Terms of recent utility acquisitions reflect favourable market for sellers
November 2015 | SPECIAL REPORT: ENERGY & NATURAL RESOURCES
Financier Worldwide Magazine
Recently announced acquisitions of electric and gas utilities reveal a trend toward seller-favourable terms in this sector. In addition to purchase prices that in many cases have been at a significant premium to market prices, the terms of recent acquisition agreements also reflect a trend toward more seller-favourable provisions. This trend is evident in provisions regarding the standards for determining whether the terms and conditions of a required regulatory approval are acceptable, which is the focus of the following discussion.
One aspect of mergers and acquisitions in the electric and gas utility sector that differs from transactions in many other industries is that the acquisition or change of control of a rate-regulated utility frequently requires the approval of the state public utility commission (PUC) in each state in which the utility operates. In addition, if the transaction involves utilities with assets or operations under the jurisdiction of the Federal Energy Regulatory Commission (FERC), approval of FERC may also be required.
In determining whether to approve a transaction, PUCs generally focus on the impact the transaction will have on the utility’s customers, and often require a conclusion that the transaction will not harm the interests of customers in the state, or alternatively, a conclusion that the transaction will result in net benefits to customers. In reaching this conclusion, PUCs have considered a broad variety of factors in addition to customer rates, including the utility’s post-transaction presence in the state and related jobs, local control over the utility, the possibility of degradation of customer service and the financial condition of the post-transaction utility, among others.
In the event that a transaction is subject to approval by FERC, the regulatory review will be to determine whether the transaction is consistent with public interest, but focuses on a narrower set of factors, including the ability of the post-transaction utility to exercise market power in the wholesale electric market and the potential for cross-subsidisation between the utility and a non-utility affiliate. FERC considers whether the proposed transaction would have an adverse effect on rates, regulation or competition and the applicants are not required to demonstrate that a proposed transaction will result in benefit to consumers or to organised markets.
In an effort to ensure that the transaction meets the relevant approval standard, a PUC will often grant its approval on certain terms and subject to certain conditions, which may require that the post-transaction utility commit to undertake (or not to undertake) certain actions following the consummation of the transaction.
For example, the post-transaction utility may be required to provide rate credits to customers, freeze rates for a certain period of time, share synergy savings with customers, maintain an investment grade credit rating or a certain level of customer service metrics, or other varied items, all of which must be satisfied as a condition of the PUC’s transaction approval.
It is the buyer, after the consummation of the transaction, that ultimately bears the risk and economic cost of complying with these commitments, because they typically apply to the post-transaction utility. Predicting exactly what commitments will be required by any particular PUC to obtain approval of a transaction can be challenging, and acquisition agreements typically do not provide any purchase price adjustment for a buyer to reflect the costs relating to the imposition of these commitments. A similar concern can arise with respect to obtaining FERC approval. If the applicants are concerned that FERC would conclude that a proposed transaction would have an adverse effect on market power or rates, the applicants may offer a mitigation proposal that could include divestiture of certain assets, investments in transmission assets or other mitigation measures.
Buyers typically mitigate the risk that a PUC order will be accompanied by onerous commitments by including provisions in the acquisition agreement specifying that: (i) the buyer’s obligation to obtain regulatory approvals do not require the buyer to agree to onerous commitments to a PUC (or FERC); and (ii) that the buyer is not required to consummate the transaction if onerous commitments would be imposed by a PUC. Just how onerous these commitments must be in order to permit the buyer not to proceed with the transaction is typically one of the most heavily negotiated contract provisions between the buyer and the seller.
Three recently announced transactions in the electric and gas utility sector – the proposed acquisition of SourceGas Holdings LLC by Black Hills Corp. announced on 12 July 2015, the proposed acquisition of AGL Resources by Southern Company announced on 24 August 2015 and the proposed acquisition of TECO Energy by Emera announced on 4 September 2015 – each include provisions illustrating this trend.
Pursuant to the transaction agreement in the SourceGas acquisition, Black Hills agreed to take all actions and make all undertakings required to complete the transaction, including agreeing to any conditions imposed by any PUC, unless the action would result in a ‘material adverse effect’ on SourceGas and its subsidiaries, taken as a whole. This covenant is mirrored by a closing condition under which Black Hills is not required to proceed with the transaction if the terms of any PUC order approving the transaction would reasonably be expected to have such a material adverse effect.
This standard, which requires the buyer to proceed unless the terms of a regulatory order would result in a material adverse effect on the company being acquired, is favourable to the seller given the level of adversity required to prove a material adverse effect under relevant M&A case law. Although the use of this standard is fairly common, what is interesting is the contrast with the sellers’ obligations under the agreement with respect to obtaining regulatory approvals. Unlike the buyer, the agreement is explicit that with respect to obtaining regulatory approvals, the sellers are not required to consent to the imposition of any terms, conditions or limitations on the businesses of the sellers or their affiliates, or on the benefits of the transaction to the sellers, and this standard is also reflected in a closing condition for the benefit of the sellers.
Under similar provisions in the AGL Resources transaction agreement, Southern Company must take any action and agree to any conditions necessary to obtain PUC and other regulatory approvals, unless they would result in a ‘burdensome effect’ which is defined as a material adverse effect on the combined enterprise of Southern Company and AGL Resources, or a requirement to divest subsidiaries of either company that are collectively allocated more than 25 percent of the cost of shared services at the applicable company. The condition to each party’s obligation to close the transaction incorporates the same burdensome effect standard.
The combined enterprise material adverse effect standard used here would require an extremely adverse regulatory outcome in order to be implicated, particularly when considering that Southern Company is significantly larger than AGL, and accordingly should be viewed as favourable to the seller, since the buyer’s right to withdraw from the transaction on this basis is extremely limited. As a practical matter, this could result in Southern Company having an obligation to proceed with the transaction in the face of a PUC order that erodes a significant portion of the value of AGL.
In the third and most recently announced of these transactions, Emera, as the buyer, also agreed to use its reasonable best efforts to take all actions and undertake any commitments that may be required in order to obtain the required regulatory approvals. However, under the terms of this transaction agreement, Emera’s obligation is not bound by a material adverse effect or other standard, and Emera does not benefit from a closing condition that would permit Emera not to proceed in the face of an onerous PUC order.
In fact, the general condition to Emera’s obligation to proceed if TECO has suffered a material adverse effect specifically carves out the terms of any regulatory approval order. Furthermore, in the event that the transaction does not close prior to the outside date due to a failure to obtain the required regulatory approvals, TECO has the right to require Emera to pay a termination fee of $326.9m and terminate the transaction.
This combination of terms provides Emera with little ability to avoid proceeding with the transaction even in the face of a PUC order that is extremely adverse, and potentially pay a significant fee if regulatory approval is not obtained for any reason and the transaction is not consummated.
The terms of the three transactions discussed above reflect a larger trend in the sector toward seller-favourable deal terms, both commercial and legal, and sellers appear to have the leverage to require greater deal certainty in the current volatile equity market.
Fritz Lark is a partner and Richard W. Chen is an associate at Bracewell & Giuliani LLP. Mr Lark can be contacted on +1 (212) 508 6169 or by email: firstname.lastname@example.org. Mr Chen can be contacted on +1 (212) 938 6804 or by email: email@example.com.
© Financier Worldwide
Fritz Lark and Richard W. Chen
Bracewell & Giuliani LLP