CHAPTER 4 MAJOR PURCHASE AGREEMENT ISSUES

• Jurisdiction: United States

Oil and Gas Acquisitions
(Nov 1995)
CHAPTER 4
MAJOR PURCHASE AGREEMENT ISSUES
Steven B. Richardson ¹
Holme Roberts & Owen LLC
Denver, Colorado

TABLE OF CONTENTS

SYNOPSIS
Page

Introduction

Objectives of the Parties

I. Representations and Warranties

A. General Purpose

B. Seller's Representations and Warranties

C. Purchaser's Representations and Warranties

D. Stock Purchase Representations

II. Covenants

III. Due Diligence Rights and Procedures

A. General

B. Title Procedure

B. Other Matters

IV. Conditions to Closing

V. Purchase Price Adjustments

VI. Post-Closing Indemnities

A. Matters Covered by the Indemnities

B. Losses Covered by the Indemnities

C. Survival and Time Limits for Indemnity Claims

D. Procedures; Dispute Resolution

E. Security for Indemnity Obligations

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VII. Contract Law Principles and Remedies

A. Basic Contract Law Principles and Remedies for Breach

B. Closing Conditions

C. Other Contract and Tort Issues

Conclusion

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Introduction

Purchase agreements for acquisitions of oil and gas properties take many forms, from single page instruments that look like a summary of a term sheet which the parties intend to constitute a binding agreement, to letter agreements for smaller transactions that briefly address the principal terms, to hundred page documents that address almost every conceivable issue in some detail—detail that often seems to the client during the negotiations to be unnecessarily excruciating and tedious but which, to the discomfort of the lawyer, is guaranteed to be silent or ambiguous as to whatever the disputed issue is that arises after signing. The purchase agreement should unambiguously express the basic business deal and terms agreed upon by the parties, which often occurs before the first call to the lawyer, and further reflect that deal in a coherent way in the representations and warranties, due diligence rights, conditions to closing and indemnities.

Companies have been buying and selling oil and gas properties for over a hundred years. It has been said that the original trust indenture for municipal bond issues came over on the Mayflower, it has become so recognizable and standardized. Although purchase agreements for oil and gas transactions are not quite so venerable, they have assumed certain standard patterns. The focus of these agreements changes over time depending upon the seller's and purchaser's individual concerns in a given transaction, whether it is a seller's market or buyer's market and changes in law. For example, environmental representations, due diligence provisions and indemnities are often the most time consuming and heavily negotiated provisions as a result of the development over the last 20 years of new and sometimes startling environmental liabilities and uncertain risk exposures. In 2010 there will likely be additional significant concerns. It is the job of the attorney drafting and negotiating a purchase agreement, whether for a billion dollar acquisition or a $100,000 one, to balance the desirability of precision and thoroughness against the respective parties' needs, patience and expectations. No matter how often one negotiates a "standard" purchase agreement there is usually something unique about the transaction that will require the lawyer to reexamine his "standard" form and how it may be changed to accommodate the rational concerns (or the irrational but harmless idiosyncracies) of the parties without unintentionally affecting some other right under the agreement. This paper explores the

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structure of the typical purchase agreement for a package of producing oil and gas properties, with some development potential, the key provisions and their interrelationship.

Objectives of the Parties

The objectives of the seller and purchaser of producing oil and gas properties are obviously different. The seller has decided to sell for any number of reasons—the properties may not fit the seller's corporate objectives, a large oil company may not be interested in properties nearing their economic life given the company's overhead, the seller may be shedding domestic production, consolidating its operations elsewhere, closing its regional office where the properties are located, a family owned company may be getting out of the oil business entirely, the seller may have decided to focus on other "core" businesses, may not want to operate properties anymore, may need cash, may not be able to utilize tax credits that it can monetize by selling the properties, or may believe the price of oil is about to significantly decline and its money better invested in T-Bills or real estate. Once the seller has decided to sell, its objective is then to maximize the price it receives without having to incur undue additional time, expense or interruption of its other activities in making the sale, get to a closing quickly, sell all of the properties, limit its future environmental and other liability from the properties, and transfer operations and accounting burdens to the purchaser as soon as possible after closing.

For an equally diverse set of reasons, the purchaser has a general desire to purchase oil and gas properties — it believes it can operate more efficiently than the seller, that oil and gas prices will significantly increase in the long run, it is focusing on the particular area or already owns an interest in the subject properties, or it believes there is development or infill potential or that deeper or shallower formations are attractive. Whatever reasons motivate the purchaser generally to desire to purchase oil and gas properties, the purchaser has always made a very specific judgment that it desires to purchase the particular properties because it believes it will realize an attractive return from the properties compared to other available investment opportunities — whether by simply producing the properties, undertaking workovers, reducing operating costs, infill or development drilling, taking advantage of tax credits, promoting other parties through direct participation, a securities offering (of partnership interests, royalty trust units, or of the purchaser's own stock bolstered by the additional income from the properties), or direct use of the product (e.g., refiner, utility or independent power producer). The purchaser wants to use the purchase agreement to tie up the deal, as a vehicle to verify and protect its assumptions in pricing the properties and to get comfortable with the potential liabilities associated with owning the properties. The agreement will often have to have sufficient flexibility for the purchase to simultaneously satisfy a lender or investor.

It is important for the lawyer to understand his client's particular objectives which should be reviewed and understood prior to drafting the purchase agreement or commencing negotiations. The client may not volunteer this information and sometimes wonders why the lawyer is spending billable time inquiring in detail about the economic aspects of the business deal and does not just get on with drafting the agreement. It is far better to extract tactfully this

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information at the beginning of a transaction than to experience the sinking feeling several drafts and many days' of negotiation later that some issue of importance to your client is not covered by your "standard" form and to be faced with raising new issues and the concomitant ire of the other party and its attorneys.

The economic evaluation of one producing oil and gas well and the development potential of associated acreage is complex. This complexity increases markedly as a package is expanded to include dozens or hundreds of wells in various states and at different stages of their economic life, to include wells that are required to be plugged and abandoned, gas processing plants, saltwater disposal facilities, old pits and other sites and facilities with potential environmental problems, and a multitude of marketing, operating and development arrangements. It is beyond the scope of this paper, and competence of this author, to explain in detail the judgments involved. However, such evaluation entails a review of the well's historical decline curve, the potential to increase production through workovers and other operations, operating costs and the potential to reduce operating costs, prices received for production and the development potential of other formations. In multi-property transactions the evaluation is usually embodied in an engineering report that projects the estimated future decline curve for each well, operating costs, prices for production and escalations thereof, and tax burdens, and then discounts the projected net income stream from the properties to a net present value using various discount rates. Where a package of properties is being marketed by the seller it will often retain an independent petroleum engineering firm to prepare the reserve report which the purchaser may adjust to reflect its own assumptions regarding pricing, development potential and discount rates. In smaller transactions the purchaser may not prepare an engineering report and will base its offer price on some more basic economic evaluation such as some multiple of current cash flow from the properties. The engineering report and the purchaser's evaluation is premised on the assumption that the seller has the right to produce the oil and gas, has correctly stated its working interest share of expenses and net revenue interest share of production including any after payout or other reversionary interests, and numerous other matters. Especially with respect to a large package of attractive properties for which offers have been widely solicited from multiple bidders, in today's market the successful bidder will probably have had to stretch to find some extra "value" in the deal beyond just extrapolating existing production. The...