The Rise of Mergers and Acquisitions in the Energy Sector: What to Expect and How to Be Prepared for Potential Litigation Issues


"By failing to prepare, you are preparing to fail."
-- Benjamin Franklin

The trend toward mergers and acquisitions in the energy sector is accompanied by an increased risk of post-transaction litigation. Since post-transaction litigation can take many forms, a single merger or acquisition can give rise to many different types of litigation and differing causes of action.

Both management and its counsel must be aware of these risks. It is also important to understand that the risk of litigation is not limited to the merging or acquiring entities.

Often litigation will involve shareholders, subsidiaries, other oil and gas producers or operators, or governmental enforcement entities. Accordingly, litigation risk should be assessed even by management not directly involved with the merger or acquisition.

Mergers and Acquisitions in the Energy Sector

The number of mergers and acquisitions in the energy sector has trended upward and is expected to continue for the foreseeable future. With this upward trend in merger and acquisition activity comes a concomitant increase in the potential risk for post-transaction litigation. It is important to understand, however, that a number of different types of litigation may arise out of a single merger or acquisition.

For example, since a single merger or acquisition may give rise to claims asserted by:

  • shareholders for alleged misrepresentations
  • competitors for possible antitrust liability
  • federal agencies for regulatory violations
  • shareholders for derivative actions
  • environmental cleanup claims for successor liability

One merger or acquisition could potentially spawn several different types of litigation. On top of all of this, the failure of the transaction itself may give rise to litigation between the parties.

The changing culture of the energy industry also increases the risk of litigation. The industry is no longer led by a consistent cadre of individuals who largely know one another and who have communications on an informal basis.

Instead, the industry has continued to evolve through a series of mergers and acquisitions, whereby smaller oil patch companies have grown into much larger international concerns. Mid and upper level management have become correspondingly vulnerable and migrant, further diluting the network that had in the past oftentimes facilitated compromise.

In this new age, it is often more difficult for the businessmen to resolve a dispute over lunch or a cup of coffee simply because relationships are less permanent, and the issues increasingly complex. Nevertheless, proper preparation and prompt response to disputes may still bring resolution informally and expeditiously, and allow the parties to proceed amicably.

Post-Merger and Acquisition Litigation Concerns

Management and their counsel should be aware of the potential litigation issues that arise out of mergers and acquisitions, and they should specifically assess possible areas of dispute for any potential transaction. Once identified and assessed in advance, measures can then be taken to address the risk during negotiations and drafting of the agreement. For example, merging companies increasingly use "material adverse change clauses" to safeguard against unforeseen developments, although their use does not guarantee a dispute-free post-transaction.

Although some issues may be addressed in the transaction agreements, not all contingencies concerning a particular issue may be considered ahead of time. In this way, the potential for litigation survives despite, and sometimes because of, the transaction agreement. Even when issues are identified and addressed within the agreements, the parties may subsequently disagree on interpretation. See, e.g., Consolidated Edison, Inc. v. Northeast Utilities, 249 F.Supp.2d 387, 411-412 (S.D.N.Y. 2003) (litigating the meaning of the terms of the material adverse change clause contained in the merger agreement of a failed merger).

Four Litigation Risks Common to Most Corporate Mergers and Acquisitions

Four litigation issues common in merger and acquisition scenarios are briefly identified below:

Personal Injury Liability and Indemnity

Although personal injury liability is usually addressed by commercial general liability insurance, merging or acquiring companies can address future liability in the form of indemnity as well as with their respective insurers.

Accounts Receivable, Accounts Payable and Outstanding Business-Related Issues

Outstanding invoices or business liabilities, including accounts receivable to other businesses and accounts payable to vendors, are another post-transaction litigation risk. Despite having accounted for debts and liabilities, there is still the danger that some debt is asserted after the merger or acquisition, or that additional liability will accrue and claims will be asserted against the surviving entity as a result.

Employment Benefits, Retirement Issues and Future Employment Liability

Liability for employment matters generally survives the merger or acquisition, and the parties can face significant post-transaction potential litigation risk.

Antitrust Issues and Possible Third Party Liability for Monopolization

Depending upon the size of the merging entities and the specific industry, government approval may be required prior to execution of the merger or acquisition. Also, government approval may be necessary both from domestic governmental agencies and from those abroad.

A related post-merger or acquisition risk is that posed by possible third-party antitrust liability based on monopolization claims from competitors.

Post-Merger or Acquisition Litigation Risks Specific to Energy Corporations

As noted above, even with a comprehensive agreement and "material adverse change clause," the risk of dispute and litigation may remain. Not only is every contingency impossible to prophesy, the parties may dispute the terms governing those issues that are actually addressed. Some common post-transaction litigation issues specific to energy corporate mergers and acquisitions are discussed below:

Environmental Liability and Operations Site Cleanup

Environmental liability presents an important potential post-merger or acquisition litigation risk for energy companies. In some cases, plaintiffs assert claims against the merged corporation based on the alleged environmental record of the company acquired. See, e.g., National Union Fire Ins. Co. of Pittsburgh, P.A. v. U.S. Liquids, Inc., 88 Fed. Appx. 725, 730 (5th Cir. 2004)(unpublished opinion) (construing insurance provision exclusions regarding post-merger claims for environmental liability allegedly accruing to merger target corporation).

