There have been a number of trading portfolios acquired and disposed of in the commodities trading sector in the last 18 to 24 months (commodities acquisition(s)). This activity has been due to a number of factors, such as some banks exiting the commodities markets due to increased regulation, new entrants into the commodities trading sector, and a shift in market fundamentals of commodities such as oil and metals.
The change in the regulatory landscape has seen the re-entry of physical players, trading houses and private equity funds in this space.
This article explores the potential legal and structuring issues and considerations that may arise in the context of a commodities acquisition in the commodities trading sector, and what parties may wish to look out for.
The Subject of the Transaction – What is Being Sold
The nature and content of the asset being disposed of (the book of trades itself) will dictate a number of factors including, among other things, the documentation required to structure the deal, the duration of the process, and the regulatory and tax implications of the sale.
A ‘typical’ trading book might comprise both physical and financial over-the-counter (OTC) trades and transactions entered into on an exchange or other trading system. The book of trades might also include grid transactions with network operators, highly structured trades and long-term offtake agreements.
OTC trades in gas, power and emissions allowances, as well as cash-settled derivatives, will typically be entered into pursuant to the terms of standard master agreements (such as the ISDA master agreement or EFET general agreements). Other trades may be entered into using standard terms of business (of a party or its counterparty) or on the terms of a network operator. Structured deals and long-term offtakes are likely to be subject to bespoke documentation.
Depending on the nature of the portfolio being sold, the portfolio may comprise a single commodity (e.g. freight), or multiple commodities (e.g. power, gas and emissions). In addition, the seller may also be disposing of physical assets, as well as underlying trades.
The initial review of the portfolio will feed into structuring and project management considerations, and will help determine the resources that will be needed to successfully effect the sale/purchase.
While prospective buyers will need to focus on the contents of the portfolio, the seller will need to consider the merits of each of the prospective buyers. When submitting proposed bids, sellers may ask prospective buyers to disclose the nature of their coverage in respect of the commodity in question. For example, if a proposed bidder has existing relationships with counterparties to the trades that are to be part of the sale, and is a member of the exchange(s) on which many of the trades are undertaken, the sale process will be simpler, compared with a situation where there is little overlap with the seller and proposed buyer’s existing business.
The first consideration when structuring a commodities acquisition is the subject of the transaction, that is, whether it will involve a share or an asset purchase. A share purchase entails taking over both assets and liabilities of the target company, while an asset purchase potentially allows the parties greater flexibility as to the assets and liabilities that are to be the subject of the sale. This decision depends on various factors, such as the corporate structure of the selling group, the willingness of the buyer to take on the target company’s liabilities, and also concerns surrounding the ease of novating or assigning the trading contracts (see ‘Novation agreement’ below).
The decision on whether to use an asset or share purchase structure is important given the fact that transactions in commodities trading markets tend to be concluded on a forward basis (such as a day, month or year ahead), and thus will have implications on how long and how complex the transaction will be.
Share purchase A share purchase is procedurally simpler, as the acquirer is ‘stepping into the shoes’ of the previous owner of the shares. The acquirer takes over all the assets and liabilities of the company, including employees, premises, etc., and the seller cannot remove assets from the sale, except by transferring them out of the target. Accordingly, where the target is a party to a trading contract, a share purchase entails no change to the parties to that contract.
While the change in ownership of the target will not normally cause the target to require new regulatory licences, the acquirer may need to obtain regulatory approvals to become the ‘controller’ of the target.
Asset purchase By contrast, an asset purchase tends to involve more procedural complexity. This is especially true of the commodities trading sector since an asset purchase requires a transfer of each individual asset of the business, such as facilities or trading contracts. A typical commodities trading portfolio comprises many trading relationships with different counterparties. Each party will tend to have rights and obligations under these transactions, and there may also be restrictions on assignments/transfers without having obtained prior counterparty consent. For these reasons, a transfer of the portfolio will ultimately require the seller, buyer and counterparty to enter into a novation for each trading contract, which may take a significant amount of time. This can be an important factor when structuring the sale.
