Mergers and acquisitions are a hot topic in the oil and gas industry at present. This article sets out some of the human factors that can affect a business decision about a proposed merger or acquisition and the ways that use of an outside expert during the merger process can favorably affect potential litigation over the transaction. Specifically, this article analyzes the interaction of psychological factors at play within the framework of objective factors in a dynamic field such as oil and gas in Texas.
Oil and gas deposits figured in Texas history from the time of the earliest European expeditions. The first recorded discovery was in 1540 when the Spanish explored Luis de Mancuso discovered a petroleum seep. His comrades used the tarry substance to caulk the seams on their boats. The stories of larger than life oilmen (and women) have inspired movies and television shows such as Dallas and Giant.
Even today, some oil and gas investors, petroleum engineers, and shareholders are the descendants of the early 20th century pioneers of the industry in Texas. Pioneer oil and gas investors founded dynasties, not merely of wealth but of participation in an industry.
Many oil and gas mergers and acquisitions are taking place recently, especially in Texas, as companies jockey to acquire technology, resources, fields, or other desirable assets. One investment banker has stated recently that the “long term fundamental outlook” for oil and gas mergers and acquisitions is the best seen in 20 years.[i] Industry publications report numerous mergers and acquisitions of large and small companies. In 2011, Ernst and Young reported that, according to a survey, 37% of oil and gas companies were considering a merger or joint venture within the next 12 months.[ii]
Although this article does not consider any particular transaction, recent activity in Texas oil and gas mergers and acquisitions provides fruitful hypothetical examples of complex, multi-billion dollar transactions. The surge of exploitation of shale resources, the risks of dramatic accidents such as an oil leak or explosion, and the expanded development of natural gas production in east Texas are only a few of the current factors at work in current merger and acquisition activity.
Any merger or acquisition necessarily involves determination of the value of the respective companies. The nature of the oil and gas industry involves the evaluation of prospects that cannot be determined with certainty. Obviously, the valuation of oil and gas assets presents unique issues. In the simplest terms, the value of a field, for example, may turn on the applicability of new technology, as the boom in the exploitation of shale formations reveals. The value of a field may also turn on the rights to leases or ownership of trade secret information, such as a proprietary method for locating productive places to drill in an underutilized formation. The merger may also involve evaluation
Although the old time 1920’s “wildcatter” may be almost extinct, the analysis of a potential new field or the use of new technology to further exploit an existing formation involve intrinsic uncertainty. The industry is intrinsically one of betting on new technologies and new markets.
In this highly technical field, where a great deal of the critical information is proprietary trade secret analysis, the valuation of assets and projection of future revenues may be done by person working for the two companies, who may possess unquestioned expertise. Unfortunately, the employees (or principals) doing the analysis may have their own perspective, biases, and interests at heart.
Prospective litigation and the use of outside experts
Litigation over a merger is always a possibility so counsel advising those involved in mergers always have planning for possible courtroom challenges to the business transaction. If the planned marriage of the two companies does not work out profitably, the corporate transaction may be challenged by dissident shareholders or other investors. Two well-known grounds are the alleged failure of the board of directors to use sufficiently informed judgment to be protected under the business judgment rule and the failure of the board to make adequate disclosures to the shareholders.[iii] Shareholders may also accuse directors of a breach of fiduciary duty if the directors’ decisions are unduly tainted by their own self-interest.[iv]
This is particularly so in the intrinsically risky and uncertain oil and gas industry. If family members are involved in the companies, whether as active management or as passive shareholders, the litigation risks are complicated by the prospect of sophisticated and bitter second-guessing.
Experienced merger and acquisition counsel are familiar with the objective, rational basis for expert consultants in mergers involving oil and gas interests. In reported cases, the focus of the experts’ testimony is on the facts involved in the three questions that underlie most litigation – were the directors sufficiently careful in their decision-making to be protected by the business judgment rule,; did the company adequately inform the shareholders; and did the directors and officers unduly advance their own interests in the structure of the merger?