Shareholders of the acquiring corporation bring claims asserting that the value of the company acquired was misrepresented based on its outstanding and allegedly undisclosed environmental liability. This risk is not limited to shareholders, however, as other entities may assert dormant environmental cleanup claims based on past operations.

In other cases, former lessees may assert claims against the merged corporation based on successor liability, alleging, for example, that the acquired company failed to clean up sites where it operated. ee, e.g., Davis Oil Co. v. TS, Inc., 145 F.3d 305, 307-8 (5th Cir. 1998). Often oil and gas leases pass through several operating entities, or are assigned between entities that later merge or are acquired.

Environmental liability or plugging and abandonment claims may be pursued by governmental agencies against a former owner in the chain of title for a mineral or operating interest that was assigned to a now defunct third party. Such potential liability may be difficult to address when successor entities seek to merge. For this reason, environmental liability poses a significant post-merger or acquisition litigation risk to energy corporations.

For example, Halliburton, a pipeline services company based in Houston, took on asbestos liabilities when it bought Dresser, a pipeline equipment maker whose former subsidiary, Harbison-Walker Refractories Inc., had used asbestos in products like bricks and pipe coatings. See Glater, Jonathan D., Halliburton Tries to Settle Asbestos Suits, NEW YORK TIMES, Dec. 31, 2002 ("Lawyers representing both the company and plaintiffs outlined a strategy that would allow Halliburton to resolve tens of thousands of asbestos related health claims it inherited when it bought Dresser Industries in 1998 -- and resolve them without taking the usual step of having the whole company file for bankruptcy.").

Disclosure of Assets in the Form of Oil and Gas Reserves

Exploration and production-based energy companies are valued by and large on the basis of their "reserves." Since the hydrocarbons represented as reserves have not yet been produced, energy companies must include in their disclosures and as part of their business accounting a calculated risk of the production of such hydrocarbons.

Energy companies also evaluate the progress of exploration and production projects and the risk and likelihood of success of such projects. When risking factors change, requiring energy companies to re-calculate their reserves, shareholders may claim prior misrepresentations. See, e.g., Cohen and Silverstein, et al. v. Royal Dutch Petroleum Company, et al., No. 2:04-cv-00283-JWB-GDH (D. N. J., filed January 23, 2004) (litigation arising out of reserves disclosures made by Royal Dutch Shell) ; see also, e.g., Flood v. Miller, 35 Fed. Appx. 701 (9th Cir. 2002). Gunter v. Ridgewood Energy Corp., 32 F.Supp.2d 166, 171 (D.N.J. 1998).

Energy corporations disclose their reserves on a regular basis. However, as noted above, when energy corporations merge, the valuation of the assets of the companies being acquired often forms the basis for plaintiff shareholder allegations. See McDonald v. Kinder-Morgan, Inc., 287 F.3d 992 (10th Cir. 2002). For this reason, oil and gas reserve disclosures present a very significant post-merger or acquisition litigation risk.

Regulatory Issues

The purpose of the Federal Energy Regulatory Commission (FERC) is to ensure that the natural monopoly held by oil and natural gas pipeline operators over the transportation grid does not give them an unfair advantage over non-pipeline sellers of gas. Colorado Interstate Gas Co. v. F.E.R.C., 146 F.3d 889, 890 (D.C. Cir. 1998). The FERC is also empowered to approve the disposition of any assets by public utilities and to ensure that the merger or acquisition of public utilities is consistent with the public interest. 28 U.S.C. § 824(b) (2004).

The courts have held that, in some instances, private parties who are competitors with the merged entity may bring suit challenging the FERC approval. See, e.g., Wabash Valley Power Ass'n, Inc. v. F.E.R.C., 268 F.3d 1105, 1113 (D.C. Cir. 2001) (holding that a competing public utility could challenge FERC approval of a merger and that the plaintiff's "competitive injury is fairly traceable to FERC's decision to approve the merger [of plaintiff's competitors].").

In addition to the FERC, other governmental agencies regulate and license energy and power generation companies on both the federal and state level. Such regulatory agencies may institute litigation or become party to post-transaction litigation as private parties challenge the rulings that the agencies make.

State and federal agencies may also directly challenge aspects of a merger or acquisition involving energy companies and public utilities. Accordingly, governmental regulatory authority, on both the state and federal level, present important post-merger or acquisition litigation risks to energy companies.

Royalty Accounting

Energy corporation management and its counsel face a risk of post-merger or acquisition litigation arising out of dormant royalty claims. Energy corporations that generate revenue from hydrocarbon production often must assign royalty interests to natural resource owners and operators.

Over the life of the production from a particular well or field, these royalty interests may be assigned continuously to different parties and the royalty interest fragmented. Accounting for such assignments and fragmentation over the life of production presents the energy corporation with accounting problems.

In addition to the assignment of leases between producers, the producers themselves may merge or become acquired. In such cases, the accounting problems become more significant as the dormant claims can be unknowingly amalgamated and multiplied. As the claims lie dormant over a period of many years, very small royalty payments may become multiplied by both time and the prejudgment interest plaintiffs may seek in court.

