Marc H. Folladori and Charles L. Strauss
Fulbright & Jaworski LLP
Houston
Energy companies tapping the US and international capital markets have special issues and concerns to deal with that are unique to their industry. This article explores some of these special issues and concerns.
Registered and non-registered offerings
Companies issue debt or equity securities to raise capital in the US capital markets. Issuing securities to the public requires the preparation and filing with the Securities and Exchange Commission of disclosure documents describing the issuer, its operations and properties, its risks, and its results of operations and financial condition. The preparation and SEC clearance of these registered filings require a lot of time and expense.
However, energy companies have increasingly also relied on Rule 144A under the US Securities Act of 1933 for non-registered offerings. The SEC adopted Rule 144A to improve the liquidity and efficiency of the private placement market for securities. Rule 144A gives institutional investors more freedom to trade these privately-placed securities, and better enables foreign companies to sell their securities in the US capital markets.
At its core, Rule 144A is a bridge to a quasi-public market that allows a company to sell its securities in a private placement to an investment banker, who then resells them to institutional investors. Often, the private securities are later exchanged for SEC-registered securities having the same terms as the private securities. This form of transaction is loosely referred to as a 144A/B offering. Usually, the purchasers of the securities in the private placement are either Qualified Institutional Buyers (QIBs) or energy industry players. However, in some cases, they may be financially accredited individuals.
At the sophisticated end of the market, the QIBs are largely institutional investors of various types - insurance companies, pension funds, mutual funds, brokerage firms, banking institutions, state or other political subdivisions, and investment advisors. To qualify as QIBs, these entities must hold existing investments with a cumulative value of $100 million (apart from their investment in the offering).
The advantage of a 144A/B offering is that deals can get funded more quickly. Typically, a registration statement for the second-stage exchange offer can be filed and cleared by the SEC and registered securities placed in the hands of investors within six months from the date of the private placement. Generally speaking, if the exchange offer isn’t completed within a specified period of time, a contractual penalty is imposed on the company to, in effect, pay additional interest to the holders of the privately placed securities until the SEC clears the offering and the exchange offer is completed.
An important thing to remember in these deals is that the investment bankers will want to see an offering document that is nearly as complete in explaining the company’s business, financial condition, and risks as would be required in a public offering. Investment bankers don’t want to have to explain to the SEC why a 125-page document was filed for the exchange offer, but the private placement had utilized only a four-page offering memorandum.
Disclosures in offering documents
In the current cautionary environment, energy companies try to walk a fine line in the language they use in offering documents and financial reports. While companies often stress their strategy of acquiring attractive properties, there is often also a need to present a warning statement as a risk factor that the company’s failure to fully identify and correctly evaluate potential problems (such as potential reservoir damage from development efforts), to properly estimate reserves or production rates or costs, or to effectively integrate the acquired operations could seriously affect the company’s financial results.
On the other hand, several energy companies discuss in their financial reports their expectations regarding future oil and gas prices and expected demand for their products and services. In the service sector, these analyses often result from peer pressure from competitors - that is, the disclosures are a common practice among a company’s competitors and are expected by analysts and institutional investors. This type of disclosure is often encouraged by the SEC, but companies should be careful to add appropriate disclaimers regarding these forward-looking statements about their future expectations.
In any case, information in offering documents for companies within the energy industry always varies by sector. The service companies, like manufacturers of all types, include discussions of intellectual property, research and development expenses, and their efforts to field cutting-edge technology to stay competitive. Many service companies enter into international joint ventures to develop new technologies more cost-effectively.
Restrictions on exports and international sales are vitally important to them, and are often disclosed in some detail. Consolidation trends and anti-competitive concerns affect many energy companies as well; these topics require great care in making the appropriate disclosures.
Refining and marketing companies generally provide summary refining and marketing data, often by geographic regions. There is generally a lot of discussion of environmental matters and related costs of compliance, as well as information on commodity price risks and hedging strategies and interest-rate risks.
