1. Introduction
A distinguishing feature of the oil and gas industry is the significant level of cooperation that exists between competitors, particularly in respect of the upstream aspects of petroleum operations. This cooperation is driven to a large extent by oil and gas companies’ need to share the extensive risks and high costs of upstream operations, thereby reducing their exposure to individual assets. It also means that there is a particularly active market for the acquisition and disposal of upstream interests in the oil and gas industry.
This chapter analyses: the different methods by which upstream interests can be transferred from one party to another; the key considerations influencing the choice of sale structure; the sales process; and the key elements of the sale and purchase agreement. An upstream interest typically includes the rights acquired under a petroleum exploration and/or production concession, a joint operating or venture agreement and other ancillary agreements, for example petroleum processing, transportation and sale agreements.
2. Takeovers
A public takeover is the acquisition of control of a company which is listed on a regulated market and is the most regulated, although not necessarily the most complex, form of upstream transfer. It involves the takeover of a company that is the direct or indirect owner of the assets, rather than the assets themselves. Takeovers in the United Kingdom are governed by the City Code on Takeovers and Mergers (or ‘the UK Takeover Code’). The code applies to offers for, and other transactions involving a change in control of, companies with their registered office in (or who are considered to be resident in) the United Kingdom, the Channel Islands or the Isle of Man, if any of their securities are admitted to trading on a regulated market or a multilateral trading facility in the United Kingdom or on any stock exchange in the Channel Islands or the Isle of Man. The Main Market of the London Stock Exchange is the only recognised regulated market in the United Kingdom. With effect from 30 September 2013 the residency test no longer applies in respect of companies that have their registered office in the United Kingdom, the Channel Islands or the Isle of Man and which have their securities admitted to trading on a multilateral trading facility such as the Alternative Investment Market (AIM) or the ISDX Growth Market. As such, all companies whose shares are traded on AIM or ISDX are subject to the code regardless of whether they have their central management and control overseas. Jubilee Easo
Andrews Kurth Joanna Kay Tullow Oil
The code does not apply to private companies unless there has been some marketing of their shares to the public in the previous 10 years.
The code applies to takeover and merger transactions, however they are effected, including by means of a statutory merger or court-approved scheme of arrangement. It imposes a set of statutory rules on all such transactions creating the form, structure and timetable of the transaction in order to ensure the fair and equitable treatment of shareholders in the target company.
A number of other UK statutory and regulatory provisions import conditions on the nature of the sales process where a target company is publicly listed. These include insider-dealing provisions under the Criminal Justice Act 1993 and Financial Services Act 2000, market abuse and financial regulations under the Financial Services and Markets Act 2000, shareholder consents under the Listing Rules, disclosure and transparency obligations under the Disclosure Rule and Transparency Rules and the Prospectus Rules as well as merger controls under the Competition Act 1998, the Enterprise Act 2002 and EU Merger Regulation.
The vast majority of public takeovers and mergers take the form of private company and asset acquisitions and so this chapter will focus primarily on the issues surrounding these transactions.
3. Share sales and asset sales – making the choice
If a party wishes to acquire or dispose of an upstream interest, one of the first issues to be addressed is whether the interest will be transferred by means of a share sale or an asset sale. Consideration will be given to the tax and business aspects of the transaction in order to agree a structure which is commercially acceptable to both parties. In addition, there are a number of legal issues outlined below that will drive the decision-making process.
3.1 Assets and liabilities
What a purchaser acquires in a share sale and an asset sale are fundamentally different.
In a share sale, the share purchase agreement (SPA) effects an indirect transfer of the upstream interest through the sale of the share capital of the target company that holds the relevant upstream interest. The purchaser therefore acquires all of the rights and liabilities of the target company, known and unknown, including those arising prior to the acquisition. The purchaser will generally need to undertake extensive due diligence into the financial, legal, tax and commercial position of the target company and seek disclosure from the seller of all liabilities of the target company in order to identify and quantify the risks associated with the purchase of that company.
In an asset sale there is instead a direct transfer of the relevant upstream interest. The purchaser will acquire only those assets, rights and liabilities expressly transferred to the purchaser in the sale and purchase agreement. There are limited exceptions to this principle: in certain jurisdictions regulatory requirements impose additional liabilities on the holder of an asset. In the United Kingdom, for example, liability for the decommissioning of an installation can be imposed on any party
entitled to derive a financial or other benefit from that installation. Notwithstanding these limited exceptions, asset sales offer the purchaser the advantage of being able to cherry-pick assets that have the greatest financial or strategic value to it and to insulate itself from most unwanted liabilities that may be associated with those assets.