Despite the added procedural complexity, the advantage of an asset purchase is the greater degree of flexibility afforded to the parties. This is important where the seller has liabilities which are difficult to value or where the parties do not want certain assets to be subject to the sale.
The obverse of such flexibility is that the buyer may be required to take on certain contractual liabilities in exchange for obtaining the benefit of the contract. The buyer will also need to take into account the potential difficulties in obtaining counterparty consent. Further, the Transfer of Undertaking (Protection of Employment) Regulations 2006 (SI 2006/246) (TUPE) apply so as to transfer the employment contracts of those employees who are wholly or mainly assigned to the business being acquired, regardless of the intentions of the parties concerned (see ‘TUPE’ below).
Types of risk transfer structures If the transaction is to take place by way of a share purchase, the buyer will assume all the assets and liabilities of the business upon closing. In cases where completion is delayed, for example, because of the need to obtain regulatory approvals, a price adjustment mechanism would be needed to account for any changes in the value of the business during the interim.
Where the transaction is structured as an asset purchase, two types of structures may be used to manage and transfer benefit and risk:
Structure A An asset purchase of the relevant commodities transactions for a fixed price stipulated in the sale and purchase agreement (SPA) and paid at closing. A purchase price adjustment mechanism will then account for any changes in asset value between signing and closing, and all assets will be transferred on the closing date. This is suitable where underlying trades do not need to be novated.
Structure B An asset purchase of the relevant commodities transactions for a fixed price stipulated in the SPA and paid at signing with a total return swap (TRS) or other back-to-back trading arrangement, such as a mirror transaction, coming into effect upon signing (see ‘Total return swaps’ and ‘Mirror transactions’ below). Alternatively, the parties can choose to have the TRS come into effect upon closing rather than signing. Where only a TRS is used, a price adjustment mechanism is not needed because the TRS will transfer all risks (market and credit) to the buyer. The TRS terminates upon transfer of the underlying assets to the buyer (e.g. by way of novation). However, where a mirror transaction is also used (for reasons, see ‘Mirror transactions’ below), a price adjustment mechanism would be needed as only market risk is transferred to the buyer.
This section highlights the main documents typically required in a commodities acquisition, and some of the issues to consider when negotiating them in the context of each of the structures outlined in the previous section.
Sale and purchase agreement The main points in the SPA that parties will want to negotiate in a share purchase are broadly the same as any typical M&A transaction: warranties, indemnities, payment provisions and termination clauses. A key difference, however, is the price adjustment mechanism. If such a mechanism is being used, it will be specific to the valuation methods used for the underlying assets. The representations and warranties will also be drafted so that they are appropriate for that particular market.
An SPA for an asset purchase will likely be quite different from a standard SPA due to the more complex procedures required to transfer the underlying assets and liabilities. The time needed for such transfers is also often significantly longer than for other types of transactions.
Another issue concerns the provisions that deal with the conduct of the business between signing and closing. This is important due to the longer time required for novation in an M&A transaction in the commodities trading sector, and the legitimate concern any buyer will have around a potential deterioration in the ‘trading value’ of a business.
When considering individual trading relationships, the level of risk in each contract should be evaluated and dealt with in the SPA. In cases where credit risk or counterparty default risk is a concern, it may be necessary for (additional) collateral to be provided. Such credit support can take the form of cash or a parent company guarantee.
Parties should reach consensus on how the novation process is to take place, and agree on a numerical threshold level of counterparty novations required to close the transaction. This will likely be heavily negotiated during discussions. Termination rights should also be clearly set out, in the event that parties wish to terminate before closing, for reasons such as unreasonable delays in the novation process.
