The Elections
Written by: Jim MacLean
THE SECOND DRAFT OF THE 2017 CAPL PROPERTY TRANSFER PROCEDURE (“PTP”) WAS MADE AVAILABLE TO INDUSTRY IN LATE JANUARY THROUGH A WEB ENABLED DISTRIBUTION. The package on the CAPL web page includes: (I) an overview of the project scope and the major changes relative to the 2000 PTP; (ii) a detailed matrix that outlines all material changes relative to the 2000 PTP and their rationale; (iii) a clean copy of the text and annotations; (iv) a 34 page coded comment matrix that presents the detailed verbatim comments we received from a modest number of commenting parties, together with our responses to each individual comment; (v) a redline of the second draft relative to the initial July draft; (vi) Word versions of the election sheet and the case studies included as Addendums to the PTP to facilitate early use of the PTP for anyone that wishes to use the draft in a new transaction; and (vii) a redline of the second draft relative to the 2000 PTP. While we do not expect that the redline to the 2000 PTP will be reviewed in any detail, we believe that even a cursory glance at that document will demonstrate convincingly the thought and effort that has been invested in the 2017 document over the last year by our 15-member committee.
This month’s article offers additional context about the PTP by reviewing the elections that are included in the 2017 draft.
Reduction in Number of Elections
One of our objectives when preparing the 2017 PTP was to minimize the number of elections and optional elements, so that the 2017 PTP would be more user friendly. One of the things we did, for example, was to choose a value that we thought reflected the prevalent practice or a logical outcome without presenting it as an option, while recognizing that there are several these for which Parties might modify the PTP to use a different value in any transaction.
Ignoring the need to select applicable Vendor representations under Clause 6.02, the identification of GST registration numbers and the addresses for service, the number of data fields required to be completed has been reduced from 21 to 13. Even then, two of the 2017 data elements pertain to provisions that were expected to be handled in the Head Agreement when using the 2000 PTP.
The reduction in the number of elections has allowed for a single page Schedule of Elections and Modifications in Addendum I. As noted near the end of this article, it also includes a bolded instruction for users to assess if they wish to override certain listed time periods or thresholds, including several 2000 elections that are no longer elections in the 2017 PTP. Those potential modifications are also identified in the general annotations at the beginning of the PTP and in the applicable provisions.
Overview of the PTP Elections
An overview of each election included in the PTP follows.
Definition of Title Defect: The PTP includes two Alternate elections. The first, Alternate 1, is like the definition in the 2000 PTP, and is a simple objective test. It does not include the prescriptive elements included in Alternate 2 that are examples of deficiencies that are and are not Title Defects. Alternate 1 would most likely be used with the simple “walk or close” approach in Alternate 1 of Subclause 8.02B. That approach is most likely to be used on low value transactions.
Alternate 2 is a much more elaborate definition, designed primarily for the threshold based approach to Title Defects in Alternate 2 of Subclause 8.02B. Those Alternates are more likely to be used for transactions on the higher end of the range for which the PTP is likely to be used. In summary, the threshold approach included in the latter requires the Purchaser to close on all applicable Assets if the Title Defects have an attributed value not greater than 10% of the Base Purchase Price. The Purchaser may exclude the affected Assets if the attributed value is greater than 10% of the Base Purchase Price, and either Party may terminate the transaction if the attributed value is greater than 25% of the Base Purchase Price.
Definition of Wells: The identification of an accurate list of wells is becoming increasingly important because of the restrictions on the transfers of well licences under the Regulations and the sensitivity about the handling of Abandonment and Reclamation Obligations and the assumption of other Environmental Liabilities. Given the importance of the issue and the nature of the typical transaction for which the PTP will be used, this definition has been structured with three Alternates, recognizing that Alternate 1 might be used singularly or in combination with Alternates 2 or 3. While Alternate 2 can be used without Alternate 1 being selected (albeit unlikely), it is inherent that Alternate 3 can only be used with Alternate 1.
