By Chris Richardson and James Comyn, Partners of the international law firm Andrews Kurth Kenyon LLP, in the Houston and London offices, respectively.
With the Egyptian oil and gas market continuing its rapid development amid increased stability in the country and exciting new deepwater discoveries, upstream merger and acquisition activity is poised to increase significantly. When considering a sale or purchase of an interest in oil and gas properties in Egypt, the most critical document governing the transaction is the sale and purchase agreement (SPA).
Although SPAs can be heavily negotiated and are usually tailored to the specific transaction, there are certain elements common to nearly all upstream oil and gas SPAs. In this article, we seek to highlight and explain the key SPA terms that would prove essential to any acquisition or divestiture of oil and gas interests in Egypt.
Given the nature of the business, the oil and gas sector has always generated a significant amount of M&A activity worldwide — and Egypt is no exception. Oil and gas companies regularly seek to bring in new partners by selling down a portion of their interests after a large exploration success in order to spread development costs and risks, and to monetize the initial success. At the other end of the spectrum, long-term investors holding substantial interests in mature oil and gas operations will often seek to limit their exposure by bringing in new partners, or they may decide to exit altogether if such assets no longer form a core part of their strategy. Sometimes such divestitures are made to entirely new players looking to make an entry into the country’s market, while, in other cases, the sales are made to familiar names looking to strengthen their current position in country.
Egypt has seen and should continue to see these trends play out in its upstream sector. There have been a number of transactions in Egypt that follow this well-established energy industry pattern. In August 2013, Sinopec acquired a 33% stake in Apache’s Western Desert portfolio of assets for $3.1 billion. More recently, Eni has sold down its interests in the giant Zohr field/Shorouk concession to both BP, a 10% interest announced in November 2016 for $375 million, and Rosneft, a 30% interest announced in December 2016 for $1.13 billion. In late December 2016, Shell announced that it was considering divestiture of its interest in the Rosetta block offshore Egypt.
Key Terms in SPAs
Although every deal is unique, in our experience, the key terms to consider in a SPA for an acquisition or divestiture of upstream interests in Egypt should include provisions covering:
Purchase Price Calculation, Adjustment, and Payment Terms
Warranties Regarding the Acquired Interests
Conditions to Closing and Interim Period Covenants
Post-Closing Liabilities and Limits on Liability
It is worth noting that transactions in the oil and gas industry can be structured as either a corporate i.e. share sale or as an asset transaction. In the United States, for instance, asset transactions predominate, given the nature of private ownership of minerals, which permits oil companies to own undivided interests directly in the underlying oil and gas. For a variety of reasons including government regulations, tax considerations, preemptive rights, and joint venture structuring, a deal can also be structured (or in some cases, must be structured) as a corporate sale. In a corporate sale, the buyer acquires some or all of the shares in a company, which directly or indirectly holds the underlying oil and gas assets. Although there are important legal distinctions between these two types of transaction structures, the core concepts described below generally apply in both types of deals. Even when buying shares in a company that indirectly holds oil and gas properties, the SPA’s treatment of the underlying assets is usually a core aspect of the deal (although less so in public company deals).
- Purchase Price Calculation, Adjustment, and Payment Terms
Although mutual agreement on the purchase price remains the essential prerequisite for any deal, agreeing on the headline number is only the first step. The SPA often addresses considerations regarding how and when the purchase price will be paid and how it should be adjusted before and after closing.
The purchase price is not always paid in one lump sum. When signing the SPA, the seller will sometimes demand that the buyer provides a deposit (usually 5% to 10% of the purchase price) in order to encourage the buyer to complete the transaction. If a deposit is included, the SPA will set forth how it will be held and under what circumstances it will be returned to the buyer. If the buyer does not complete the deal (except where excused under the SPA), the seller may be entitled to retain the deposit as the seller’s sole remedy and as liquidated damages. The SPA will also need to address whether interest will accrue on the deposit and whether it will be held by the seller or by an escrow agent.
The converse to the seller demanding a deposit upfront is the buyer withholding a portion of the full purchase price in the form of a holdback or contingent payment. The portion of the purchase price withheld could be used as security to cover any claims that the buyer may have against the seller for breach of the SPA following closing e.g. breach of warranty claims, or to cover specific identified risks e.g. pending the resolution of a tax dispute or lawsuit. Contingency payments can be used to increase the purchase price payable upon the occurrence of certain events, including approval of development plan or a final investment decision on the project. Alternatively, contingency payments can be tied to commodity prices over a certain period of time, such that the seller shares in the potential upside. Both of these mechanisms can be heavily negotiated and must be carefully addressed in the SPA.
