The ongoing merger and consolidation discussion, sparked by the publication of the Ontario Distribution Sector Review Panel Report in December 2012, and, more recently, the proposed sell-down of Hydro One, has led to a number of enquiries as to what best practices exist in the Ontario distribution sector with regard to merger, acquisition, amalgamation and divestiture (MAAD) transactions between and among the various local distribution companies (LDCs).
As LDC managers, municipal owners and prospective private sector investors continue to investigate opportunities, issues relevant to the design and negotiation of MAAD transaction documents have come to the fore, including what market norms are evolving for these transactions and what Ontario-specific regulatory peculiarities drive the form of the agreements. The answers to these and other questions need to be fully understood by utility executives and utility shareholders before the start of any serious discussion pertaining to LDC assets.
Here, we examine some of the essential contractual elements peculiar to MAAD transaction documentation in the Province of Ontario in order to provide guidance to decision makers under the present laws. We will not examine basic points of corporate law, or standard elements of commercial transaction documentation, but will instead focus on the elements of deal documentation that apply specifically to Ontario LDC MAAD transactions.2
The complexity of Ontario MAAD transaction documentation arises both from the mix of federal, provincial and municipal law applicable to the electricity distribution sector in the province and from the need for the parties involved to look into the future to contemplate elements of regulatory risk, political uncertainty, sweeping technological change, and ever-fluid community stakeholder concerns.
Ontario’s regulation of its LDCs has been a story of slow, but certain transformation since the late 1990s when the Province had more than 300 LDCs (formerly unincorporated utilities) operating at various levels of scale across the province. Subsequent to the passing of the Energy Competition Act (ECA) in 1998, the Province saw a brief period of LDC consolidation, with the number of electrical utilities operating in the province reduced from 307 to just 89 in just a few years’ time. Since then, there have been a few acquisitions and amalgamations among municipally owned entities, but over-all the landscape of the Ontario LDC sector has remained stable.
Informed readers will know that this is likely to change. Driven both by the dictates of oncoming technological change3 (see "LDC consolidation and valuation: Blind faith") and by public policy decisions at the provincial government level, Ontario’s highly fragmented electricity distribution sector is almost certain to see consolidation over the next few years. How the pending transactions are structured and upon what terms is as a result highly relevant to decision makers at this stage.
As a general rule, any acquisition of, or substantial investment in, an Ontario LDC requires leave from the Ontario Energy Board (OEB).
Section 86 of the Ontario Energy Board Act, 1998 (the Act) requires OEB approval for any merger, acquisition of shares, divestiture or amalgamation that results in a change of ownership or control of any electricity distributor in the province. Section 78 of the Act engages the OEB to set rates, including any rate reduction that municipal LDC owners (e.g. municipal councils) will view as justification for a proposed sale transaction. The impact of these two sections of the Act should form a vital part of any agreement of purchase and sale pertaining to an Ontario LDC.
Since being promulgated in 1998, the OEB has applied a “no harm” test to determine whether a proposed MAAD transaction would have an ‘adverse effect’ on ratepayers of any of the involved LDCs. The OEB has recently reiterated that, as matters currently stand, it will not review the sufficiency of the purchase price or potential benefits of a MAADs transaction, other than to ensure that rates do not increase and that there is otherwise no fiscal harm or risk posed to ratepayers as a result of the transaction.
Despite relative regulatory stability in the legal test to date, the outcome of every MAAD application to the OEB carries some residual uncertainty as to any terms and conditions that might be placed on the approval. Further, unlike in others businesses, substantial structural or spending initiatives by Ontario electricity distributors will generally be subject to some regulatory scrutiny.
These considerations must be accommodated in the negotiation and drafting of transaction documentation. Who bears the regulatory risk, who leads the OEB application process, who pays the cost of the application, who bears the sunk transaction costs if the application is denied or substantially conditioned and what happens if future spending or organizational commitments become problematic? These are all questions which will need to be addressed in the transaction agreements.
For obvious reasons, the use of a standard “share or asset purchase agreement is not recommended. One size does not fit all and careful thought must be applied in MAAD transactions. Specifically, attention should focus on ensuring that risk is appropriately and adequately allocated, that the necessary and aptly worded representations and warranties are made, that closing conditions are clearly predetermined, that post-closing adjustments are properly accounted for, that the market-appropriate indemnification coverage and limitations are put in place and that the proper coordination occurs between the controlling purchase and sale transaction document and the various ancillary documents affecting real estate matters, employment, regulatory matters, dispute resolution, tax, intellectual property, future commitments and other items of concern.