Preparing for the Unexpected: Handling Litigation Risks and Arising Issues

Although management cannot anticipate every potential dispute regarding the transaction and its immediate aftermath, it can prepare effectively to address the issues that arise. Importantly, with an understanding of the potential litigation issues that may arise, management and counsel may be better prepared to react quickly and decisively.

Looking forward, we focus on two emerging areas of post-merger or acquisition litigation: potential liability arising out of environmental issues or oil and gas field cleanup and disclosures of oil and gas reserves.

In some cases, quick and decisive action provides an advantage in incipient litigation arising post merger or acquisition. In other cases, it may allow management and its counsel to prevent the need for formal litigation entirely. In both scenarios, being forewarned is being forearmed.

The parties to the merger or acquisition may opt for alternative dispute resolution of the issues between them. With regard to exposure arising out of from potential shareholder misrepresentation or shareholder derivative actions, the Private Securities Litigation Reform Act may provide a defense. Shareholder derivative and shareholder misrepresentation claims may achieve class action status, elevating exposure risk to the corporations.

Environmental Liability or Oil and Gas Reserves Disclosures

As we focus on environmental liability and disclosures of oil and gas reserves, we note that the same form of litigation risk accompanies both types of claims. In both instances, the merged or acquiring company may not have knowledge or notice of the exposure at issue.

First, with regard to environmental liability, the actual extent of the environmental record of the acquired entity may not be known prior to the merger or acquisition, or even for years post-transaction. There may be successor liability arising out of leases or operations that had been assumed or merged previously.

Similarly, with regard to the disclosure of reserves, the difficulty and risk accompanying their calculation may be exacerbated by the fact that it was conducted under the management (and the engineering) of the acquired entity, not those of the merged or acquiring company now the target of the claims.

Being Prepared Allows for an Effective and Prompt Response

With regard to the parties to a merger or acquisition and any governmental agencies, management may first explore resolution informally. Based on the fact that the parties and their representatives have likely endured extensive negotiations together to consummate the transaction, relationships may still be in place that allow for informal resolution of any unexpected disputes.

It is important, nevertheless, to consult litigation counsel, as the steps taken post-transaction may impact the parties' positions in any litigation that results.

Since the parties to an acquisition may have a relationship in place, they and their related entities should first consider alternative dispute resolution, if no informal resolution can otherwise be arranged. Importantly, even in alternative dispute resolution, management should have the advantage of understanding the issues involved ahead of time.

In this way, not only can management and its counsel proceed in alternative dispute resolution, they will already be preparing for litigation, should it be necessary.

Shareholder Claims and the Private Securities Litigation Reform Act

Environmental liability and oil and gas reserves disclosure often give rise to shareholder claims against the merged company. See, e.g., In re FirstEnergy Corporate Sec. Litig., 316 F.Supp.2d 581 (N. D. Ohio 2004). Management is left to ascertain the extent of this liability and how best to address the claims asserted. Additionally, the plaintiffs in such litigation will be less likely to reach an expedient resolution, either informally or through alternative dispute resolution.

In shareholder derivative cases, and at times in shareholder fraud cases, the plaintiffs often target corporate officers and directors directly and sue them individually. This also makes informal resolution or alternative dispute resolution less likely.

In the event of litigation, energy corporations targeted by shareholder claims or class actions may assert the Private Securities Litigation Reform Act ("PSLRA"). 15 U.S.C. § 78u-4. The PSLRA was enacted by Congress specifically to address shareholder fraud suits; however, it applies to energy corporations in most shareholder claims and may benefit energy corporations facing post-merger or acquisition litigation. See FirstEnergy Corporate Sec. Litig., 316 F.Supp.2d 581, 589 (N.D.Ohio 2004) ("In major part, Plaintiffs say Defendants misled investors to facilitate a merger with General Public Utilities, Inc. ('GPU').

Since the merger with GPU required FirstEnergy to assume a significant amount of new debt, the Company allegedly misled investors to maintain its already precarious credit rating."); see also Sandmire v. Alliant Energy Corp., 296 F.Supp.2d 950 (W.D.Wis. 2003) (in investors' suit against energy utility that had merged an alleging misrepresentation to facilitate merger, held that the scienter requirements of the PSLRA were not met and dismissing case).

Under the PSLRA, the plaintiffs must set forth each of the statements upon which they base their claim and specify each statement alleged to have been misleading and the reason or reasons why the statement is misleading. See 15 U.S.C. § 78u-4(b)(1).

In considering claims brought by shareholders claiming that they were misled in order expedite a merger or acquisition, the courts require that they set forth with respect to each alleged act or omission the particular facts that give rise to a strong inference that the defendant acted with the required state of mind. See FirstEnergy Corporate Sec. Litig., 316 F.Supp.2d 581, 591 (N.D.Ohio 2004)

Conclusion

Increasing merger and acquisition activity in the energy sector continues to spawn post-transaction disputes and litigation. To respond effectively and successfully, management and counsel must work together to identify, assess and address potential litigation issues when they arise.