The SPA will also typically cover adjustments to the agreed purchase price. Most oil and gas transactions feature a valuation date — often called the “effective date” — set several months prior to signing, usually at the end of the prior year or quarter. This permits the buyer to make a determination of the value of the underlying assets as of that fixed point in time. In the case of a corporate deal, the buyer will also have to evaluate the financial assets and liabilities (including debt and working capital) of the company as of the effective date through examining the financial statements. Because the effective date occurs in the past, the SPA must set out provisions adjusting the purchase price from such date through to the closing date, which can occur months, or even over a year, after the effective date. For example, the proceeds from the sales of produced hydrocarbons that are paid to the seller after the effective date should reduce the purchase price, while funds contributed by the seller to the operations should increase the purchase price. In a corporate deal, the final purchase price payable at closing is adjusted based on changes in working capital or debt, or dividends paid out and capital contributions paid in. SPAs will often contain detailed provisions on the calculation of these adjustments, as well as covenants and warranties regarding what actions the seller can take during the time period between the effective date and closing date that would so affect the purchase price.
Finally, external factors might also affect the final calculation of the purchase price payable by the buyer, and the SPA will need to address these contingencies. If third parties or other shareholders exercise any applicable preferential purchase rights to acquire a portion of the interests being sold, the SPA should set forth a mechanism for adjusting the purchase price in a manner that reflects the removal of this portion of the interests from the deal. The buyer will generally allocate its purchase price among the various assets or corporate interests being acquired such that a party holding preferential purchase rights will know what price it has to match to acquire the assets, and to ensure that the purchase price is adjusted appropriately in light of the removal of such interests. In situations where all or substantially all of the interests are acquired by those parties holding preferential purchase rights, the SPA will likely provide for termination of the deal between the original buyer and seller; in these cases, the seller will instead sell the interests to such third party on substantially the same terms as contained in the SPA.
- Warranties Regarding the Acquired Interests
A warranty is a legal promise that certain conditions are true and correct, and a breach of a warranty provides the counterparty with a breach of contract claim for damages. Warranty provisions are often one of the most heavily negotiated sections in an SPA. Warranties serve several important functions in a SPA: they drive the seller’s disclosure regarding the assets or company being purchased; they may permit the buyer to refuse to close a transaction; and they provide the buyer with some level of liability protection post-closing. In other words, warranties provided are a primary factor in determining the allocation of risks in the transaction.
A buyer will likely seek — but may not ultimately be able to obtain — comprehensive warranty coverage from the seller regarding the oil and gas interests being transferred, whether indirectly in a corporate deal or directly in an asset deal. These warranties may cover the following topics:
- Title/Ownership/Host Country Agreement
The buyer will want to ensure that the seller directly or indirectly owns the underlying oil and gas interests. Unlike deals in other industries where warranties regarding title or ownership are rather straightforward, ownership of oil and gas properties is more complicated. This is due to the fact that in most jurisdictions, including Egypt, the government is the ultimate owner of the resources. Given this unique nature of oil and gas properties, there is no standard way to document these warranties in cross-border deals, so the language is often carefully negotiated. As such, a seller of oil and gas assets will typical warrant that it has not transferred or encumbered any portion of the underlying assets and that it is validly a party to the host country agreement (e.g. the concession, license or production sharing contract or other instrument granting the company the right to explore for, develop, and produce oil and gas). In a corporate deal, the seller will also warrant title to the shares being transferred.
- Compliance with Laws; Environmental Matters
The seller will seek warranties that operations have been conducted in compliance with applicable laws and regulations, that all necessary environmental standards have been followed, and that material required permits have been obtained and maintained. The seller typically will warrant that it has provided all information regarding non-compliance and has disclosed the receipt of any notices of claims from the government or third parties about non-compliance, pollution, or contamination. Most SPAs will also include warranties (and covenants) regarding compliance with anti-bribery laws.
- Preferential Rights and Consents
The buyer will seek warranties regarding whether any third party holds a preferential purchase right or a consent right over the transaction. The requirement of Egyptian government consent to the transfer is customarily covered by this warranty where applicable, but consents might also be needed from counterparties under important contracts related to the operations. Existing partners may have the right to match the offer made by the buyer for all or some portion of the assets or shares involved in the transaction. Anti-trust filings may also need to be made in various jurisdictions.