Total return swaps The two main types of back-to-back contracts used to manage/mitigate risk are TRSs and mirror transactions. A TRS is a financial contract that transfers both the credit and market risk of an underlying asset and is typically used in Structure B above (see ‘Types of risk transfer structures’ above), although if the trading book comprised physical trades, then the back-to-back confirmation that deals with risk transfer will need to be crafted accordingly. It may be structured as an option, with physical delivery requirements usually settled in cash, or the party will enter into a back-to-back physical contract to on-sell the physical delivery obligation. A credit support document will set out the collateral requirements, and there will likely be a fee to cover various charges. It should be noted that trades will continue to be novated even after the termination of the TRS (or other back-to-back confirmation).
Subject to obtaining the relevant consents and approvals, the seller can use a TRS to transfer the benefits and burdens of the trade contracts to the buyer through novation before the trade transactions complete. Risks that buyers should look out for include market, credit, legal and operational risks. Where the buyer is able to negotiate with the seller as to which risks it will assume, a TRS is appropriate as it allows for such flexibility, for instance, in terms of which party is to assume the risk in the event of a default by a counterparty.
Setting up a TRS usually requires the underlying master agreement, or other bespoke agreement detailing the general terms and conditions of the TRS, and a confirmation documenting the terms of each individual trade.
Mirror transactions A mirror transaction, on the other hand, only transfers market risk. In such a transaction, the parties will enter into trades where the buyer takes the position opposite to the seller’s position with the counterparty. This becomes a back-to-back arrangement as it nets the seller’s market position.
The choice between the above two types of back-to-back trading arrangements depends on whether the consent of the counterparty to disclose its identity to the buyer can be obtained. A buyer would be unwilling to take on a counterparty credit risk where it does not know the identity of that counterparty. In such a scenario, a mirror transaction, rather than a TRS, would be used as it only transfers market risk and not the credit risk of the counterparty.
Services agreement It is common for sellers to not retain the employees necessary to service the portfolio. Such employees can include staff who can act as scheduling agents with a transmission provider; staff who can act as nomination agents with commodity transporters and storage operators; and staff who can manage and resolve disputes with counterparties. In these cases, the buyer can step in and sign a services agreement with the seller to provide such services for the portfolio prior to the transfer. Alternatively, the buyer may appoint a third party to provide such services. In the reverse scenario where the buyer lacks the relevant staff or operational assets, the seller can be the one providing such services. Where a service agreement has been concluded, a service fee will usually be charged, which may be separate or combined with the SPA or TRS. The parties will have to agree on how long such services are intended to be provided post-completion.
Special attention must be paid to how the indemnities in the services agreement are drafted as they will be crucial once the risks of the transaction have been transferred under the TRS. The seller will appoint the buyer as its sole agent responsible for the provision of the services, and it will execute powers of attorney in order to avoid having to send the services agreement to all counterparties in the portfolio.
Novation agreement Novation is an important aspect for the purchase of a portfolio of trade contracts. Therefore, it is essential that parties make provision for the conduct of this process either within the SPA or as a separate agreement. In both instances, the parties will need to agree to a form of novation agreement. The buyer may charge the seller a fee for preparing the novation agreement and trade schedules.
The novation agreement is tri-partite; that is, the counterparty will also need to be a party to it. The agreement will include standard representations and warranties, and a termination option that can be exercised in the event that a related agreement, such as a TRS or services agreement, is terminated. Depending on how the transaction is structured, the parties may require novations before or after the closing date.
The legal effect of a novation agreement is that the buyer takes over the obligations of the seller by entering into a new contract with the counterparty. The seller is hence released from its obligations under the original contract.
When negotiating the novation agreement, the parties should be careful to limit the extent to which they are contractually obliged to obtain the consents of counterparties, as it would be in the interest of both buyer and seller to avoid an opportunistic counterparty who attempts to take advantage of the situation created by the need for a novation by attempting to renegotiate its contract. The buyer may also wish to obtain an indemnity from the seller for any pre-novation breaches of contract by the seller.
