Inspectioneering
Inspectioneering Journal

Managing Asset Transfers: Negotiating the Deal and Minimizing Risk

Part 1

By Brandon M. Watson, Esq. at GableGotwals. This article appears in the January/February 2014 issue of Inspectioneering Journal
This article is part 1 of a 2-part series.
Part 1 | Part 2

Introduction

Inspectioneering Journal is focused on informing its readers of innovative and trailblazing trends in day-to-day asset integrity management and asset risk reduction activities. How does an entity best manage risk, however, when purchasing or selling an asset - an event that sets in motion (or halts) the day-to-day operational activities? In this article and the follow up, scheduled for the March/April issue, we will highlight techniques routinely employed by Sellers and Buyers to reduce risks associated in the purchase and sale of complex oil and gas assets (this issue will focus on the Seller’s point-of-view). As the asset purchase agreement is the primary document that addresses the allocation of risks between Sellers and Buyers in an asset transaction, we will focus on three sections found in most asset purchase agreements: (a) the Representations and Warranties, (b) the Covenants, and (c) the Indemnifications.

Seller Representations and Warranties

How it works: Most asset purchase agreements contain several pages of extensive representations and warranties made by the Seller to the Buyer regarding the Seller’s right to sell the assets, the condition of the assets, and any consents or approvals necessary to operate the assets. With complex oil and gas assets, these representations and warranties become increasingly important to the Buyer as they act to compliment the Buyer’s due diligence efforts by providing the Buyer with a clear understanding of the assets it is purchasing. If a Seller makes a representation or warranty that is inaccurate, and the Buyer incurs losses due to the inaccuracy, the Buyer may receive protection under the indemnification provision contained in the purchase agreement (more on that later).

How the Seller Reduces Risk: Certain representations and warranties are easy for Sellers to make (e.g., “the Seller has full power and authority to enter into the Asset Purchase Agreement”). Other representations, however, are more difficult (e.g., “the Seller is in compliance with all laws applicable to the Assets”). Often, Sellers can reduce their risk in making these “difficult representations” by either (a) qualifying the representation by “materiality” (e.g., “the Seller is in material compliance with all laws applicable to the Assets”), (b) limiting the representation to the Seller’s “knowledge” at the time the representation is made (e.g., “to the Seller’s knowledge as of the date of this Agreement, the Seller is in compliance with all laws applicable to the Assets”) or (c) scheduling an exception to the Seller’s representation (e.g., “except to the extent set forth on Schedule X, the Seller is in compliance with all laws applicable to the Assets”).

Seller Covenants

How it works: It is often the case in asset sales that there is a gap in time between the signing of an asset purchase agreement and the closing of the transaction (a structure commonly referred to as a “delayed closing”). Among other things, this period of time allows the Seller to obtain any requisite consents or approvals from third parties or governmental authorities in order to effect the transfer of the assets in question to the Buyer. With limited exceptions, after the asset purchase agreement is executed, the Buyer will be obligated to close the transaction. As a result, after executing the agreement, the Buyer has a vested interest in the continued operation of the assets and they will want to ensure that the condition of the assets does not deteriorate between the time of executing the agreement and closing. In order to ensure that the assets are properly maintained by the Seller until such time as they are owned by the Buyer (i.e., at closing), the Buyer usually imposes affirmative (“Seller shall . . .”) and negative (“Seller shall not . . .”) covenants on the Seller’s activities relating to its ownership, maintenance and operation of the assets to be sold during this period of time.

How the Seller Reduces Risk: Due to their routine usage, the Seller will likely need to acquiesce to the Buyer’s request to include affirmative and negative covenants in an asset purchase agreement that contemplates a delayed closing. The Seller will want to ensure, however, that the covenants do not act to excessively restrain the Seller in its ownership, maintenance and operation of the assets—after all, title to the assets remains with the Seller until closing and, while remote, there is always a chance that a transaction will not close and the assets will continue to be owned by the Seller. Sellers often reduce their risk in breaching these covenants by adding caveats to the covenants which permit the Seller to own, maintain and operate the assets in a manner consistent with the Seller’s ordinary course of business (e.g., “without first obtaining the Buyer’s written consent, the Seller shall not renew any material agreements relating to the assets, except to the extent such renewal is entered into in the ordinary course of business and consistent with Seller’s past practices”).

Seller Indemnification

How it works: If the Seller’s representations and warranties are inaccurate and that inaccuracy results in the Buyer incurring a loss (typically broadly defined), the Buyer will usually request that the Seller agree to reimburse the Buyer for that loss or, in the event of litigation asserted against the Buyer arising from the inaccuracy, “step into the shoes” of the Buyer and defend the claim. This concept is captured in the indemnification provision, whereby the Seller will “indemnify, defend and hold harmless” the Buyer from and against any and all losses it may incur arising out of or relating to a breach of the Seller’s representations or warranties.

How the Seller Reduces Risk: Once a transaction closes, Sellers typically want to move on and never look back—they strongly prefer language in an asset purchase agreement favoring a definitive end to their obligations relating to the assets. Any looming obligations post-closing produce potential risks for Sellers. As a result, Sellers reduce their risks under indemnity provisions in several ways: (a) by limiting the period of time by which the Buyer may rely on the Seller’s representations after the closing (6 to 24 months is typical); (b) by including a “deductible” or “basket” that losses must exceed before they are covered by the indemnity and, therefore, eliminating the Buyer from distracting the Seller with small losses the Buyer may incur (up to 2% of the purchase price is typical) and (c) by limiting the total amount the Seller can be “out of pocket” under its indemnification obligations by including a “cap” (up to 15% of the purchase price is typical) on its obligations, ensuring that, even in the worst case scenario (absent certain exceptions, usually including fraud), the Seller will know that its total liability under the agreement will be limited to somewhere between 10% and 15% of the purchase price.

The information herein is provided for educational and informational purposes only and does not contain legal advice. The information should in no way be taken as an indication of future legal results. Accordingly, you should not act on any information provided without consulting legal counsel. This article reflects the opinions of the authors and does not necessarily reflect the view of the Firm or all members of the Firm.

Continue to the next article in this series.


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