The fact that distribution rates are carefully regulated in Ontario, and that the regulatory applies a “no harm test” to MAADs transactions, means that purchasers cannot simply pass costs through to their customers, and so the financial implications of a MAADs transaction – both near term and longer term –must be addressed as between the parties in their documents.
Most purchase agreements pertaining to LDC MAAD transactions will specify a set purchase price with post-closing adjustments to be made depending upon certain factual outcomes. Typical post-closing purchase price adjustments which are specific to these types of transactions include:
Closing balance sheet adjustment: Most agreements will establish a regime whereby an appointed accounting firm will prepare and circulate a draft closing balance sheet for the LDCs being sold, along with a process and a timeline for the review and settlement of the draft balance sheet by the parties and the adjustment of the final purchase price based upon the closing balance sheet taking into account such factors as working capital, the value of property and equipment and long-term debt balances.
Depending on the circumstances, the auditors assigned to prepare the initial draft balance sheet may be the existing audit firm of the company being sold. Parties will want to specify which accounting standard will be used in the preparation of the balance sheet (distributors in Ontario are required, for rate making purposes, to use a form of IFRS accounting standards modified specifically for regulatory application in Ontario, and the implications of these standards need to be considered) and whether the adjustment to be made to the final purchase price will be on a one-for-one basis or otherwise.
Properly drafted documentation should establish a clear and rapid dispute resolution process regarding the settlement of the closing balance sheet which either uses, or sits logically with, the over-arching dispute resolution provisions governing the agreement.
Payment in lieu (PILS) and the transfer tax: Under the Electricity Act, any equity investment in an Ontario LDC by a private sector investor which exceeds a 10% share ownership will cause the LDC to lose its tax-exempt status and leave behind the PILS regime which was set up by the Province back in 2000 to level the playing field between municipally-owned and non-municipally-owned sector participants4. As a result, unless a transfer tax holiday is declared by the Province, the transfer of LDC shares to private sector participants will likely be made cost prohibitive as a result of the transfer tax. This does not apply where a MAAD transaction is taking place among LDCs or their municipal owners.
Parties seeking to rely upon the exemption available to municipally-owned entities will need to notify the Ontario Minister of Finance under Ontario Regulation 124/99. Accordingly, provision should be made for the requisite filings as a condition of closing and, assuming that the proposed transaction proceeds, for an adjustment to be made to the purchase price equal to any amount of the transfer tax payable by the purchaser if the transfer tax becomes payable.
Adjusting for rate changes: Recently, a key selling feature of LDC merger transactions for municipal government owners has been a promise of a rate freeze, or in some cases lower electricity rates. Accordingly, if the OEB does not approve a proposed rate reduction, some adjustment may be needed to the purchase price to compensate the party that was counting on the rate reduction.
Deposits: Most purchase and sale agreements entered into with respect to LDCs will see a form of deposit made by the buyer. In the transactions done to date, these deposits have ranged between 2% and 15% of the purchase. They are generally made returnable to the purchaser subject to escrow arrangements which may specify certain pre-closing obligations of the purchaser such as pre-closing deliveries, regulatory consent applications and other matters of concern to the seller.
Competition Act approval: Depending upon the nature of the transaction, the book value of the ‘target’ assets, and the residency of the acquiring party or parties, it is quite possible that the transaction may cross the notification and/or review thresholds applicable under Canada’s Competition Act. Both parties should be made aware of these thresholds and proactive steps should be made to plan for agency notification and/or review where required. Both parties will want to make Competition Act approval a condition precedent to the closing of any agreement of purchase and sale.
Representations and warranties are, of course, statements made by the parties with regard to essential factual or ‘near-factual’ elements of the transaction. They can often take a long time to negotiate; therefore, having a realistic idea as to what items will be absolutely essential to each party and what constitutes ‘market’ can be invaluable to parties as they negotiate. Not everything that might be relevant to a given transaction can be known for certain. Who bears what responsibility – and liability – for imputed knowledge of factual circumstances which cannot be verified prior to closing can be critical in the negotiation of MAAD documentation.