Alternate 1 captures all wells the Parties have chosen to list in a Schedule. This is the preferred approach because of the certainty and the context it offers for the acquired interests. It unlikely to be an onerous obligation for the typical transaction for which it is likely that the PTP will be used in practice. This is subject to the important qualification that the list of wells on the Schedule is not necessarily limited to wells located on the Lands or other lands pooled or unitized therewith. This structure recognizes that there may be circumstances in which the Parties have agreed to transfer residual responsibility to the Purchaser for certain other wells not located on the live mineral rights (e.g., a well drilled into deeper rights that have since reverted to the Crown, a well drilled under one of the Title and Operating Documents at a location for which the mineral rights have expired, etc.). Alternate 1 can be used by itself or in combination with Alternate 2 or 3. Alternates 2 and 3 are mutually exclusive, though, and are only relevant if the Schedule of wells is incomplete (e.g., the Schedule did not list unit wells).
The PTP is not structured to include a requirement to list all wells to be included in the Assets. Although it is a preferred practice to be as precise as possible, it can often be difficult (e.g., a disposition of a large area, units with many wells, units for which the operator does not maintain a current well list exhibit in the unit agreement, etc.). Alternates 2 and 3 include the more typical generic reference to wells located on the Lands and other lands pooled or unitized with them insofar as those wells have not already been set forth on the Schedule.
Alternate 3 offers a major exception to the handling in Alternate 2, however. Insofar as abandoned, injection, water source or disposal wells not included in a unit are intended to comprise part of the Assets, they must be listed on a Schedule if Alternate 3 is selected to apply. This requires the Parties to address the handling of these wells specifically, and is designed to minimize the possibility of subsequent disputes. This treatment reflects the degree to which the handling of abandoned wells is a matter of negotiation and the need to confirm if service wells are intended to be retained by the Vendor because they serve other assets. (See the last paragraph of the definition of Tangibles for a similar treatment of abandoned non-unit pipelines.) The corollary of this if Alternate 2 applies is that all wells not set forth on a Schedule (including reclaimed) are included in the transaction if the unscheduled wells are located on the Lands and other lands pooled or unitized therewith
Base Purchase Price and Tax Allocations (Clause 2.02): The 2000 PTP required the Parties to address the Base Purchase Price and the tax allocations among the Petroleum and Natural Gas Rights, the Tangibles and the Miscellaneous Interests in their Head Agreement. To simplify preparation of the Head Agreement, this content was moved to Clause 2.02 of the 2017 PTP. This sees the Base Purchase Price being a blank that the Parties would need to complete and the tax allocations specified as the typical 80-20 split between the Petroleum and Natural Gas Rights and Tangibles, respectively, after an allocation of $10 to the Miscellaneous Interests.
The onus is on the Parties to modify Clause 2.02 for an Asset Exchange and for circumstances in which a different tax allocation is required, as identified in the annotations on the Clause and on the Addendum I election sheet.
Deposit (Clause 2.03): This Clause has been modified significantly to simplify the Head Agreement. It is an optional Clause that addresses the requirement to submit a Deposit, if any. It includes some content from Subclause 2.02B of the 2000 PTP. If selected, the Deposit threshold has been specified at 10%, when the amount of the Deposit was expected to be addressed in the Head Agreement used with the 2000 PTP. The 10% Deposit was chosen to reflect the typical handling in industry agreements. The Parties would need to modify the provision if they wished to use a different Deposit threshold after selecting that this Clause will apply.
GST/HST Election (Clause 2.05): As was the case in the 2000 PTP, the Parties can have the Vendor collect and remit the applicable GST/HST (Alternate 1) or to make a joint election under Section 167 of the Excise Tax Act (Canada) in Alternate 2. This Clause also requires the Parties to include their respective Business Registration Numbers.
Interest Accrual (Clause 2.06): Although it is a widespread practice for Vendors to require the accrual of interest prior to Closing, the Parties will often choose not to use an interest mechanism for the low to modest value transactions for which the 2017 PTP will be used. As was the case with the 2000 Clause, the Parties will choose if their Agreement includes an interest accrual for the period up to Closing. If so, the Parties will select whether the interest accrual is from the Effective Date (Alternate 1) or only from the original Scheduled Closing Date (Alternate 2). The latter is designed to recognize the logistics of effecting a transaction and to link the interest accrual to delays in Closing.
Distribution of Specific Conveyances (Clause 3.05): The structure is consistent with the 2000 PTP.
Alternate 1 provides that the Vendor is to handle the distribution and registration of the Specific Conveyances described in Paragraph 3.03A(b) on behalf of the Purchaser. This reflects the practical fact that the Purchaser’s immediate focus after Closing is on getting the property into its system. Both Parties benefit through earlier recognition by the operator, as less accounting rework will be required. The Vendor particularly benefits by reducing the recognition period and in knowing that the registration of documents is complete.