- Material Contracts
The buyer will want to understand what key contracts are involved in the operation of the underlying oil and gas properties and whether those contracts have been breached or terminated. Material contract warranties often cover joint operating agreements (or, as is often the case in Egypt, the agreements governing joint operating companies); unitization agreements; hydrocarbon sale and transportation agreements; major construction contracts; key long-term supply and service contracts; and other contracts involving significant sums of money or those that will bind the buyer for a long period of time. The seller often lists these contracts in connection with providing this warranty.
- Status of Operations
The buyer will want to understand whether there are any outstanding commitments to the government or project partners in connection with the conduction of operations, including but not limited to minimum work obligations under the host country agreement, drilling obligations, the status of development plans, non-consent or sole risk obligations, authorities for expenditures, work programs, and budgets.
- Litigation and Claims
The seller is usually required to disclose all material litigation and claims that affect the target company being acquired or the underlying assets, including government investigations, threatened litigation, and notices of potential claims. The seller is usually liable for failing to disclose litigation or claims if they result in liability to the buyer, and in some cases the buyer might have the right to terminate prior to closing. The SPA should also address how the obligation of the buyer to close the transaction will be affected by litigation or claims that arise unexpectedly after signing but before closing.
- Egypt-Specific Concerns
A buyer of upstream interests in Egypt should also consider obtaining warranties, and conducting diligence, regarding: (i) the timing of payment for gas sold to the Government of Egypt and the status of any outstanding receivables; (ii) whether there are any indirect government-imposed restrictions on transfer or bonus payments that might be due under the underlying concession; (iii) whether the concession has been ratified by the Egyptian Parliament; (iv) the status of minimum work obligations and relinquishments under the concessions; (v) the status of the joint operating company operating the assets (including employee related matters); (vi) any arrangements with government-owned entities regarding the sale, transportation or processing of production; (vii) cost recovery status (and whether there are any cost recovery disputes, audits or disallowances); (viii) currency convertibility and foreign exchange controls; (ix) whether there are any local content requirements; and (x) the import of materials related and duties on such imports.
- Other Issues
The list above is certainly not exhaustive. The seller’s warranties often also address other issues such as tax matters, employees and labor relations, payment of royalties, and finders’ or brokers’ fees. Additionally, both the buyer and seller typically offer a set of standard warranties regarding corporate authorization, approvals, non-contravention, bankruptcy, financing, etc.
Importantly, warranties are rarely given in absolute terms. Certain warranties are qualified by knowledge of the party giving the warranty, by materiality, or by reasonableness, and are further qualified by disclosures accompanying the SPA. Disclosures are often given in the form of a disclosure letter or schedules attached to SPA, but in some instances the seller will also seek to include all the material disclosed in a data room, which is often resisted by buyers. The repetition of the seller’s warranties regarding the condition of the assets at closing and the ability of a party to update its disclosures after signing (and the effect of such updates on liability and the obligation to close the transaction), are often contentious topics in negotiating the SPA.
The breadth and scope of warranties largely depends on the relative commercial leverage that each party has in the transaction, but it will also be influenced by the agreed purchase price, the ability of the buyer to conduct sufficient due diligence to identify and “price in” the risks, the nature of the underlying assets i.e. whether it is a new discovery or a mature field, and the extent to which the seller controls the operations of the underlying oil and gas properties. Depending on these factors, a seller may ultimately provide a robust set of detailed warranties in favor of the buyer, but in other instances the warranties may be in a limited scope, heavily qualified, and provide scant protection for the buyer.
- Conditions to Closing and Interim Period Covenants
Transactions involving the acquisition and divestiture of oil and gas interests in Egypt and in most other jurisdictions typically involve a separate signing and closing, due to the need to obtain government and other consents to the transfer and in order to deal with preferential purchase right issues. As such, the SPA will set out conditions for closing, establishing when the buyer and seller must proceed with the transaction and the circumstances where one or both of the parties may elect to terminate the deal without closing. Common closing conditions include: (i) obtaining consents, usually by some agreed deadline; (ii) confirming that there has been no change in laws or any litigation filed that would prohibit the transaction from occurring; (iii) confirming that warranties given by the other party are true and correct in all material respects; (iv) confirming that the parties have complied with their obligations in the SPA in all material respects; and (v) sometimes, but not always, allowing the buyer to refuse to close the transaction upon the occurrence of a “material adverse event,” the definition of which is always heavily negotiated.