Legal advisers to the participants in the proposed merger may recommend the use of an outside consultant to give an objective opinion on those aspects of a merger that are most often challenged in later litigation. Some of those aspects include the value of the assets of the respective firms; the risk and potential cost of pending or expected litigation; the fairness of the consideration to be paid to shareholders; and the fairness of any compensation or benefits to be received by executives as part of the exchange.
The consultation of merger & acquisition experts serves three rational functions. The first is, of course, furnishing information to management for use in the decision process about the proposed merger. That information may be used in deciding how to structure the transaction or indeed whether to go forward with it. The second use is to influence the various stakeholders in the transaction, including those who might oppose it. For example, an expert’s report on asset values may persuade a reluctant shareholder that the proposed transaction is a desirable one. The third use is to establish the due diligence and good faith of the officers and directors in advance of anticipated litigation.
The remainder of this article considers how the experts’ work can be used either to create consensus among the various stakeholders or to defuse ammunition likely to be used in later litigation.
An entirely hypothetical case would be this. The fictional events may be found to some degree in many transactions.
Imagine that a relatively small oil and gas exploration company, Little Oil, is considering merging with an even smaller oil and gas exploration and development company, Tiny Oil.
The smaller company holds leases on several tracts of land in an area that is widely believed to have been fully exploited. One of the petroleum engineers at the smaller company has formulated an analysis of where the fields can profitably be reworked; the company contends that his analysis is a valuable trade secret, belonging to the company.
On the surface, the merger could benefit both parties. The larger resulting business might be more competitive. Little Oil could offer deeper capital resources while Tiny Oil has its leases and ideas to contribute. The valuation of the assets of the smaller company, of course, involves some objective and many subjective factors, including consideration of whether the analysis is in fact a trade secret and whether the leases can be profitably exploited.
However, stakeholders may endorse or oppose the merger for reasons of their own, reasons that are somewhat independent of the more or less objective facts. To the extent that the stakeholders are involved in the analysis of the factors, their interests may affect their analysis.
The young petroleum engineer at Tiny Oil is the grandson of a legendary Texas oilfield pioneer. The young engineer has a big stake both in repairing the family’s finances and in demonstrating his ability to carry on the family’s heritage. He wants Tiny Oil (in which he owns a stake) to acquire the capital to rework the field.
On the other side, dividends from Little Oil’s relatively conservative focus on oilfield maintenance and modest new development support the comfortable lifestyles of the elderly families of the two founders. These family members, who have no involvement in the day-to-day management of the business, have a significant stake in business policies that preserve the payment of dividends.
These shareholders may fear that their interest will be diluted in the resulting entity. They may fear that a restructured post-merger management of the new entity will not be favorable to their interests. For example, the larger company shareholders who inherited their stock and who are not active in the company may fear that the new board directors will focus on reinvestment of earnings rather than on keeping up the dividends that sustain their lifestyle.
Whether they are active in corporate governance or not, shareholders may fear that the new management of the resulting firm will not be as competent as the existing team. If the shareholders are active participants in the company, they may dislike the idea of losing that role.
Dissenting shareholders are the likely plaintiffs either to try to block the merger or to seek damages from those involved if things do not go well.
Hidden dissent within the management and staff can also distort the analysis of the transaction. Tiny Oil’s senior employees may have his or her own concerns about a potential merger or acquisition. They may reasonably fear the new entity will not need their services. For example, a mid-level executive or senior engineer may fear that he or she will be the “extra” person who will be discarded and dread having to seek new employment at the age of 55 or 60.
Less obviously, senior staff at Little Oil may be understandably proud of their work or jealous of their position in the company. Even if a senior engineer is assured of continued employment, he or she may not look forward to new persons being injected into the management structure or to working on an exciting new project formulated by a much younger person.
Therefore, for example, a senior petroleum engineer at Little Oil, who fears losing her job if there is a merger, may raise various concerns about the value of the other company’s holdings, about the feasibility of developing the proposed joint venture, and so on. She may emphasize the uncertainties in Tiny Oil’s analysis.