The Regulatory Landscape
Competition law Competition law is a necessary consideration in any M&A transaction, and this is no different in the commodities trading sector. While competition authorities may view some commodities trading markets as insufficiently consolidated to give rise to competition issues, each commodity market must be considered separately, as they have different levels of competition. In any event, notifications to competition authorities may often be required as a result of the size of the deal or parties, regardless of whether there are substantive sectoral competition issues. Accordingly, it should never be assumed that competition issues are irrelevant to an M&A transaction in the commodities trading sector.
Merger control regulations may apply to the transaction, resulting in the need to obtain regulatory clearance before the deal can close. In general, authorities will establish jurisdiction according to the level of worldwide and in-country (or in the case of the European Commission, Europe-wide) sales of the buyer and target. Generally, regarding physical trades, sales are taken to be gross turnover (Article 5(3)(a)(iv) EC Merger Regulation (139/2004/EC)). This is in contrast to the test for financial derivatives, where a net basis is used.
Another relevant issue is whether, in the case of an asset purchase, the portfolio of contracts comprises an ‘undertaking’ – that is, a business, rather than simply a collection of assets. If it does not, the transaction will not be subject to merger control.
Competition law risk should also be considered when undertaking due diligence on the target, as in most cases the acquirer will take over the compliance history of the target (even in some cases where a business is acquired rather than a company) and can therefore acquire liability in respect of any pre-close competition law infringements.
Financial and energy regulation Both financial services and energy sector regulations may apply in some way in the context of a commodities acquisition.
Financial services licensing In an asset deal, the prospective purchaser will need to ensure it has the appropriate regulatory permissions and licenses, if applicable, to enter into and perform the deal. This might include authorisation under financial services legislation (in the UK, the Financial Services and Markets Act 2000) and/or appropriate grid and network access under energy regulation.
In a share deal where the target is an authorised person, the prospective acquirer may need to satisfy regulators that it is a fit and proper person to become a “controller” of the target.
EMIR The European Market Infrastructure Regulation (EMIR) applies to the trading of derivative contracts, and it aims to reduce systemic risk and increase transparency in the derivatives markets by imposing various obligations on certain counterparties.
One such obligation is the reporting of trades and parties should consider whether TRS trades and novated trades need to be reported under EMIR. EMIR allows one person to delegate reporting to another and if the parties put in place such an arrangement, they may have to enter into a delegated reporting agreement (if they have not already done so).
Under EMIR, mandatory clearing and collateralisation obligations are being introduced and parties should consider the application of these requirements to asset deals.
REMIT If the commodities acquisition involves power and gas and/or related transportation contracts and derivatives, then the Regulation on Wholesale Energy Market Integrity and Transparency (REMIT) may apply to underlying trades. REMIT applies to the wholesale power and gas markets, and was implemented as a means to curb market abuse by imposing reporting and other obligations on market participants. Parties may have to report TRS and other back-to-back trades to the extent not required under EMIR, and also novated trades. All trades are reportable from 7 April 2016.
MiFID II Parties looking to rely on the ancillary exemption in the Markets in Financial Instruments Directive (2014/65/EU) (MiFID II) when it comes into force, (now expected to be on 3 January 2018), should consider carefully the potential effect of the transaction on whether they meet the strict pre-conditions to rely on that exemption.
Other regulatory approvals For certain more exotic commodities, certain regulatory approvals will be required. By way of example, acquisitions and disposals involving uranium will require the approval of the European Atomic Energy Community (Euratom). Euratom will have to approve the SPA, prior to the SPA being signed. Time taken for Euratom to approve the SPA will hence have to be factored in by parties when setting the transaction timetable.
TUPE TUPE has the greatest potential to apply where there is an asset purchase arrangement. It also has potential to apply where there is a share purchase arrangement, specifically where service agreements are involved.
TUPE has significant effects. Where it applies, the contracts of employment of affected employees will transfer from the seller to the buyer, together with all past service liabilities. Accordingly, it is not just a case of buyers having to honour existing terms and conditions of employment. If there have been any failures to pay salaries or any workplace disputes, liabilities relating to these matters will transfer to the buyer despite the seller being the party at fault. Likewise, buyers become solely liable for any employee benefits and entitlements that accrue over the period prior to the completion of an acquisition, but do not become due for payment until afterwards.
