Chapter 8 How Covenants and Conditions Shape A&D Transactions1
JESSICA RODRIGUEZ joined Norton Rose Fulbright's Houston office in 2015. As a senior associate, she regularly assists domestic and international clients in energy M&A and regulatory matters covering every sector of the energy industry, including matters relating to LNG export projects, pipeline systems, and oil and gas properties. Jessica works closely with our energy partners, including the firm's Global Head of Energy and the US Head of Oil and Gas. She has advised on several of Norton Rose Fulbright's most notable transactions on behalf of energy clients.
I. Introduction
Various milestones mark the timeline of an oil and gas upstream acquisition and divestiture transaction (an "A&D Transaction"). These milestones include execution of the purchase and sale agreement or other applicable primary transaction document (the "PSA"), the period between execution of the PSA and the closing of the A&D Transaction, if any (such period, the "Interim Period"), the closing of the A&D Transaction ("Closing"), and the period following Closing.
At PSA execution, the Transaction Parties (as defined below) agree to, at a future date (assuming the A&D Transaction is not a simultaneous sign and close), buy and sell the assets or equity that are the subject of the A&D Transaction (such assets, the "Subject Assets", and the company that is the target of an equity A&D Transaction, the "Target Company"). During the Interim Period, the buyer in the A&D Transaction ("Buyer") and the seller in the A&D Transaction ("Seller", and together with Buyer, the "Transaction Parties") will take the steps necessary for Closing to occur. Following Closing, the Transaction Parties will then take certain additional steps to finalize the A&D Transaction and ensure that the relevant parties are put on notice that the A&D Transaction has occurred.
This paper (this "Paper") examines the function of and interplay among Interim Period covenants, closing conditions, and post-closing covenants in the context of A&D Transactions in Texas and governed by Texas law.4 This examination will begin by defining what Interim Period covenants and closing conditions are and analyzing what purpose they serve in a PSA. It will then describe certain common (and certain less common) Interim Period covenants and closing conditions as well as touch on certain post-closing covenants. Finally, this Paper will discuss standard remedies in the event of a breach of the PSA with respect to Interim Period covenants, closing conditions, or post-closing covenants.
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II. Covenants and Conditions Precedent - What Are They, and What Purpose Do They Serve?
A. Covenants
A covenant is "an agreement to act or refrain from acting in a certain way" or "an ongoing promise by one party to take or not to take certain actions".5 Covenants can be affirmative (promises to take certain actions) or negative (promises not to take certain actions).6 PSAs (1) describe actions that Sellers or Buyers must do (or refrain from doing) during the Interim Period or on the Closing date in order to achieve Closing and (2) "mandate how the [Subject Assets or Target Company] will be operated between signing and [Closing]" (collectively, "Interim Period Covenants"). PSAs also mandate Transaction Party covenants following Closing that "button up" the A&D Transaction and preserve the agreed liability allocation between the Transaction Parties (such covenants, "Post-Closing Covenants").7
An Interim Period permits Buyers and Sellers the time to take those steps necessary for Closing to occur, including, as discussed further in Section III, seeking consents, waivers for Preferential Purchase Rights (as defined below), and governmental authorizations as well as preparing closing documentation, proceeding through title and environmental defect processes, and completing any other activities that each Transaction Party may require to be completed prior to Closing, all while operating under the comfort that a PSA provides that Closing likely will occur (making foregoing other potential Buyers or Sellers and the monetary commitment of performing Interim Period Covenants more palatable). Interim Period Covenants create a contractual obligation for the applicable Transaction Party to perform its Interim Period Covenants (and therefore also afford Buyer or Seller, as applicable, a remedy for the other Transaction Party's failure to perform such Interim Period Covenants).
Once Closing occurs, Transaction Parties will still be obligated to perform Post-Closing Covenants. Post-Closing Covenants (1) direct Buyers and Sellers to perform certain actions necessary to finalize the A&D Transaction, including, as applicable to each Transaction Party, curing title and environmental defects, delivery of the final settlement statement, recording any documents that might require recording, and obtaining customary post-closing consents and (2) preserve the liability allocation structure agreed between the Transaction Parties through indemnification obligations. This Paper describes Post-Closing Covenants in further detail in Section V below.