3.2 Complexity
Whereas an asset sale allows the purchaser to select only those assets that it perceives to be of value, an asset sale brings with it the additional complication of requiring the purchaser to identify each of the assets it wishes to acquire. This may be a relatively simple task where an asset is in the exploration phase of its life cycle but becomes considerably more complex where an asset has moved into a development or production phase. Without careful scrutiny of the contractual arrangements associated with an asset, a purchaser could discover too late that the perceived value of an asset has been substantially eroded by the omission from the sale and purchase agreement of a key contractual arrangement that underpins the asset.
Notwithstanding the relative simplicity of the sales process in a share sale, additional complexity may be created prior to the sale in order to package up the upstream interests in a single target company, or after the sale in order to extract those interests from the target company. Where a business has grown organically, the assets and services required to operate that business may not all be situated neatly in a target company ready for sale. A pre-sale reorganisation may therefore be required to clean up an existing subsidiary to ready it for sale or to establish a new special purpose vehicle to package up upstream interests that were formerly sitting in a number of different subsidiaries for the sale process. A post-sale reorganisation may equally be required by the purchaser once the sale process has completed. This may be driven by the need to move the target company to a more appropriate place in the group structure of the purchaser (since the tax structuring of the original acquisition may have resulted in the target company sitting in a sub-optimal place from an operational perspective). Equally, where the target company was previously a trading company in the seller’s group, the purchaser may wish to transfer the constituent assets into a known or clean entity and liquidate the target company in order to remove from its books a company that it knows little about. Whether effected pre or post sale, any reorganisation of the target company will need proper documentation. Intra-group transfer arrangements may be structured as either an asset sale or a share sale but, regardless of the approach, the documents will typically be much shorter than in a true arm’s-length sale. Care will also need to be taken in the structuring of the consideration of any intra-group transfer to ensure there is no unintended under-valuation of the transferred interests that could trigger company law issues and invalidate the transaction or expose the directors to civil or criminal liabilities.
The sale process for a share sale will involve the transfer of only one asset: the shares in the target company. The transfer of title to those shares from the seller to the purchaser will usually be effected relatively simply by registration in the members’ registry of that target company. In contrast, in an asset sale there may be
a number of different types of assets being transferred (concession interests, trading arrangements, real property and/or intellectual property) with different procedures and registrations required to effect a valid transfer of each type of asset.
3.3 Consents
Asset sales involve a change in the asset holder and generally existing contracts or trading arrangements do not automatically transfer to the purchaser. Transfers will invariably require the consent of third parties to the various contracts, adding time to the sale process and creating scope for those third parties to impose new terms to gain advantage from the change, or even to refuse the transfer.
In a share sale, the relationship between the target company and its contractual counterparties and suppliers does not change. This considerably reduces the number of third-party consents which may be required to effect a transfer of the target company and consequently reduces the potential for value impairment of the underlying business as a result of the transfer. As a result, share sales are often simpler to implement than asset sales.
In certain circumstances, however, the requirement to obtain consent may be triggered not only by a change in ownership of the upstream interest itself but also on a share sale as a result of a change in ownership of the ultimate owner of the upstream interest, so-called ‘change-in-control’ clauses. In the oil and gas industry, the underlying concession which grants title to the upstream interest will often contain such a change-in-control clause. Thus host government consent is likely to be required on both an asset sale and a share sale. Change of control clauses may also be incorporated in other contractual arrangements relevant to the upstream interest; a careful analysis of those arrangements should be undertaken as part of the acquisition due diligence process.
3.4 Pre-emption rights
Pre-emption raises specific concerns in oil and gas acquisition transactions as joint operating agreements commonly include a pre-emption right to allow existing co-venturers to control the entry of a new participant into the joint venture. Typically, pre-emption rights under a joint operating agreement are triggered only on an asset sale and require the selling party to offer its co-venturers a priority right to acquire the upstream interest offered for sale on the same terms and conditions as those agreed to by a third-party purchaser. If a pre-emption right applies, the purchaser will need to ensure that any co-venturer’s right to pre-empt a transfer under the joint operating agreement is waived as a condition precedent to the purchaser’s obligation to acquire the upstream interest.
While less common, pre-emption may also apply on a share sale where a co-venturer’s right to pre-empt is triggered by a change of control in the asset-holding company. In such a case, the asset-holding company is required to offer its co-venturers a right to acquire the upstream interest offered for a monetary amount equivalent to the value ascribed to the upstream interest in the share sale. The valuation method and a mechanism to resolve any valuation disputes will need to be clearly described in the sale and purchase agreement.
