CHAPTER 8 NEW FORMS OF EQUITY FINANCINGS
| Jurisdiction | United States |
(Nov 1982)
NEW FORMS OF EQUITY FINANCINGS
Kutak, Rock & Huie
Denver, Colorado
INDEX
Introduction
Royalty Trusts
Royalty Trusts--What Are They?
Trustee
Duties of Grantor
Purposes of Royalty Trusts
Securities Law Concerns
In Contrast to Royalty Funds
Tax and Accounting Considerations
Acreage Financings
General
Securities Law Concerns
Other Equity Financing Techniques
General
Delayed Convertible Offerings
Mandatory Stock Purchase Contracts
Proposed Changes in Limited Partnership Offerings
The Equity-Income Offering
Introduction
How Equity-Income Transactions Work
General
Equity-Income Offering vs. Other Financing Techniques
Oil and Gas Exchange Offers
Appendices 24
A. Houston Oil Royalty Trust 24
B. NASD Notice to Members 82-13 41
C. NASAA Exchange Offer Proposal 50
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NEW FORMS OF EQUITY FINANCINGS
Introduction
In the recent past, issuers have experienced difficulties in financing their operations through the equity markets. The reasons for these difficulties have to do not only with the condition of the equity markets in general being in a depressed condition but also because of other conditions with respect to mineral activities in particular, such as a decrease in the price of petroleum, an increase in the supply available, and general worldwide conditions for petroleum products affecting supply and demand.
It is against these conditions that issuers have recently begun to devise new and novel methods of equity financing for their operations. While most of the new and unique financing methods that are being described in this outline involve primarily oil and gas matters, many methods also are directly applicable to the mineral industry in general and would be available to that industry if equity financing is required with respect to their operations.
ROYALTY TRUSTS
Royalty trusts as a financing technique appear to have great potential and have been used over the past couple of years with greater frequency. While royalty trusts have not been used extensively, they do have great potential particularly in this market environment, and, because of this appeal, this paper will go into some depth with respect to royalty trusts in order to allay some of the misconceptions that have arisen when considering dealing with them.
In order to more easily assist the reader in following the discussion herein, there is included in the Appendix to this material certain excerpts from the Houston Oil Royalty Trust prospectus.1
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Royalty Trusts—What Are They?
A royalty trust is an entity that holds overriding royalties or other interests that are carved from oil and gas or other leasehold interests.2 If structured properly, the income to the royalty trust is taxed at the investor rather than the trust level. A trust is formed when the sponsor, which is normally a corporation,3 carves out the royalty interests from leasehold interests that it maintains in inventory or acquires and transfers those interests to the trust to be created. In a financing transaction, the interests are transferred to the trust in exchange for funds obtained by the trust in issuing trust interests to the public.
The interests by the trust are fractionalized and sold or distributed to public investors who then own units of beneficial interest in the trust. It is important to note that the interests held by the trust are passive in nature; in otherwords, they are nonworking interests owned by the trust for which the trust gets an overriding royalty interest or a share of net profits from operations. As an owner of overriding royalty interests, net profits or other interests, the trust has no right to cause the leasehold owner, from which the interest is carved out, to drill on the property, complete wells, develop wells or have any control over the production from any wells once production is established.4
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The trust when it is formed establishes a contractual relationship between the trust, the trustee of the trust and the beneficial owners thereof. The trust agreement sets forth in detail all rights and obligations of the parties thereunder. In particular, it establishes the terms of the trust, the business of the trust, the nature of the trustee's activities and his involvement with respect to the operation of the trust, divides profits derived from operating the trust and sets forth other relevant contractual rights of the parties.
Royalty trusts, while similar to limited partnerships, have one overriding advantage in that the beneficial trust interests held by investors are freely transferable and most of the major trusts have their interests listed on national securities exchanges.
Trustee
The trustee's duties, as established by the trust agreement, basically include ministerial duties that the trustee is allowed which include receiving, holding and distributing revenues received with respect to the mineral interests held by the trust.5 In this regard, it is important to note that for tax purposes the trustee does not manage the properties as one normally would associate management of oil and gas properties.6 The trustee is not allowed to invest in additional properties and therefore he cannot hold back any revenues received with respect to the interest held. Fees are paid out periodically, normally at monthly intervals, with the trustee retaining such fees as are established by the trust agreement. As an example, the agreement included in the Appendix with respect to Houston Oil Royalty Trust establishes fees initially in the amount of $100,000 per year to pay for administrative fees, accounting fees, engineering fees and legal fees of the trustee. While such fees may appear rather high, it should be noted that the size of the trust there being administered is in the neighborhood of $60 million.
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Another activity that the trustee must administer is the issuance of periodic reports as required by the trust agreement and applicable securities laws.7 The nature of the reports and the timing thereof may be affected by whether the trust is registered under the '34 Act and whether the North American Securities Administrators Association ("NASAA") guidelines relating to oil and gas disclosures are also applicable with respect to the distribution thereof. Normally, periodic reports are required to be prepared by the trustee quarterly, tax information must be provided to beneficial owners within 90 days of the calendar year end and audited financial statements must be provided to beneficial owners within 120 days of the end of the issuer's fiscal year.
The question of who is the appropriate entity to be the trustee under a royalty trust is dictated by various concerns. For instance, state law under which the trust agreement is established may provide that only certain persons, such as banks and other companies that are allowed to maintain trust powers, may act as the trustee. Even if state law does allow other entities to act as a trustee, there may be other overriding concerns dictated by the marketability of the beneficial interests. For instance, a major underwriter for purposes of marketing the beneficial interests may require that a major bank or trust company be designated as a trustee.8
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Duties of Grantor
The grantor or the creator of the trust generally has little or no duties with respect to the maintenance of the trust once it is established. There may, however, be situations where the grantor is the operator of the properties transferred into the trust and, as operator of the properties, may have drilling or other commitments with respect thereto. Likewise, if the grantor is the operator of the properties, there probably will be some duty to provide reserve, drilling and other data with respect to the oil and gas properties to the trustee in order for the trustee to properly and accurately prepare data for submission to the beneficial owners and for purposes of the reporting requirements of the '34 Act, if applicable.9
Purposes of Royalty Trusts
The creation of royalty trusts can be for many varied purposes. For the primary purpose of this article, royalty trusts can be used as financing transactions in that the sponsor of the trust is in essence capitalizing in-ground reserve assets at favorable interest rates by selling beneficial interests therein to the public. This is the purpose of the Houston Oil Royalty Trust included with these materials. Secondly, royalty trusts can be used to transfer income producing property to shareholders in the form of a spinoff for reasons which include increasing the market value of securities that are under-valued,10 changing the nature of a company,11 as a defensive
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tactic to takeover or tender offer attempts12 and to create a smaller company for which larger relative potentials of discovery are available.13 A royalty trust can also be used to assist in financing an acquisition such as in the case of the second royalty trust established by Houston Oil.14 Lastly, it would appear that royalty trusts can be used for financing other activities such as leasehold acquisitions, development activities and acquiring the outstanding securities of the sponsor and others. See Equity-Income Offerings, infra.
Using royalty trusts as a financing vehicle involves the beneficial interests in the trust being sold to the public for cash which is used to purchase the interests from the sponsor. One way to more easily follow such a vehicle is to analyze the first Houston Oil Royal Trust. The Houston Oil Royalty Trust involved the transfer by Houston Oil of overriding royalty interests on producing as well as exploratory acreage. Title to the properties, however, was held in the name of a general partnership rather than the trust for tax and state law purposes as described in the attached material. The trust...
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