UK: Pre-emption Clauses Under Attack

Pre-emption clauses have long been a topic of discussion in the area of UK upstream oil and gas agreements. They are seen as a commercial barrier to activity and development on the UK Continental Shelf. Caroline Kehoe, a partner in Herbert Smith’s London litigation practice and Nicola Foate, a senior assistant in the firm’s Energy Group take a look at the attention they have recently attracted from PILOT and the DTI who have undertaken to reform industry behaviour with a view to eliminating practices which can discourage activity on the UKCS.

PILOT is the successor body to the Oil and Gas Industry Task Force, which was established in January 2000 with the objective of securing the long-term future of the oil and gas industry in the UK. PILOT is made up of 23 key government representatives and recognised leaders from the industry.

PILOT was established to address concerns that while short term activity was improving in a mature North Sea base, finds are smaller, exploration levels low, managers risk adverse and there is therefore little incentive to turn over inactive licence holdings. Also, there are several barriers to new players who may be more innovative.

PILOT’s aims are to achieve the following outcomes for 2010:

• Maintenance of the production level of £3 million barrels of oil equivalent per day;
• £3 billion per annum investment;
• Prolonged self sufficiency in oil and gas;
• Up to 100,000 more jobs;
• 50% increase in exports by 2005; and
• £1 billion per annum additional revenue from new business.

PILOT has set up a Progressing Partnership Work Group (PPWG) which has as one of its aims to identify all commercial barriers to development that exist, to consider the degree to which they have a negative impact on development activity, assess their causes, develop options for removing or limiting them and to recommend an appropriate way forward. In doing so, they looked at best practices in the Gulf of Mexico, Australia, Canada and Norway.

One of the recommendations made by the PPWG on 4 January 2002 related to pre-emption provisions in Joint Operating Agreements. They identified these provisions as being commercial barriers to licence trading which therefore stifle activity, especially with regards to exploration and the facilitation of early development of discoveries.

Pre-emption rights came about because of a traditional view that co-licensees, who have chosen to exploit a licence together, should have advantages in relation to each other’s shares in the licence over prospective newcomers who may wish to obtain rights under the licence. Rather than allowing interests in the licence to go to outsiders, pre-emption rights were developed to allow participants to exclude newcomers.

Pre-emption rights take various forms and are found in many Operating Agreements. The first and most traditional form is an obligation on the seller to offer the partners a deal equivalent to that which has been negotiated with a buyer. Such a right cannot be exercised until after the end of the negotiation process by which time a potential third party purchaser has spent substantial time and money. A common alternative, which developed because it was seen as less of a deterrent as it would arise early in the negotiation process, is a right of first refusal. That is an obligation on the seller to offer the interest to its co-licensees first before negotiating with third parties. Pre-emption rights usually apply only to asset transfers. Pre-emption clauses that are expressed to apply to a change of control through a sale of shares are rare.

Over the years disposals of interests have become more common and pre-emption rights have caused delays and difficulties in disposing of interests. This has led to the use of a number of different ‘devices’ to circumvent the pre-emption provisions. For example, an argument can be raised that the right cannot be exercised because no match can be made, if, for example the consideration being offered by a buyer is not all cash, but instead consists in whole or part of an interest in another field, equity in a company or loan notes from a particular lender. Another way in which transactions can be structured to fall outside pre-emption clauses is to transfer the assets in question to another company and then to allow the buyer to acquire the share capital in the new company.

It is questionable to what extent these devices are in fact effective. There have been few cases before the courts in which they have been tested. The few there have been, however, have suggested that English courts in particular are willing to go to extensive lengths to give effect to pre-emption clauses.¹

The PPWG recognised that pre-emption provisions arise through valid commercial considerations and can have a positive role in facilitating and progressing development and generating activity in the licence. They found, however, that the uncertainty for new entrants resulting from the possible exercise of pre-emption rights late in the negotiation process and the associated time and costs wasted in negotiations did act as a deterrent to newcomers or companies considering bidding for licence interests. They came to the view that while pre-emption is not inherently bad, the negative aspects of pre-emption rights would be overcome if the parties with existing rights were clear and open about their intentions throughout the process, and if existing pre-emption rights were invoked as early in the process of negotiation as practicable.

They recognised that there would be exceptional circumstances where invoking more stringent pre-emption rights could be justified, such as where it was necessary to secure alignment between co-venturers i.e. to ease decision making or to maintain co-venture activity, for example, when high risk decisions are imminent, development approval is imminent, the field is in a late stage of its life or there is a commitment to pre-existing collective undertakings of co-venturers such as environmental undertakings in relation to reduction of CO2 or emissions trading.