3.5 Taxation
The tax consequences arising on a share sale are quite different from those arising on an asset sale. As a result, taxation is often one of the most influential factors in structuring the acquisition or disposal of upstream interests.
As a broad generalisation, the tax advantages of a share sale will usually be preferable for a seller whereas the tax advantages of an asset sale will usually be preferable for a purchaser. However, the specific circumstances of the companies and assets involved will be the determining factor.
4. Documenting an asset sale
Asset sales can broadly be categorised into four different types reflecting the form, nature and timing of the consideration paid by the purchaser for the asset: sale and purchase; farm-in/farm-out; earn-in; and exchange of assets.
4.1 Sale and purchase
In the simplest formulation, the seller agrees to transfer some or all of its interest in an upstream interest and the purchaser agrees to pay to the seller an upfront cash consideration upon completion of the sale of the upstream interest. The basis on which the consideration is paid for the asset and the terms of the agreement reached between the seller and the purchaser for the transfer will be documented in a sale and purchase agreement. Such agreements typically do not include any restrictions or requirements in relation to the ongoing obligations (or work commitments) of the purchaser as defined under the terms of the underlying concession and joint operating agreement.
4.2 Farm-in/Farm-out
A form of asset acquisition which is almost exclusively used in the oil and gas industry is the farm-in/farm-out (where the choice of terminology is dependent upon the party in question’s perspective). In general terms, a farm-out is a form of asset sale whereby the seller (or farming-out party) agrees to transfer part of its interest in an upstream interest to the purchaser (the farming-in party) while continuing to retain part of the upstream interest. The farm-out construction enables the farming-out party to reduce its exposure to an upstream interest and to finance the work commitments it is obliged to deliver under the terms of the underlying concession and the joint operating agreement.
The distinguishing feature of a conventional farm-out agreement is the link between the consideration due from the farming-in party and the ongoing obligations (or work commitments) of the farming-out party as defined under the terms of the underlying concession and joint operating agreement. The consideration due from the farming-in party for such transfer can be structured either as:
• a performance obligation: the actual performance of certain work commitments that would otherwise be required of the farming-out party; or • a payment obligation: the payment of a defined share of the costs that would otherwise be incurred by the farming-out party in respect of those work commitments.
Where the consideration for a farm-out is structured as a monetary amount, part of that sum may represent a premium to be paid by the purchaser for the right to acquire the upstream interest part way through its life cycle rather than from the outset. This premium is often expressed as a ‘promote’ and represents the ratio between the proportion of the expenditure that will be assumed by the farming-in party and the proportion of the interest it will receive as a result of the farm-in. The consideration might also be structured as a ‘carry’ by the farming-in party of the farming-out party’s interest in the upstream interest. Whether the carry is ‘soft’ (with repayment from petroleum revenues) or ‘hard’ (with no repayment) will depend on the negotiating strength of the parties.
Where the consideration for a farm-out is structured as a performance obligation of the work commitments under the underlying concession, care will need to be taken to define the farm-in obligation clearly, for example the drilling of a well to a defined depth or the expenditure of an amount in the performance of the work commitments up to an agreed cap.
Under a conventional farm-out there is an upfront transfer of the upstream interest to a farming-in party in consideration of the future performance (actual or monetary) by the farming-in party of the agreed proportion of the farming-out party’s share of the work commitments (possibly subject to certain conditions precedent to the complete effectiveness of the intended transfer).
4.3 Earn-ins
Earn-ins are a further formulation of the farm-in/farm-out structure for upstream interest sales. As with the conventional farm-in/farm-out structure, the consideration due from the purchaser is linked either to the actual performance, or to payment of a defined proportion of the seller’s share of the costs of performance of the work commitments associated with the underlying concession and joint operating agreement. The distinction of an earn-in structure, however, is that title to the upstream interest will not transfer to the purchaser until it has performed the work commitments. This is a seller-friendly structure but is often driven by the inability of the parties to obtain the necessary government consents for a transfer where the transfer is conditional upon the performance of work commitments. That said, the earn-in structure provides a clear benefit for sellers in that it obviates the need to address potentially complicated re-transfer arrangements if the purchaser were to default on its obligations under the earn-in arrangements.
4.4 Asset exchanges
An asset exchange structure is a further alternative to a traditional sale and purchase arrangement. An asset exchange involves the exchange of upstream interests between the contracting parties as mutual consideration.
Where a transaction is structured as an asset exchange, there is no clear delineation between the seller and the purchaser. Each party will act as seller of its respective asset and purchaser of the other’s asset. This mutuality of roles means that the asset exchange agreement will need to address the giving of reciprocal warranties, representations and indemnities between the parties and contain an appropriate
