Institutional investors and the Queensland resources sector: a new challenge to clean exit

The Australian resources sector has recently seen strong interest from the financial institutional investor space. However, organisations in Queensland must structure their sale process thoughtfully and select their buyer very carefully. Under the intentionally pervasive Environmental Protection (Chain of Responsibility) Amendment Act 2016 (Qld) there could be serious issues when financial institutional investors seek to realise their investment on a clean-exit basis. 

The law being considered is the Environmental Protection (Chain of Responsibility) Amendment Act 2016 (Qld) (CORA). This Act became law in Queensland in April 2016. In its simplest terms, CORA introduces a risk, which did not previously exist, that a former owner of a mining or petroleum resource project in Queensland could be given an order (called an EPO) to rehabilitate the resource site, or a cost recovery notice (CRN) to pay to the State an amount required for rehabilitation or monitoring. The powers created are designed to be used where the current owner of the project is unable to discharge its environmental rehabilitation obligations (for example, due to insolvency). In these circumstances, the State will look for someone else to discharge the rehabilitation obligations. This can include former owners. CORA cannot be contracted out of - there is no way to avoid its operation.

Some basics

In light of CORA, any former owner of a resource project will need to understand the circumstances in which they could remain liable for an EPO or CRN after they have exited the investment.

Under CORA the circumstances will be:

• where the current project owner (for convenience, the project company) is not able to discharge its environmental rehabilitation obligations; and
• the former owner is determined to have a relevant connection with the project company.

A former owner (indeed, any person) can have a relevant connection to the project company if the former owner:

• benefitted significantly from the relevant activities of the project company; or
• has been in a position in the previous two years to influence the project company’s conduct in relation to the way in which, or extent to which, the project company complied with its environmental obligations under law.

The responsible authority, the Department of Environment and Heritage Protection (DEHP), has issued lengthy and detailed guidelines setting out the circumstances in which it may look to persons other than the project company. DEHP must have regard to the guidelines (Guidelines), but is not obliged to follow them.

Benefitting Significantly

Whether a former owner benefitted significantly from the conduct of the relevant resolute activities by the Project company is context dependent; in broad terms the receipt of normal investment returns (including income distributions and capital receipts from sale) commensurate with ownership and the nature of the project will not necessarily satisfy this requirement. The Guidelines suggest that DEHP is looking for something more – outsize returns achieved at the expense of environmental compliance, for example.

The Guidelines make clear that, in the context of potential liability of a former owner, even if a relevant connection between the former owner and the project company is found to exist, they will look for some form of culpability: to be clear, the mere fact of former ownership is not, under the Guidelines, in and of itself sufficient to attract liability under CORA.

Two Year “Look Back” Period

The question in the 2-year look back period is simply one of influence and control during the period of ownership; the question of the economic benefit obtained by the former owner is not relevant. The path to the door of a former owner (particularly a majority owner), within this period is much more direct; the forensic examination will focus on the conduct of the former owner vis a vis the project company’s compliance with its environmental obligations.

A few other things to know:

• The issue of unfunded environmental rehabilitation obligations and potential recourse will arise (broadly) in two circumstances; where there is a current failure to rehabilitate, and where the project company enters into external administration.
• DEHP can issue an EPO or CRN to more than one person under CORA – for example to a current parent entity of the project company as well as a former owner. The liability when this occurs will be joint and several between the recipients of such notice.
• Often a condition of an environmental authority, which allows a company to undertake a resource project, requires the provision of a financial assurance in favour of the State. If a project company becomes insolvent (for example) neither CORA nor the Guidelines indicate that DEHP will have first recourse to the financial assurance. To the contrary, an EPO or CRN could be issued to a related person to implement the rehabilitation, and the financial assurance will be held as a last-resort security for the State.
• For completeness, CORA allows DEHP to issue an EPO or CRN to the holding company of a project company as a consequence of the parent-subsidiary relationship; in this way there is an immediate “piercing of the corporate veil” for unfunded rehabilitation costs. Questions of a relevant connection do not need to be considered.

Financial institutional investors

So what might be unique about the context of investment and exit by financial institutional investors that might warrant particular consideration of potential CORA issues? Arguably the following, to greater or lesser degrees:

• Financial institutional investors invest explicitly on a limited recourse basis – the fund and intermediate holding structures employed are designed to ensure that “upstream” assets, including the uncalled capital commitments of limited partners, are quarantined from project level recourse.
• Investment funds are often closed-end or otherwise have a limited life; the legal entity that made the “upstream investment” may not necessarily exist when rehabilitation obligations are brought into question.
• Once an investment is realised, returns are often distributed to investors with limited claw-back rights which would allow a general partner or fund manager recourse to distributed returns to meet a future unexpected liability.
• The controlling or decision making entity (for example, general partner) would typically be a special purpose entity with no assets.
• Strategic investors often have an exposure to a jurisdiction beyond a project in question, creating a “social licence contract” between the investor and the jurisdiction and it regulators. This is not necessarily (and indeed unlikely to be) the case with financial institutional investors.