The Purchaser controls the distribution and registration of the documents under Alternate 2. This Alternate may be attractive if there are concerns about the diligence with which the Vendor would distribute the ancillary documents. While this structure had typically been used for industry’s dispositions in the 1980s and much of the 1990s, it is now used infrequently.
Pipeline Records and Associated Transfers (Subclause 3.07B): Clause 3.07 is new in the 2017 PTP
The references to Pipeline Records reflect AER Bulletin 2015-34. It contemplates that the AER could conduct compliance monitoring (for existence and transfer of required records) on a random basis or during routine field inspections, typically after the transfers have been processed. The new licencee (transferee) is responsible for producing the applicable records on request of the AER, which places an onus on the Purchaser to protect itself through its due diligence process. A licencee that fails to do so will be in a non-compliance position. Non-compliance could, among other things, force it to conduct an engineering assessment to demonstrate that the applicable pipeline is fit for its intended use and service. Pending such an assessment, the AER could order the pipeline out of service, which may require wells to be shut-in. Compounding the challenge of compliance is that the Parties might not agree about whether the Pipeline Records are complete for the purposes of the review by the Regulatory Authority and that the Regulatory Authority’s expectation for completeness might not be known until any site inspection.
The references to Pipeline Records require the selected Party (Vendor or Purchaser) to bear accountability to address any deficiencies associated with Pipeline Records. The optional representation included in Paragraph 6.02(r) is onerous, and Vendors will typically be extremely reluctant to assume a trailing liability. One would typically expect Vendors would have a strong preference not to accept that representation and to select Alternate 1 (Purchaser accountability) in this Clause therefore. Conversely, one would expect that Alternate 2 (Vendor accountability) would be selected only (but not necessarily) if a Vendor has agreed to provide that representation.
Per Diem Rental Adjustment (Paragraph 4.01(d)): Paragraph (d) is an optional Paragraph as of the 2017 document. Parties will often choose to ignore a per diem rental adjustment for many small to modest sized transactions for which the PTP will be used, particularly for any transactions involving only undeveloped lands. This is consistent with the approach in the CAPL Farmout & Royalty Procedure, which has significantly reduced the frequency with which per diem rental calculations are used in farmouts. If selected, rentals are apportioned on a per diem basis under Paragraph (d).
Adjustment for Income Tax-Interim Period Income (Clause 4.03): This Clause has been modified significantly relative to the 2000 PTP because the CRA is no longer willing to offer the latitude in enforcement from its general practice contemplated in optional Subclause 1B of the 2000 PTP. That Subclause reflected some latitude in enforcement with respect to transactions for which: (a) the Effective Date and Closing were in the same calendar month; (b) the amounts in question were minor (or there was no significant tax benefit accruing to a Party); and (c) all the income realized during the Interim Period was fully recorded as between the Parties.
The CRA’s view is that beneficial ownership of the Assets is retained by the Vendor until Closing, notwithstanding that beneficial ownership might be acquired at Closing by the Purchaser under the Agreement retrospectively to an earlier Effective Date. The net effect is that this Clause reflects the CRA’s requirement that income realized during the Interim Period be reported by the Party that has beneficial ownership of the Assets on a real-time basis during the Interim Period. This necessarily requires an equitable adjustment mechanism to the Base Purchase Price.
The CRA’s needs are satisfied if Interim Period income is recognized by the Vendor for tax purposes. The CRA is not normally concerned by the percentage negotiated by the Parties under this Clause.
The negotiation of this percentage can often be contentious, though. Vendors will often request an adjustment percentage that reflects that they are currently fully taxable (even if in a tax deferred position). On the other hand, Purchasers will often request a very small percentage to be used if their belief is that their Vendor is in a tax deferred position in the near to medium term, even though this outcome would not consider the resultant impact on the Vendor’s tax position in the outer years.
The Parties should be cautious about deviating from the CRA’s requirements for recognition of Interim Period income. Audit risk for the transaction potentially increases significantly if the Parties purport to handle Interim Period income in a different manner, particularly if the amounts involved are significant.
