Oil & Gas: OGA’s role in M&A transactions – letters of comfort and judicial review

In R (on the application of Thornton) v OGA [2020] EWHC 2615 (Admin) the English courts considered, for the first time, whether a ‘letter of comfort’ given by the Oil and Gas Authority (“OGA”) concerning a change of control should be overturned. Although the application was unsuccessful, the decision provides insight into (i) the OGA’s process in considering a request for a letter of comfort; and (ii) the grounds upon which the OGA’s decision to give such a letter may be challenged. As the facts concerned the financial covenant of a new entrant to meet decommissioning liabilities, it will be of significant interest to the industry.

Background

Third Energy UK Gas Limited (“Third Energy Gas”) is licensee under a licence granted under the Petroleum (Production) Act 1934, to search and bore for and get petroleum (defined to include natural gas) in Yorkshire (the “Licence”). It is a subsidiary of Third Energy Onshore (“Third Energy Onshore”), which is in turn owned by Third Energy Holdings Limited (“Third Energy Holdings”). Subsidiaries of the Barclays banking group were the primary investors in Third Energy Holdings.

The Claimant (“Mr Thornton”) is a member of the public, living in North Yorkshire. The Defendant, the Oil and Gas Authority (“OGA”) is empowered by statue to regulate, influence and promote the UK oil and gas industry in order to maximise the economic recovery of the UK’s oil and gas resources.

A Deed of Variation in 2018 amended the Licence to incorporate Model Clauses 1-44 set out in Schedule 2 to the Petroleum Licensing (Exploration and Production) (Landward Areas) Regulations 2014. Amongst other things, Model Clause 41(3) gave the OGA certain powers, including to revoke the licence or require a further change of control, in the event of a change in the control of the Licensee.

On 25 April 2019, Third Energy Group announced that it had agreed to sell Third Energy Onshore to York Energy (UK) Holdings Limited (the “Buyer”) “subject to satisfaction of agreed conditions precedent, including regulatory review” (the “Transaction”). One such condition precedent was that a letter of comfort be received from the OGA confirming that it would not exercise its powers in response to the change of control that would result from the Transaction.

The OGA undertook an internal review of the question whether to issue the letter of comfort. The review’s conclusions were submitted on 3 July 2019 to the OGA’s Director of Regulation, Mr Tom Wheeler (“the OGA Internal Submission”). He agreed with the recommendation made in it, noting all of the risks identified in it, and decided that a letter of comfort should be sent, concluding “that this is the course that provides the greatest probability of those commitments being discharged by the Licensee”.

The Claimant was concerned that the Buyer would not have the financial ability to meet its acquired licence commitments, which included proper decommissioning of gas wells, and instead taxpayers would have to meet the financial liabilities. The Claimant was aware that in other countries fracking companies were becoming insolvent and taxpayers were picking up the costs for decommissioning and clean-up. As a result, in October 2019, the Claimant sought permission to bring a judicial review, claiming the OGA had failed to carry out adequate financial assessments of the companies involved in the sale. The Claimant asserted in particular that the OGA did not properly consider the risk that the sale could leave the taxpayer paying decommissioning and clean-up costs if the target company became insolvent.

Judgment

In summary, the Court considered that, taking account of the Petroleum Act 1998 and related regulations (and in particular, the applicable Model Clauses), the OGA had properly considered the risks identified by the Claimant. Permission to bring a judicial review application was refused.

Three main issues arose in the case, which came before Knowles J:

1. Whether the OGA misinterpreted the terms of Model Clauses 40 and 41

The Claimant argued that the OGA had misinterpreted Model Clauses 40 (“Restrictions on assignments etc”) and 41 (“Power of revocation”) and their interaction with each other. In particular, the Claimant asserted that the two should be read together so that Model Clause 40, restricting assignment, was wide enough to cover a change of control and was not limited to instances of licence assignment. Read together, the Claimant argued the Model Clauses mean that a change of control of a licensee requires the prior written consent of the OGA. As such, the OGA’s written consent should have been obtained to the Transaction.

The Court did not consider this argument to be well founded. The wording of the Model Clauses is clear. Model Clause 40 is concerned with what a licensee does or causes to happen. Model Clause 40 does not apply to circumstances where there is no action by the licensee to restrict, such as a change of control of a licensee on acquisition of that licensee (or its parent company), which “does not involve the licensee doing anything”. Conversely, Model Clause 41(3) regulates change of control of a licensee and is concerned with what happens to the licensee as opposed to actions by the licensee. The relevant provision was Model Clause 41 and prior written consent of OGA to the Transaction was not required.

1. Whether the OGA, in issuing its letter of comfort, had failed to assess the financial capability of both parties to the sale

The Claimant’s challenge asserted that the OGA should have (but had not) followed its own policies set out in its Financial Guidance. At paragraph 3.9, the Financial Guidance describes that, where an existing licensee intends to retain a commitment after the completion of the transaction, the OGA will “consider the financial capability of both parties to the transaction…” to “seek to ensure the transaction is not detrimental to either the new and existing licensee’s capacity to meet their Commitments in their post-completion portfolios.” The focus of the contention was that the OGA should have examined the financial capability of Third Energy Gas absent the sale against such capacity once the sale was completed. A seller ‘backed’ by Barclays was to be replaced with the Buyer that was a subsidiary of a Cayman Islands company “with no reputation to lose”.

