The low oil price and limited capacity for oil and gas producers to further reduce operating costs is presenting challenges for producers of all shapes and sizes. In 2015 we expect that a number of producers will conduct strategic reviews which may lead to the sale of ‘non-core’ assets.
Traditional solutions of raising capital or debt may not be available on acceptable terms for many producers due to the uncertainty about the timing and extent of the oil price recovery. The option of warehousing a marginal project until economics improve may not be available either because such a project is now ‘non-core’ or because the producer must comply with minimum work obligations.
If strategic reviews trigger M&A activity in 2015 in the oil and gas sector, one challenge will be matching price expectations of producers with prospective investors. This is because of the inherent uncertainty around the recovery of the oil price. In this scenario, some junior producers may encounter difficulties and enter the M&A market as a distressed vendor.
This article considers some tensions between the positions of vendor and purchaser in an M&A transaction where the vendor is in financial distress.
Diligence is crucial in a distressed sale process
Effective due diligence typically provides the framework for the risk/pricing profile in an M&A transaction. In a distressed vendor environment, the purchaser’s ability to conduct effective due diligence may be impacted by a number of factors including:
- shortened deal timeframes sought by vendors as a means of limiting the further deterioration of the asset and to obtain certainty, or
- imperfect information being available due to the transaction being forced upon the vendor (rather than planned as part of an orderly sales process).
A risk to purchasers in these circumstances is ensuring that all key issues are considered and priced into the deal.
Prospective purchasers also need to be wary of the risk of using their bargaining position to obtain a deal which might later be challenged by a liquidator as an uncommercial transaction.
Warranties and indemnities
Where the vendor is in formal insolvency, the insolvency practitioner vendor administering the sale process will be concerned to limit personal liability and will usually resist giving any meaningful warranties or indemnities.
Where possible in a distressed vendor transaction, the purchaser should insist on warranties that provide comfort:
- that the insolvency practitioner has been validly appointed and has the power and authority to enter into, and give effect to, the transaction,
- that no consents or registrations are required to give effect to the transaction, other than as set out in the transaction documents, and
- as to title to the assets and that the assets are unencumbered.
The practical value of any warranties and indemnities given by a distressed vendor or insolvency practitioner to a purchaser may be severely limited in any event. This is because a distressed vendor may not have the financial resources to honour a warranty or indemnity claim. Where such a claim is honoured, there is a risk that a liquidator appointed later may challenge the payments as ‘unfair preferences’. Any warranty or indemnity claims given by an insolvency practitioner as agent for a distressed or insolvent company will be unsecured debts of the company and may form part of the broader unsecured creditors’ pool in liquidation.
Possible options to enhance warranty and indemnity protection for the purchaser include:
- obtaining security or a guarantee from a third party whose credit worthiness is not in doubt,
- structuring the transaction so that there is a hold back as to part of the purchase price (provided that the purchaser does not have notice of, or suspicion, that the vendor was insolvent), or
- obtaining buy-side warranty and indemnity insurance against insurable warranties.
Purchase price adjustments following completion
Post-completion purchase price adjustments may also be at risk where a distressed vendor does not have the financial resources to honour its obligation or, if it does, the amount paid may be later challenged as an ‘unfair preference’. The solutions listed above may be of assistance to protect the purchaser. It is also noted that a drafting solution may be to ensure that it is more likely that the purchaser will be required to pay the adjustment payment (e.g. in respect of a working capital adjustment, to make a conservative estimate of target working capital).
Negotiating a sale and purchase agreement where a vendor is distressed or in formal insolvency is unlikely to be an orderly process. For prospective purchasers, due diligence is critical before making an assessment of whether to proceed with a deal due to the limited legal protection typically on offer in these circumstances.
Recently, there have been three important studies by prominent economists and law professors, each of which points out serious flaws in the so-called empirical evidence being put forth to justify short-termism, attacks by activist hedge funds and shareholder-centric corporate governance. These new studies show that the so-called empirical evidence omit important control variables, use improper specifications, contain errors and methodological flaws, suffer from selection bias and lack real evidence of causality. In addition, these new studies show that the so-called empirical evidence ignore real-world practical experience and other significant empirical studies that reach contrary conclusions. These new studies are:
- Emiliano Catan and Marcel Kahan, The Law and Finance of Anti-Takeover Statutes, October 2014
- Yvan Allaire and Francois Dauphin, The Game of ‘Activist’ Hedge Funds: Cui bono? August 31, 2015
- John C. Coffee, Jr. and Darius Palia, The Wolf at the Door: The Impact of Hedge Fund Activism on Corporate Governance, September 4, 2015
For an earlier recognition of these defects in the so-called empirical evidence see, The Bebchuk Syllogism.
These new studies provide solid support for the recent recognition by major institutional investors that while an activist attack on a company might produce an increase in the market price of one portfolio investment, the defensive reaction of the other hundreds of companies in the portfolio, that have been advised to “manage like an activist”, has the potential of lower future profits and market prices for a large percentage of those companies and a net large decrease in the total value of the portfolio over the long term. Recognition of the Threat to Shareholders and the Economy from Attacks by Activist Hedge Funds and Some Lessons from BlackRock, Vanguard and DuPont—A New Paradigm for Governance.
Hopefully these new studies will enable and encourage major institutional investors to recognize that they are the last practical hope in reversing short-termism and taming the activist hedge funds. Institutional investors should cease outsourcing oversight of their portfolios to activist hedge funds and bring activism in-house. Short of effective action by institutional investors, it would appear that there is no effective solution short of federal legislation, which runs the risk of the cure being worse than the illness. For an interesting attempt to legislate institutional investor focus on long-term rather than short-term performance see, European Commission Proposes to Moderate Short-termism and Reduce Activist Attacks.