There are also obligations to inform and consult that must be complied with. Failures to comply may result in liabilities of up to 13 weeks’ actual pay in respect of each affected employee. Therefore, consideration should be given to identifying the employees whose contracts of employment might be within scope of a TUPE transfer, the potential liabilities associated with those contracts and how they should be apportioned between the parties.
Where there is no desire on the part of the buyer to continue the employment of any transferring employees, consideration should also be given to ways and means of avoiding the effects of TUPE. For example, could it be agreed for the seller to move employees away from the business that is to be sold and redeploy them elsewhere in its organisation? Where dismissals are unavoidable, consideration should also be given to which of the parties should carry these out, and how any related liabilities should be shared between the parties.
While the purchase of shares in a commodities trading company is unlikely to give rise to any material difference in tax treatment compared to the purchase of shares in any other sector, particular issues are likely to arise in the case of an asset purchase. In particular, the following matters should be considered:
Corporation tax As the majority of physical commodities will be traded, rather than held as investments, a commodities trader subject to UK corporation tax will be taxed on the income of any profit on sale in accordance with the rules in Part 3 of the Corporation Tax Act 2009. Likewise, a trading buyer of commodities should be able to deduct the cost of purchase by computing its corporation tax liability under the same rules.
Derivatives trading, on the other hand, will be taxed or relieved for corporation tax purposes in accordance with their accounting treatment under the derivative contract rules contained in Part 7 of the Corporation Tax Act 2009.
VAT The VAT treatment will need to be carefully considered. A variety of factors will affect the VAT treatment, such as the nature of the particular commodity, whether it is treated as a supply of goods or services, whether delivery occurs, and if so, where.
While financial commodity derivatives should be VAT exempt as financial transactions within item 1, group 5 of Schedule 9 to the Value Added Tax Act 1994, physical commodity derivatives will generally follow the VAT treatment of the underlying commodity. Where a mix of such contracts is being acquired, it will be important to review the VAT treatment with care as it may follow the predominant supply.
Where a portfolio is being acquired, it may be possible to take the acquisition outside the scope of VAT altogether if it is possible to treat the sale as a transfer of (part of) a business as a going concern for VAT purposes. It will be necessary to determine whether the necessary conditions have been met. In particular, where only the underlying assets are being acquired, and not the facilities and staff to support the business, it will be vital to ensure that it is capable of separate operation (for example, by means of integration into an existing business) to meet the transfer of a going concern conditions. In any event, it will be important to ensure that the consideration for the portfolio is expressed as exclusive of VAT to ensure that the seller is not left bearing any VAT costs.
Stamp taxes Stamp duty and stamp duty reserve tax (SDRT) are unlikely to be an issue in the transfer of a commodities portfolio on the basis that the contracts are neither stock or marketable securities for stamp duty purposes, nor chargeable securities for SDRT purposes.
Foreign taxes Given the global nature of the commodities sector, it will be important to consider whether any form of taxes may arise outside the UK as the result of the sale of a commodities portfolio – particularly where the commodities are kept in a foreign jurisdiction, which may create a tax nexus within that jurisdiction.
Consolidation in the commodities trading sector is likely to continue, both with the continuing stream of portfolio disposals and the increasing number of asset acquisition opportunities arising in the market. As highlighted herein, parties need to consider numerous factors when structuring any proposed transaction. This requires an in-depth analysis of the various issues so that a holistic approach can be developed to deal with any potential problems.
While there would appear to be an embarrassment of riches on the market for the prospective buyer, benefitting from such opportunities requires appropriate preparation, due diligence, risk management and structuring, in order to maximise the potential revenue that such opportunities may bring. Structuring the transaction with a view on each of these issues will ensure that negotiations between parties run efficiently and effectively, and that the transaction proceeds smoothly and successfully.
Client Alert 2016-059