The Claimant considered that the OGA had failed to comply with this requirement by considering only the Buyer’s financial capability and not also that of Third Energy Gas and its parents, Third Energy Onshore and Third Energy Holdings. Amongst other things, the Claimant drew attention to the fact that the Buyer had no accounts filed with Companies House, meaning there was no publicly available information as to its ability to cope with the acquired liabilities and work commitments of Third Energy Gas. In addition, the debt write-off and cash injection by Barclays shortly before the Transaction improved Third Energy Onshore’s financial health such that other potential buyers might have been interested in acquiring control of Third Energy Onshore.

However, the OGA’s internal considerations showed that:

• The OGA had relied upon its own Financial Guidance and the financial capability of both parties was indeed considered.
• Third Energy Onshore had cut operational staff “to the bare bones” and Barclays might be unwilling to continue funding and, without that funding, insolvency might follow.
• The sale effectively released security in place for the decommissioning of Third Energy Gas’s installations and wellbores.

As such the Court considered that OGA did give sufficient consideration to the financial capability of both parties prior to issuing the letter of comfort. The OGA considered that whilst there were risks associated with the change of control, the risks would have been greater had the sale not occurred.

In relation to the scope of enquiry required by the OGA, the Court decided that “It is obvious that the consideration or assessment needed will depend on the case. In the present case it is questionable what a fuller financial capability assessment of Third Energy Onshore or Third Energy Holdings in the absence of the sale would have added to the fundamentals that were considered.”

In respect of the Buyer, the Claimant averred that no proper investigation of financial capability had taken place. However, the Court concluded that the OGA was fully aware of the risk that it may not be able to meet its commitments. Further, the Financial Guidance suggests that “more importance” might be placed on financial capacity than financial viability in the case of a newly-incorporated applicant. In such cases, the OGA would “consider in detail the identity and track record of the shareholders, directors and officers”. This it had done.

1. Whether the OGA had failed to take into account the serious risk that the change of control would lead to the Subsidiary Licensee being unable to pay for its decommissioning costs

When discharging its functions, including making its decision in relation to the requested letter of comfort, the OGA is required to have regard to “the need to minimise public expenditure relating to, or arising from, relevant activities” where relevant activities are defined as “any activity in relation to which the OGA has functions” (section 8 of the Energy Act 2016). The Claimant argued that the OGA failed to comply with this duty by failing to assess whether Third Energy Gas had the financial capability to discharge its decommissioning obligations imposed by Model Clause 20 and to consider any risk of decommissioning being carried out at public expense. Model Clause 20 imposes a number of obligations on licensees in relation to the plugging and abandonment of wells, including an obligation to plug wells in accordance with a specification approved by the OGA.

The evidence before the Court confirmed that the OGA had identified a foreseeable risk that Third Energy Gas would be unable to pay its decommissioning costs following the sale and considered this risk in particular when deciding whether or not to provide the letter of comfort. It had taken steps to raise this issue with BEIS, the department directly in charge of ensuring that decommissioning programmes are approved and carried out, but also had in mind other factors (including the potential risk that decommissioning costs could not be met by Third Energy Gas if the sale did not go ahead). Therefore, the Court concluded that the OGA had not failed to have regard to the need to minimise public expenditure as it had focused on this when making its decision to issue the letter of comfort.

Comment

The terms for acquisition of an oil and gas company with assets in the United Kingdom will usually include as a condition precedent for completion of the sale that a letter of comfort is obtained from the OGA, confirming that it is not minded to exercise its statutory powers to revoke any of the relevant licences nor seek further changes of control. Although commonly sought (and granted), there has been relatively little judicial consideration of the process and approach taken in that regard. R (on the application of Thornton) v OGA [2020] EWHC 2615 (Admin) is therefore of particular interest to those involved in such transactions.

Although challenging a letter of comfort might be one route for a third party seeking to prevent a change of control from proceeding, it :

1. As Pelling HHJ observed in TAQA et al v RockRose [2020] EWHC 58 (Comm) in relation to financial assessments by the OGA in deciding whether to give a letter of comfort: “The OGA's financial assessment is for its purposes not those of third parties as its own guidance material makes clear and the OGA were aware of what Mr. Lewis called the "firewall" – that is the obligation of the remaining participants to bear the obligations of a failed participant. That might have been a comfort for the OGA but was the source of the concern about RR's financial stability so far as the claimants were concerned.”. As such, the scope of the OGA’s necessary enquiry is limited to protecting the interests identified in the OGA guidance and not those of joint venture partners or other third parties.
2. In relation to the scope of enquiry required by the OGA in respect of the interests covered by its own guidance, the Court decided that “It is obvious that the consideration or assessment needed will depend on the case”. As such, there appears to be no pre-defined scope of enquiry that the OGA must undertake before issuing a letter of comfort, making it difficult to argue that a mere failure to give consideration to a particular fact or issue automatically opens up a route to challenge.
3. The mere lack of financial covenant of the buyer, or its parent, may be insufficient to challenge a letter of comfort provided that proper consideration has been given to that lack for financial covenant by the OGA.
4. In the case of new entrants, the Court appears to have accepted that the OGA acts properly when judging financial covenant if it follows its Financial Guidance, which suggests that “more importance” might be placed on financial capacity than financial viability. In such cases, the OGA should “consider in detail the identity and track record of the shareholders, directors and officers”.