve asset-level diligence and ease of execution rather than the complexities associated with buying a business. The industry has grown accustomed to, is familiar with, and trusts asset-level Transactions, and many industry participants are unwilling to abandon this structure absent a compelling reason. In addition, many oil and gas companies acquire various interests in only one or very few entities and enter into joint venture transactions ("JV Transactions")⁹ that often do not involve selling all of the assets or equity interests in one company. Unless the Transaction is an "exit transaction" for a seller, sellers often regard selling a portion of assets as the optimal approach.

In addition to prevailing industry custom and usage, asset Transactions are often the preferred structure when the legacy entity (i.e., the seller) is, or may become, subject to significant residual or contingent liabilities, including environmental and tax liabilities. In the event that a legacy entity is, or may become, subject to these liabilities, the structure of an equity Transaction often means that the purchaser will inherit or "step into" these liabilities. By contrast, an asset Transaction can substantially mitigate the risk that the purchaser automatically assumes these liabilities.¹⁰

Equity Transactions are often the preferred structure when assets are burdened by preferential rights to purchase or other assignment restrictions that would prevent (or significantly complicate) an assignment of the assets to the purchaser in an asset Transaction.¹¹ Because the entity owning the assets does not change in an equity Transaction, preferential purchase rights and assignment restrictions are not typically triggered unless they are drafted specifically to include a change of control (or other similar business combination) of the assets'

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owner. Further, in situations involving legacy entities with significant operations, including a large number of employees, a host of employee-related benefit plans, assets located in multiple jurisdictions, or special permit or contracting considerations,¹² equity Transactions often prove an optimal structure in that they limit transition costs and allow the purchaser to step into the shoes of an already going concern. Finally, in cases where a seller or its key persons are required to "roll" (e.g., reinvest in the business following the Transaction), it often makes more sense, including to achieve tax objectives, to sell all or a portion of the equity of the legacy entity to a holding company in which both the seller and the purchaser invest, rather than conveying certain interests on an asset level.

As a final matter, it should be noted that the choice between an asset- or equity-based structure is not always binary; hybrid approaches and pre-Transaction restructuring can assist the parties in striking the economic deal that most closely represents their desired business outcome.

III. Typical Purchase Price Adjustments in Asset Transactions.

A. Purchase Price Adjustments, Generally.

The period between the Execution Date and the Closing Date in an asset Transaction (with a...