The PPWG considered eliminating all existing and future pre-emption rights by requiring companies voluntarily to relinquish existing pre-emption rights. Several licensees indicated that they would be unwilling to agree to this. It was therefore decided that a solution should be found to overcome the most harmful aspects of existing pre-emption right clauses. The aspects identified which are most detrimental to the market were:

1. That parties with existing pre-emption rights frequently do not declare their intentions until late in the negotiation process because pre-emption clauses often require a fully termed purchase and sale agreement to be negotiated with a prospective buyer before they can be invoked. This means that prospective purchasers incur significant time and expense in negotiating an agreement without knowing whether or not pre-emption rights are going to be exercised. It also creates uncertainty for prospective new purchasers; and

2. Deliberation times under existing pre-emption rights can extend up to 90 days which is a significantly prolonged period of uncertainty in the time required to complete the transaction. In other countries, such as Canada and the USA Gulf of Mexico, the transfer of a licence can occur within 30 working days when a pre-emption right existed.

The PPWG recommended that pre-emption provisions should not be included in new Operating Agreements other than in special and justified circumstances.

In relation to existing licences, they proposed that any current pre-emption clauses be replaced industry wide with a standard procedure which would include transparent and timetabled guidelines for the execution of pre-emption rights in an effort to end uncertainty and speed up the transfer of assets. They proposed the following procedure:

1 Licensees to notify co-licensees of their intentions to sell and co-licensees to advise within seven working days whether they wish to reserve or waive existing pre-emption rights;

2 Licensees to negotiate simultaneously with third parties and co-licensees who have reserved existing pre-emption rights, at their discretion; and

3 Licensees to notify co-licensees of the key terms of any successful negotiations with a third party and co-licensees to then have 30 days within which to notify the disposing licensee of any intention to exercise pre-emption rights. This right is to apply only in relation to cash sales or other instances where the cash value or the compensation offered is required to be determined under the existing pre-emption rights.

They proposed that if pre-emption clauses are included in new agreements (i.e. in special circumstances) they should also follow the above procedure.

The PPWG also recommended that by way of incentive for the industry to agree to such a voluntary code, the DTI should remove, by amendment of existing licence provisions, any residual liability to the Secretary of State associated with licensed acreage that has been disposed of by companies which have agreed to the proposed amendments to their Operating Agreements.

The DTI is also in support of these recommendations made by PILOT. On 16 January 2002 Energy Minister Brian Wilson announced the 20th Licensing Round for over 270 whole or part offshore blocks in the Southern, Central and Northern North Sea. Applications for licences closed on 16 April. One of the DTI’s stated objectives was to develop a full, active and efficient market in trading licence interests by encouraging speedier decision making in relation to the transfer and assignment of licence interests. One of the ways it proposes to achieve this is only to award licences if the applicants do not include pre-emption clauses in their Joint Operating Agreements, except in special circumstances (i.e. where the applicant has satisfied the DTI that there is such a need and as to the special circumstances). This is clearly stated in the Notes for Applicants issued with the 20th round Application Forms (see note 8). It is also stated in note 8 that "In cases where there is competition for acreage, the DTI will take this issue into account." In other words, if applicants agree not to use pre-emption rights they will receive more favourable treatment from the DTI.

Various opinions have been expressed on these and other PILOT/DTI initiatives aimed at reforming industry behaviour in UKCS activities.

Paul Blakeley, co-chair of the Industry Leadership Team (ILT) within PILOT and General Manager of Talisman Energy UK, said:

"Many of the Industry’s practices today are based on methods of working that were effective for delivering the huge oil and gas projects of the 1970s and ‘80s. While there is still the potential to produce as much oil and gas again as we have to date, the future is not going to mirror the past. We will have to change radically the way we do business if we are to access efficiently and effectively these reserves which lie in smaller, more complex reservoirs."

Tom Botts, Managing Director of Shell Expro, said: "I’ve been very impressed with the spirit and determination of companies big and small, both operators and contractors, working closely with government to create the changes we all need to make the UKCS more competitive. The "Progressing Partnership" effort is a great example of what PILOT can deliver."

Sir Ian Wood, ILT Co-chair and Chairman of the John Wood Group, said: "A key outcome of the Progressing Partnership work is the Codes of Practice for licence holders and the supply chain. These should facilitate the relationships and conduct of business between the key North Sea stakeholders and will enhance commercial activity. The codes improve standards, transparency and commitment and are intended to make the UKCS a more efficient and profitable place to do business."

© Herbert Smith 2002

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