B. Conditions Precedent
Conditions precedent specify certain requirements that must be met or satisfied before a party is obligated to perform under a contract.8 Importantly, "if an express condition [precedent] is not
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satisfied, then the party whose performance is conditioned is excused from any obligation to perform".9
To protect Transaction Parties' investment in Interim Period Covenants and expectation that an A&D Transaction will occur, PSAs are structured to encourage a Closing to occur except in limited circumstances. A PSA memorializes those circumstances that permit Closing not to occur through Closing Conditions. The term "Closing Condition" refers to a condition precedent set out in the PSA that is a condition precedent to each of a Buyer's or Seller's obligation to close. Accordingly, Closing Conditions represent circumstances that, if not present at the time of Closing, would permit a Transaction Party to not proceed with Closing.10 Closing Conditions serve many purposes, including (depending on the particular closing conditions included) ensuring that (a) the Subject Assets or the Target Company (or its assets) have not undergone significant changes since PSA execution, (b) the applicable Transaction Party has performed its Interim Period Covenants, and (c) no circumstances exist that could preclude Closing (e.g., a litigation seeking to enjoin Closing). Ultimately, Closing Conditions aim to memorialize the balance between obligating a Transaction Party to close and recognizing that, in certain circumstances, such an obligation may not be reasonable.
Closing Conditions contain multitudes. Each Transaction Party will be motivated to include Closing Conditions because they will want to "impose conditions on the other Transaction Party that satisfy its own business and legal concerns about the [A&D Transaction]", but at the same time, each Transaction Party also will want to "minimize the number of conditions that it must satisfy".11 Furthermore, because Closing Conditions will allow a Transaction Party not to proceed to Closing, Closing Conditions (particularly those that fall outside of custom) can be highly negotiated.12 Customary Closing Conditions, and those that perhaps are less common, are discussed further in Section IV below.
III. Interim Period Covenants13
As described above, Interim Period Covenants are those actions that Transaction Parties must do (or not do) during the Interim Period. In this section, this Paper describes those specific Interim Period Covenants that are common to A&D Transactions.
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A. Operational Covenants
During the Interim Period, Seller will continue to own and operate the Subject Assets or the Target Company. A Buyer will want to regulate this ownership and operation to ensure that Seller (or the Target Company, if applicable) cannot act in a way that would change the nature of the Subject Assets or the Target Company and its assets or otherwise cause the Subject Assets or the Target Company to have a lower valuation than that which underlies the purchase price.
Accordingly, PSAs typically will include covenants that restrict "flexibility in making decisions about how to operate the [Subject Assets or the Target Company] pending [Closing]" ("Operational Covenants").14 These Operational Covenants typically will take the form of affirmative and negative covenants.
Affirmative Operational Covenants. The primary affirmative Operational Covenant will be a covenant generally requiring Seller to own and operate the Subject Assets or the Target Company (and its assets) in the ordinary course of business. This covenant may be "flat" (i.e., with no efforts qualifier included), or it may be qualified by an efforts qualifier such as "commercially reasonable efforts". There are few, if any, Texas court cases interpreting the phrase "ordinary course of business" in the context of A&D Transactions.15 Transaction Parties in Texas, therefore, may wish to provide further color on what constitutes "ordinary course of business" by defining the term "ordinary course of business" or further describing what constitutes "ordinary course of business" in the Operational Covenant itself. One common way to further describe "ordinary course of business" is by reference to owning and operating the Subject Assets or Target Company (and its assets) in a manner "consistent with past practice" or in substantially the same manner as such ownership and operation was conducted prior to the PSA execution date.
Although case law in Texas around affirmative Operational Covenants is scant, other jurisdictions (namely Delaware) can provide useful guidance for considerations in drafting the affirmative "ordinary course of business" Operational...