If the boards of directors are relying on in-house expertise and analysis to decide about a merger or acquisition, the bias of in-house experts may not be apparent.
Moreover, disgruntled employees (whose views did not prevail during the merger negotiations) may be damaging witnesses in later litigation. Their testimony can be of the “I tried to tell them but they wouldn’t listen to me” flavor. Such testimony can adversely affect the directors and officers’ defense under the business judgment rule because it may create an appearance of failing to consider all of the relevant information.
How outside experts can help
In selecting experts, it is important to be clear about what the expert’s input can and cannot accomplish. An expert can add more information to the decision matrix. He or she cannot change the realities of the transaction in terms of its impact on the companies and personnel involved.
Properly used, however, an outside expert can help with those objections that are based in the dissident shareholders’ differing viewpoints of the value and structure of the transaction.
For example, with regard to shareholders who rely on dividends, a neutral financial expert can help in the evaluation of the price and may be able to suggest differing approaches to avoid or mitigate a dramatic (and litigation provoking) adverse impact on the shareholders.
A familiar complaint by shareholders is that corporate management unduly favored a transaction because of its profitability to them personally, as opposed to its value to the shareholders or its business benefits to the corporation. An outside executive compensation expert can analyze the compensation being offered to officers and directors and provide an objective review of the fairness of the proposed arrangements.
Documenting the fact that the boards carefully considered the shareholders’ financial concerns and consulted an expert to obtain guidance on them can be valuable evidence in demonstrating the good faith, prudence, and honest judgment of the directors. Their decision to go forward with a merger will more likely be protected under the business judgment rule if their judgment was informed both by their own analysis and by that of objective persons. Moreover, the outside financial expert’s analysis may show that the proposed transaction structure actually is grossly unfair to one group or another and lead to a fairer transaction, which may defuse future litigation.
However, an outside expert probably cannot address the shareholders’ concerns about or loss of status or loss of a treasured seat on the board. Those concerns need to be addressed, if at all, in the structure of the transaction.
A tactful expert can address some of the other psychological factors. If a shareholder, for example, feels that his or her input is being ignored, counsel can ask the expert to address those views expressly and to respond tactfully to them. Properly done, the otherwise dissident shareholder may come to feel that he or she is being respected and not ignored. The expert may want to acknowledge, for example, the long history of the shareholder’s family in the company or in the industry.
With regard to valuation, an oil industry expert on the development of a particular formation or field can add objective information about the value of the target company’s interests in that field.
A sensible appreciation of the viewpoints of company staff may make hiring outside expert essential. To use an old Texas expression, an outside expert does not “have a dog in the fight.” On the other hand, an outside expert may not have the loyalty and commitment to the company that long time employees have.
If counsel or management is aware that company experts are, subtly or explicitly, second-guessing the valuations involved in the transactions, then it can be prudent to instruct the experts to address the substance of the second-guessing expressly. If the outside expert’s analysis of, for example, the hypothetical young engineer’s proposal to rework a supposedly exhausted field suggests that his analysis is highly speculative, then the reasons for going forward with the transaction anyway can be carefully documented.
Business is a human activity and so involves human emotions, from ambition to greed to hope to fear. Judicious use of outside experts can moderate the extent to which emotional factors affect litigation over oil and gas mergers or acquisitions. Retention of outside experts may help to show that the directors acted prudently and thereby strengthen their “business judgment” defense. The expert’s analysis can also be used to neutralize covert undermining of the transaction by stakeholders who oppose it.
[i] Bobby Tudor quoted by Don Stowers, “Long-term oil and gas M&A outlook best in 20 years, says Tudor” Oil & Gas Financial Journal, November 14, 2012.
[ii] Ernst & Young, “Navigating Joint Ventures in the Oil & Gas Industry” (2012) (downloaded December, 2012)
[iii] See, e.g. Smith v. Van Gorkum, 488 A.2d 858 (Del. 1985)
[iv] See, e.g., Revlon, Inc. v. MacAndrews, 506 A.2d 173 (Del. 1986).
By: Donna C. Kline, Attorney at Law