Aside from the standard deal representations seen in most commercial transactions (corporate status, power and authority, non-contravention of constating documents, authorized capital, etc.) and typical commercial representations which one might ordinarily expect to see in a large commercial transaction (financial statements, real property, environmental, litigation, employment matters, liabilities, material contracts, customers, tax), MAAD transactions in the Ontario LDC sector will also see the following:
Absence of conflicts: Readers will no doubt be familiar with the ‘Absence of Conflict’ representation made in the context of ordinary commercial business transactions. In the context of the sale or acquisition of an Ontario LDC, purchasers may seek a representation from the seller that the transaction(s) being contemplated will not contravene not only the by-laws and constating documents of the seller, but also a range of provincial statutory instruments, commercial contracts, municipal by-laws and decrees of government authorities (broadly defined). Sellers will seek to narrowly define the range of instruments to be included in the representation.
Regulatory approvals: Purchasers will seek confirmation from sellers to the effect that, except as expressly provided for (e.g. OEB approval) “no authorization, approval, order, consent of, or filing with, any Government authority is required on the part of the Seller or the Corporation” to effect the completion of the transaction contemplated. In the context of the electricity distribution industry, this can be read to include a broad range of statutory instruments and regulatory requirements. Sellers will normally seek to limit the range of the representation and clarify what purchasers are specifically concerned about.
Competition Act: As indicated above, both buyers and sellers will want to ensure that the transaction complies with Canada’s Competition Act. To that end, buyers will seek representations from the seller as to the value of assets and gross revenues of the target companies, determined in accordance with the relevant statutory guidelines.
Financial statements: Most commercial purchase and sale transactions will contain representations with regard to the financial statements of the target company. In the LDC MAAD context, regulatory accounting information forms a critical part of the submissions made by the parties to the OEB, the setting of electricity distribution rates, and thus the calculations made by the purchaser in deriving the purchase price. Accordingly, purchasers will seek specific representations as to the truth and accuracy of the financial statements relative to the distributor’s regulatory accounts, and the accounting principles pursuant to which they were prepared.
PILS and tax matters: In addition to standard tax compliance representations, most purchasers acquiring LDC assets will seek representations specifically confirming that the target LDC is both subject to and operating in compliance with the Ontario PILS regime.
Title to and condition of assets: Although it is becoming less and less problematic because LDCs are now required to file comprehensive asset assessment plans with the OEB at least once every five years, and because asset condition assessment is a regular part of LDC planning and approved capital budget justification, representations as to the title and condition of assets, which is standard in most commercial contexts, may in some cases be problematic for sellers to provide.
Among lawyers, there are still residual concerns regarding title to distribution assets, arising from the pre-1998 era when LDCs operated as unincorporated entities. In some instances, the condition of operating assets, which can be a century old, cannot be fully represented. In these cases, sellers are best advised to instruct would-be purchasers to complete their own investigations and satisfy themselves.
Real property: As above, title to and condition of real property assets may also be subject to uncertainty. In addition to these concerns, prospective buyers will seek representations that there are no restrictive covenants operating which would restrict or prevent the current or proposed use of the assets, that there are no existing or underlying easements or rights of use or purchase affecting the lands and that there are no expropriation proceedings underway.
The electricity distribution business is, by nature, easement/land rights intensive, and while much of this is addressed in rights of way legislation, given broad overlap between utility, municipal and private property interests, arrangements may need to be made to resolve potential conflicts and disputes before closing.
Material contracts: Most LDCs will be subject to a wide range of “Material Contracts” which will need to be disclosed to prospective buyers. Representations will be requested as to the status of these contracts (i.e. they have not been breached). What constitutes “material” will be negotiated and a list of material contracts will be included in a disclosure schedule. Buyers may also seek a representation from sellers that no counterparty to material contracts is in default or has alleged default by the seller or has sought to terminate the contracts.
Because of the nature of LDC business operations, this can be a matter of some complexity for LDC management and, accordingly, sellers will seek to limit the scope of this representation and/or add a knowledge qualifier to it.
Environmental matters: Most buyers will seek detailed representations from sellers with regard to environmental matters, including representations to the effect that the sellers have complied with all applicable environmental laws and regulations, that all necessary environmental approvals have been obtained, that no hazardous substances have been brought onto real property or disposed of on owned or leased premises, that no underground storage tanks exist on owned or leased premises or have previously existed on owned or leased premises, and, more broadly, that neither the seller nor any related parties have received any notice of any kind with regard to environmental matters.