Because there is generally an extended period of time between the signing and closing under a SPA (the “interim period”), a SPA will often set out certain covenants that the parties agree to follow during such interim period. Some of these covenants help ensure that the transaction is more likely to achieve closure and may include covenants obliging the parties to make certain filings or cooperate to obtain necessary consents. Other interim period covenants require that the seller continue to own and operate the assets or the target company in a manner that ensures the buyer will, at closing, acquire the assets or company in the condition that they valued it at signing; this also ensures that the buyer will not be saddled with additional liabilities or obligations that could be avoided through the actions of the seller during the interim period. Common interim period covenants of this type include an obligation to operate the assets in the ordinary course of business to get the buyer’s permission before entering into major new contracts or undertaking significant new commitments, complying with existing work programs and budgets, and not transferring or encumbering the assets. A breach of these interim period covenants may give rise to liability for damages. If the breach is sufficiently material, the other party (usually the buyer) may be allowed to elect to terminate the agreement prior to closing, if such breach is not cured.
- Post-Closing Liabilities and Limits on Liability
Once a closing occurs, the provisions relating to post-closing liabilities, and limits on such liabilities, are the most critical aspects of a SPA. In a major oil and gas transaction, it is not uncommon for potential liabilities to exceed hundreds of millions or even billions of dollars. The SPA is the primary document that will govern the allocation of such liabilities between the parties after closing. This reality makes the negotiation of the post-closing liability provisions in the SPA one of the most antagonistic areas for negotiators.
Although the seller is disposing of the interests at closing, the buyer will seek to ensure that the seller remains responsible, at least for a certain time period, for certain risks (e.g. liabilities arising from pre-effective date actions of the seller). This is often accomplished by requesting an indemnity from the seller for a set of specifically defined retained liabilities. The seller will seek to ensure that the buyer adequately assumes liabilities going forward and that the SPA adequately protects the seller from third-party claims relating to the divested property. This typically comes in the form of an indemnity provided by the buyer in favor of the seller, often covering all future liabilities arising after closing as well as historic liabilities, subject to the retained liabilities. The buyer will also want protection in the form of the ability to raise a claim for damages against the seller for breach of contract, if it is determined post-closing that the seller breached any of its covenants or warranties in a manner that results in the buyer suffering a loss.
The seller, however, will typically insist upon time limits and other limitations on its liability to the buyer under the SPA. These limitations often include: (i) a time limit as to when the buyer can bring a claim for a breach of the seller’s covenants or warranties under the SPA (e.g. six months to two years, although claims relating to certain fundamental matters may survive longer, or even indefinitely); (ii) thresholds that must be crossed or deductibles that must be paid by the buyer before the seller is liable to pay the buyer’s claims for damages (usually a small percentage of the purchase price, e.g. 1% to 5%); (iii) exclusions for minor “de minimis” claims (e.g. claims under $10,000 per occurrence); and (iv) overall caps on liability of the seller (usually calculated as a percentage of the purchase price, although covenants, retained liabilities and certain fundamental warranties are often carved out of this liability cap or subject to a cap of 100% of the purchase price). All of these limitations are subject to intense scrutiny and negotiation by the parties and their legal teams, and are often traded up until execution of the SPA.
Road Map for Successful Deals
The terms and conditions negotiated and agreed to in a SPA or similar agreement will form the legal and commercial basis for the acquisition or divestiture involving upstream oil and gas interests in Egypt. Although certain general trends and market standards can be identified, the key provisions of SPAs should be tailored specifically for each transaction. SPAs, when properly drafted, not only provide road map to ensure that a deal can be implemented successfully; they also serve to allocate risk and liability between the buyer and seller. That risk allocation, adapted to the particular circumstances of the deal and commercial and strategic aims of each party, is crucial to ensuring that the deal gets signed and that both parties achieve their objectives. As such, each of the buyer and seller would be well advised to obtain quality legal counsel in connection with the preparation and negotiation of the SPA. The insights provided by knowledgeable international oil and gas transactional lawyers with experience negotiating SPAs in Egypt can prove to be invaluable in protecting the rights, and in identifying and managing the risks of a buyer or seller in any such transaction.