Exploration and production companies typically caution investors about uncertainties over their reserves estimates and changes to them over time, as well as how reservoirs are classified and price projections are made. Debt covenants for E&P companies don’t generally vary much from other types of enterprises, except for limitations placed on certain asset sales and a covenant requiring maintenance of “Adjusted Consolidated Net Tangible Assets” at specified levels; this definition typically backs out certain production payments, gas balancing liabilities and other items, but is basically a tangible net worth test for E&P producers.
Finally, a concern common to all sectors of the industry is the development of a glossary in the disclosure document that contains plain English definitions. The SEC in the late 1990s began to require companies to make their disclosures in “Plain English” - sometimes a difficult task given the highly technical and specialized nature of the energy industry. Some sector-specific terms defy the use of simpler language, and developing the glossary can be one of the more time-consuming parts of crafting effective disclosures.
Supplemental oil and gas disclosure
Items such as the supplemental oil and gas disclosures for E&P companies - a product of Financial Accounting Standards Board (FASB) No. 69 - provide useful information for investors. Among other things, these unaudited financial statement footnotes show how successful a company has been in oil and gas development by showing a company’s costs in acquiring leases, its capitalized costs, its proved reserves and - important to analysts - its success in replacing reserves, both in volumes of production and discounted cash flows. Derivatives disclosures are also critical for energy companies that hedge a lot of their production or purchases.
Investment bankers will usually also want additional disclosures in an offering document, such as well spacing requirements, unitization requirements, and numerous other regulatory and other parameters. The investment bankers will usually request due diligence meetings with an energy company’s engineers, as well as the inside and outside accountants, so they can confirm this information.
They will also require “comfort letters” from the independent engineers and the outside accountants covering certain numerical information. While comfort letters are an expected component of any offering, they add time and expense to the process.
Use of non-GAAP financial measures
A positive regulatory development in recent years that aligned the interests of both issuers and buyers of securities was the SEC’s change in its approach to disclosures of “non-GAAP financial measures.” A non-GAAP financial measure is an amount that is a measure of an issuer’s financial performance, cash flows, or financial condition that either includes or excludes amounts that should be included or excluded in the most directly comparable financial measure calculated and presented in accordance with generally accepted accounting principles in the issuer’s income statement, balance sheet, or cash flow statement. Thus, GAAP-calculated financial amounts that are adjusted for various purposes are considered non-GAAP financial measures. The common E&P company cash flow yardstick of “EBITDAX” is considered a non-GAAP financial measure.
The SEC’s Regulation G requires any energy company that discloses non-GAAP financial measures to identify and define both the non-GAAP measures used and the comparable GAAP measures, and to provide a reconciliation of the non-GAAP measures with the most directly comparable measures calculated in accordance with GAAP. This involves a quantitative schedule for actual measures and, to the extent available, for estimated future measures as well, detailing the differences between the non-GAAP and the GAAP information.
Also required are statements describing why the particular non-GAAP financial measure provides useful information to the issuer’s investors and the reasons why the issuer uses the non-GAAP measure. Although the SEC has never liked EBITDA or EBITDAX, Regulation G is a recognition that non-GAAP information that many analysts expect to see, such as replacement costs per boe for E&P companies, is acceptable so long as the required GAAP information is also provided. OGFJ
The authors
Marc H. Folladori [[email protected]] is a partner at Fulbright & Jaworski LLP. He has more than 30 years experience in corporate and securities offerings, SEC disclosure and reporting requirements, and mergers and acquisitions. He has managed the legal aspects of many transactions for a variety of clients, including public and private issuers, investment partnerships, independent committees of boards of directors in connection with acquisitions, and underwriters in initial public offerings and secondary offerings.
Charles L. Strauss [[email protected]] is a partner in the Houston office of the international law firm of Fulbright & Jaworski LLP. He has extensive experience in mergers, acquisitions and divestitures, public and private issuances of equity and debt securities, exchange and tender offers, corporate restructurings, joint ventures, international law, and compliance matters. He has particular experience in partnership law, Canadian public offerings and stock exchange matters, and often represents companies in all sectors of the oil and gas industry.