Sellers will also seek representations with regard to a number of other specific items of exposure including asbestos, polychlorinated biphenyls, nuclear materials, and the like. Because of the age and complexity of LDC assets, sellers will normally seek to limit the scope of environmental representations and, as above, add a knowledge qualifier to limit their exposure.
Suppliers: As above, the nature and complexity of LDC operations means that parties which provide goods and services to the LDC can be critical to respective purchasers during the transition phase after closing. As a result, most purchasers will seek specific representations as to the identity and status of key suppliers to the LDC business and will also seek confirmation that no notice or cancellation has been received terminating these key relationships.
Privacy and personal information: Given the nature of LDCs and their huge numbers of customer accounts, most prospective buyers will seek specific representations to the effect that the LDC has operated at all times in compliance with privacy laws with respect to the collection, use, retention, destruction and disclosure of personal information.
Employment and labour matters: Prospective buyers will need to obtain absolute clarity as to the names, titles, status, seniority, salary and employment terms of all employees of the LDC being acquired along with all forms of incentive, compensation, benefit, entitlement, pension entitlement and vacation entitlement aspects. Prospective purchasers will also seek specific representations with regard to labour and union or collective agreement matters. Much LDC operational work is done by highly qualified technicians, and the unions involved are highly organized and public sector, so these elements can have a significant impact on the value of the LDC.
The nature, scope and range of the representations, warranties and indemnities required of each party will vary by transaction type and by the relative negotiating strength of the parties. Buyers will seek a comprehensive set of representations and warranties, both as a source of information about the target company and as the factual basis upon which the buyer's rights of indemnification and closing obligations are formed. During negotiations, parties will negotiate qualifiers with regard to specific representations (materiality, knowledge, time, scope, scheduled exceptions, etc.).
In the LDC sector, as much as in any other highly regulated business, our best advice to parties is to view the representations section of the contract as a mechanism for dealing with informational asymmetry and properly allocating risk and uncertainty. As a very general rule, wherever possible, those closest to the risk and having the most control over it should bear greater responsibility for it.
A covenant is a legal undertaking to do something. In the context of an LDC MAAD transaction, the covenants given by the buyer and the seller can be divided into pre-closing and post-closing covenants. Key covenants of interest to the parties in these types of transactions would include:
Seller covenants
Conduct of business: Buyers will normally seek a covenant from the sellers that the business of the LDC will be conducted in the normal course before closing “substantially consistent with past practice” and may also go so far as to restrict all hiring of new employees, any termination of employees or transfer of employees to other positions, employee remuneration and any changes to employment contract terms without the buyer’s consent. Buyers will also normally seek to require sellers to continue to maintain insurance, to refrain from entering into “Material Contracts” and to maintain compliance with all applicable laws and regulations.
Access for investigations: Most buyers will also want access to the corporation in order to permit them to carry on pre-closing investigations. Sellers will normally seek to limit this access to normal business hours on specific premises and upon reasonable notice. Access by buyers’ representatives to seller premises can be a matter of some sensitivity in the context of these transactions and may require some negotiation to arrive at satisfactory accommodations.
To assist with buyer investigations, buyers may also require an undertaking that the sellers authorize all governmental authorities to release all information in their possession to the buyers upon request.
Buyer covenants
Employment and location guarantees: Because LDCs are, in many important respects, regarded as “community” assets, both the continued employment of existing LDC employees and the continued operation of existing LDC premises in the community may be items of utmost concern for sellers which of course, are usually municipal governments.
As such, MAAD transaction documentation will often contain specific covenants by the buyer to maintain employees for a set number of years and to not change the work location of employees without their prior consent, to allow employees to apply for positions within the buyer entities on a fair and equal basis and to continue to maintain the seller’s premises in the community for a period after closing.
Community involvement, local presence: Most MAAD purchase and sale transaction documents also contain some form of covenant by the buyer to provide community assistance to the local town or township and to maintain an active presence in community events.
Ancillary utility services: In cases where the LDC employees also providing services relating to other utility operations such as water, sewer and garbage collection, some provision for the continuation and/or eventual cessation of these services may also be required.
Confidentiality: LDC-related transactions can be politically sensitive in local communities, and of interest to the press. Accordingly, a detailed and comprehensive confidentiality undertaking and provision for controlled and agreed release of information to the public will be required to be given by both parties in order to maintain the integrity of the negotiations and the closing process.