Vendor’s Representations and Warranties (Clause 6.02): The representations and warranties of the Vendor in Clause 6.02 will be a matter of negotiation between the Parties. This reflects the wide variance in transaction circumstances (i.e., operated property, non-operated property to another owner or operator, non-operated property to a third party, high or low value, ORR holder and corporate philosophies). Many of these issues pertain more to whether a specific representation should be included at all, rather than its wording. As was the case with the 2000 PTP, each representation in this Clause has been presented as an option, so that it only applies if selected, even though some of them will be used in the clear majority of transactions.
The menu of potential representations and warranties is designed to provide Parties with greater flexibility for their transaction. An election not to include an optional representation is not intended to place the Purchaser in any different position with respect to the subject matter of the representation than is the case for any item that is not included in the menu of representations in this Clause.
The Clause 6.02 representations will be addressed specifically in the next article in this series.
Rights of First Refusal-Termination Right (Subclause 7.01D): Subclause D and Paragraph (d) of Alternate 8.02B (2) were updated significantly in the 2017 document. The 2000 document included a negotiated threshold for the combination of Title Defects and ROFR exercises. As of the 2017 document, the two processes are independent.
If selected, optional Subclause D allows the Purchaser to terminate the transaction if the value of the exercised Assets is 50% or more of the Base Purchase Price, a threshold that the Parties could easily modify for any transaction. The Subclause has been included as an option because Vendors will often resist providing a Purchaser with an option to terminate a transaction because of ROFR exercises. This is particularly the case for a transaction structured as an Asset Exchange. The outcome in which the Vendor receives only cash instead of properties is a negative one to the Vendor if it originally had no interest in selling the ROFR Assets. The Party that ultimately assumes the risk of a ROFR exercise in a transaction structured as an Asset Exchange is one of the critical issues to consider when negotiating it.
A Purchaser would often struggle with a construction that would require it to close on the remaining Assets if most the original value of the Assets was with respect to a property it would not acquire because of the exercise of a ROFR by a third party.
Purchaser’s Review (Article 8.00): This Article was modified to be an optional Article in the 2017 PTP. This reflects the increasing trend to require the due diligence process to be completed prior to execution of the Agreement, particularly for the low to modest value transactions for which the 2017 PTP has been designed. This provides each Party with greater control over any negotiations required to resolve any negative matters encountered in the due diligence review, and ultimately increases deal certainty if the Parties can resolve those matters. This allows each Party to know if there are material problems before execution, rather than finding themselves in a potential lingering dispute after the Agreement is executed. This approach may be particularly attractive for the more straightforward Assets for which the 2017 PTP will typically be used, and it also offers a significant potential simplification if the Assets comprise only undeveloped lands.
Even if this Article was not selected to apply, the duties in Clause 8.01 should apply to the Vendor with respect to access provided to the Purchaser for its due diligence review prior to execution of the Agreement (something that should be reinforced in the letter of intent), and the obligations in the last paragraph of that Clause should apply to the Purchaser with respect to its due diligence review. (See also the Vendor’s representation about the provision of documents in Paragraph 6.02(p).) Similarly, Subclause 8.02D should apply to that due diligence review to ensure that the Purchaser is in the same position after Closing if the Article is notselected as it would have been if it had acquired the Assets in an Agreement in which Article 8.00 was selected to apply.
Election Respecting Title Defects (Subclause 8.02B): This Subclause is only relevant in the 2017 PTP if Article 8.00 has been selected to apply. As noted in the review of the definition of Title Defect earlier in this Article, there are two Alternates for this Subclause.
Alternate 1 provides the Purchaser with three options. It may: (a) provide the Vendor with additional time to remedy the Title Defects by delaying the Closing Time to such date as the Parties may agree; (b) waive the uncured Title Defects and proceed with Closing; or (c) terminate the transaction. Alternate 1 of the definition of Title Defects should be used if Alternate 8.02B (1) is selected.
The construction of this Alternate is ultimately binary. Unless otherwise agreed by the Parties, the ultimate choice of the Purchaser is to proceed to Closing or to terminate the transaction. The major advantages of this approach are its relative simplicity and the prohibition against “cherry picking”, such that it can be particularly attractive for minor value transactions. In addition to avoiding the potential for cherry picking, this mechanism also avoids the valuation problems inherent with the potential exclusion of portions of the Assets.
Alternate 2 includes greater flexibility in the handling of the Title Defects. Closing will proceed without any adjustment for Title Defects if the value of the outstanding Title Defects is below a threshold of 10% of the Base Purchase Price, a threshold that might not be appropriate for a minor value transaction.