Both the seller and, particularly, the buyer will want the transaction of purchase and sale being contemplated to be subject to very specific closing conditions which will need to be met by closing. In the context of a transaction involving an Ontario LDC, these closing conditions would normally include the following:
For the benefit of the buyer
No material adverse effect: Buyers will normally seek an ‘out’ in circumstances where there has been a material change in the assets, business, financial condition, earnings or operations of the target company or, where negotiated, changes to the general market conditions, regulatory environments or economic environments have occurred. What constitutes a material adverse effect is frequently the subject of some negotiation between the parties. However, in the LDC sector, it is generally agreed that the condition of the assets of the target company do fall within the definition whereas general market conditions, regulatory matters and economic matters may be subject to negotiation.
Due diligence out: Buyers will normally seek to have a closing condition based upon the satisfactory completion of due diligence investigations, to the extent that the investigations have not been completed by the time the purchase agreement is signed. Sellers will often seek to remove this item as a closing condition or impose time limitations or a financial penalty on prospective buyers for its use.
Deliveries: Buyers will normally require that sellers deliver a number of specifically identified items at closing, including a specified form of legal opinion, executed resignations of officers and directors, releases from specified individuals who may have a claim against the target assets, regulatory consents and approvals, books and records and the like. Here, LDC business specific approvals such as OEB approval, Minister of Finance approval, Competition Act approval and other regulatory approvals should be specified. In addition, the required consents of suppliers, lessors and other third parties particularly relevant to the distribution assets should be specified.
Regulatory approvals: Both parties will want to be directly concerned with regulatory approvals by the OEB, the Minister of Finance and the Competition Bureau. As such, transaction agreements should specify which party will have carriage of these matters, who will be responsible for paying filing fees, the obligation of both parties to participate and cooperate, support or assist in the process of obtaining these approvals and the allocation of the financial consequences if any approvals are not received.
For instance, if the Ontario Ministry of Finance requests a payment of the transfer tax, it would normally be expected that the purchase price would be reduced by this amount. Similarly, as mentioned above, if the OEB rejects or modifies a rate change application, the impact of this change on the purchase price should be clearly understood by the parties in advance. In addition to the items mentioned above, and given the age of some distribution assets in the province, certain environmental approvals may be required from the Minister of the Environment. These should also be taken into account and carriage of these matters should also be clearly understood.
For the benefit of sellers
As above, sellers will seek a confirmation that all regulatory approvals have been made as well as additional agreements and documents pertaining to the specific nature of the transaction, such as real estate documents, employment documents or evidence of the transfer of financial resources to the buyer’s special purpose vehicle.
Both the sellers and the buyers will be directly concerned to ensure that certain provisions of the agreement (e.g. confidentiality, deposit, forfeit/escrow) will survive the termination of the purchase agreement if it is terminated prior to closing. Similarly, certain elements of the agreement (representations and warranties, indemnification, confidentiality, etc.) may also need to be stated to survive the closing of the transaction.
Because of the complex nature of these transactions, the indemnification provisions can be intricate. Buyers will want indemnification coverage for all matters and all breaches of representations and warranties for at least one to two years after closing. Tax matters and matters pertaining to environmental, employment and labour aspects of the transaction may be made subject to indemnities that survive three to seven years after closing.
Market norms vary broadly with respect to the limits on indemnity, ranging from 50% of the contract price to 100% of the contract price with exceptions made, obviously, for fraud and criminal matters. Depending on the nature and financial wherewithal of each party, apparent guarantees and/or supporting security may be required by one or both parties. In addition, specific notice and time limitations for the indemnities will also need to be specified.
It should be kept in mind that most of the uncertainties regarding these transactions will have been resolved within two to three years after closing and that risk to both parties reduces substantially after that stage. Both parties will also want to see some form of de minimis clause included in the indemnity provision in order to reduce the numbers of claims made.
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[1] For more information, see our earlier article, “Market update: Final recommendations on Hydro One and broader LDC consolidation,” found here.
[2] Be forewarned: the contractual elements discussed here are liable to change fundamentally if and when the law and regulations applicable to LDCs operating in Ontario evolve or change.
[3] For more information, see our earlier article, “Will Electric Vehicles Consolidate Ontario’s Fragmented LDC Sector?” found here, or “Barclays Downgrades Electric Utility Bonds, Sees Viable Solar Competition,” found here, or “Disruptive change in the electricity grid — the need for a new paradigm,” found here.
[4] See s. 149 of Income Tax Act, s. 94 of the Electricity Act and Ontario Regulation 124/99.