If the value of uncured Title Defects is above the 10% threshold, the Purchaser has four options. It may: (a) provide the Vendor with additional time to remedy the Title Defects by delaying the Closing Time to an agreed date; (b) waive the uncured Title Defects and proceed with Closing; (c) proceed with Closing for the Assets not affected by the Title Defects, with the consideration being reduced accordingly, insofar as that value is greater than the 10% threshold; or (d) terminate the Agreement if at least 25% of the consideration is applicable to the Assets affected by the uncured Title Defects. However, the Vendor may also terminate the transaction if the Purchaser is proposing to exclude Assets with a value of at least 25% of the Purchase Price under Paragraph B(c). There are protections included to address the situation in which the Vendor does not agree with the values the Purchaser attributed to the Assets affected by the Title Defects.
The thresholds in Paragraphs (c) and (d) of this Alternate were modified from a blank to be negotiated for each transaction to 25% as of the 2017 document. This was done to reflect the most typical negotiated outcome and to reduce the number of elections associated with use of the PTP. The Parties always remain free to negotiate a different handling in any transaction.
Addresses For Service (Clause 15.02): The Parties are expected to add their respective addresses for service in this Clause, as was the case for the 2000 PTP.
Users Need to Validate Time Periods and Financial Values
One of the areas of emphasis in the update to the 2000 PTP was to eliminate unnecessary elections by structuring the applicable provisions to reflect what appeared to be the prevalent practice or a logical outcome without presenting it as an option. This was to facilitate acceptance of the 2017 document by reducing significantly the number of required elections to allow a more user-friendly platform for the typical low to modest value transaction.
It will not be uncommon, though, for Parties to choose a different value in any transaction. The more common anticipated changes of this type are identified in the applicable annotations and in the bolded reference in the Schedules of Elections and Modifications included in the Addendums at the end of the document. Those references remind users to confirm that the defaults in the document are appropriate for their transaction.
Modifications to the defaults included in the PTP might be considered, for example, if: (a) the transaction is an Asset Exchange (e.g., GST Business Numbers; Clause 3.01 place of Closing; and possible differences in the Clause 6.02 Vendor representations); or (b) the Parties want to override prescribed time periods or thresholds that had been elections or Head Agreement content in the 2000 PTP. Examples of these are: (i) Clause 2.02 tax allocations; (ii) Clause 2.03 optional 10% Deposit; (iii) Subclause 3.04B access to files period; (iv) Paragraph 4.02A(b) final statement of adjustments within six months; (v) Clause 6.05 and 13.01 survival period on representations and warranties; (vi) optional Subclause 7.01D 50% or more ROFR exercise threshold; (vii) Subclause 8.02A seven Business Day period for notice of Title Defects; (viii) Subclause 8.02B Alternate 2 Title Defects thresholds of 10% and 25%; and (ix) the $25,000 minimum claim threshold in Subclause 13.03B.
Other provisions that specify timing or a financial threshold that might be modified include: (i) the 31 day thresholds for marketing and J.V. agreements used in Paragraphs (c) and (g) of the definition of Title and Operating Documents and the corresponding representations in Paragraphs 6.02(i) and (j); (ii) the contemplated handling of freehold mineral tax in Clause 4.01; (iii) the $10,000 threshold in Subclause 4.02B; (iv) the $50,000 authorized expenditure threshold in Subclause 5.03A and Paragraph 6.02(h); (v) the $100,000 threshold for addressing regulatory requirements under Paragraph 6.02(l); (vi) the 60-day period prescribed for replacing signs under Clause 11.02; and (vii) any modifications to the handling of surplus equipment contemplated in Clause 11.03.
Balancing Simplification with Flexibility
As part of “making simple transactions simple again,” the 2017 PTP has been designed to balance simplification with the retention of required content and optionality.
We chose to reduce significantly the number of elections in the 2017 PTP relative to the 2000 document by retaining necessary options and eliminating options for items for which we believed there was a prevalent industry practice. We structured the annotations and the Schedule of Elections and Modifications included as Addendum I to the PTP to remind users of the timing and financial thresholds that Parties might choose to modify for any given transaction.
The overarching philosophy in the 2017 PTP is one of options where necessary, but not necessarily options. Next month’s article reviews the Vendor’s representations and warranties, as outlined in Article 6.00 of the PTP.
Published: The Negotiator, April 2017
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