The strategic goal of the financial institutional investor reflects the desire to achieve a clean-exit from a resource investment and without contingent liability (clearly all vendors want to achieve a confident exit). Therefore, for this class of investors the question of potential statutory legacy liability requires, in every exit, a thorough examination.

Who might have a relevant connection with a project company?

A relevant connection between a person and the project company can exist if DEHP is satisfied that (as relevant for present purposes):

• the person benefitted significantly from the carrying out of the relevant project; or
• the person has been in a position in the previous two years to influence the project company’s conduct in relation to the way in which, or extent to which, the project company complied with its environmental obligations under law.

For this purpose, a person includes individuals as well as all forms of corporate entities. While somewhat unclear, the law appears to provide a power to DEHP to issue an EPO or CRN to, and impose liability on, a person domiciled outside of Australia.

The law provides guidance as to what DEHP may consider, including, for example:

• the person’s control of the project company;
• the extent of the person’s financial interest in the project company; and
• the extent to which dealings have been made at arms’ length, or on an independent commercial footing.

It is clear that, in the financial institutional investor context, various people or entities could theoretically be considered to have a relevant connection: the general partner, fund or asset manager, key executives or even limited partners.

When addressing the culpability issue, the Guidelines indicate that DEHP will ask: “Did the person whose conduct or relationship is being examined take all reasonable steps in the circumstances?” For example, ensuring that an unfunded rehabilitation obligation would not exist. Reasonable steps is context dependent – a limited partner with little or no influence within a fund structure would not be seen to be in a position to direct the taking of reasonable steps.

How can an exiting investor mitigate or manage CORA risk?

In managing the risks associated with former ownership of a resource project, an exiting investor should consider two perspectives:

• When an unfunded rehabilitation exposure arises, DEHP has, somewhat comfortingly, indicated that it will look for something more than the mere fact of former ownership.
• However, ultimately the State does not want to be left with the rehabilitation costs; for various reasons (including political) it will want to find someone to meet the liability.

These perspectives shape the approach to risk mitigation for an existing investor.

So, a well-informed existing investor will, at least, consider the following risk mitigants and processes:

1. Be compliant with environmental obligations (and able to demonstrate that) at the time of exit.

This issue largely goes to the question of culpability: it should be more difficult for DEHP to conclude that a former owner of a resource project is culpable following the exit if, at the time of exit, the project company was (put simply) fully compliant with its environmental obligations. This evidence will be crucial should the project company fail within the two-year look back period.

In an M&A context, for a vendor this means firstly, clearly understanding the extent of any non-compliance issues, secondly, providing full visibility of this to your buyer, and finally, extracting evidence that the buyer understands what they are buying into.

2. Consider whether post-completion financial interest gives the vendor a continuing financial interest in the project company.

The test of a relevant connection includes an assessment of financial benefit; a sale structure that involves payment of all consideration at the time of financial close (i.e. no ongoing royalty or earn-out arrangements) can help avoid a characterisation that the former owner continues to have a significant financial interest in the project.

3. Sell on arms’-length terms.

The Guidelines explain why:

‘A vendor has made normal market value profits from the sale of an operation through an arm’s length transaction. At the time of the sale, the operation was in compliance with its EA. After taking responsibility for the operation, the purchaser failed to carry out maintenance on key infrastructure as required in its EA and has become insolvent. There is a risk that as a result of the failure to carry out maintenance, the infrastructure will fail and cause significant environmental harm. 

As the sale of the operation was through an arm’s-length commercial transaction and the vendor received normal market value profits from the sale of the operation, the vendor would not be considered to have a relevant connection on the sole basis of significant financial benefit.’

In competitive sale processes it will be readily apparent that the term, condition and price received by the exiting vendor are arms’ length.

4. Sell to a quality buyer.

The extract from the Guidelines set out in paragraph 3 above indicate that a subsequent failure by new owners to comply (or ensure compliance with) environmental obligations and responsibilities should not put the former owner in the firing line. However, ultimately if the question of CORA arises it is because an unfunded rehabilitation liability occurs and the State does not intend to pick this liability up: on this basis it is in the interest of a vendor to sell to a quality buyer with strong financials and some demonstrable ability to comply with environmental and other corporate obligations.

In a sale context it can only help a vendor’s cause if they have obtained and assembled evidence (as well as warranties) that support their decision as to why they sold to the particular buyer: that they did all they could in the circumstances to satisfy themselves that the project would continue to be appropriately controlled and resourced in relation to forward-looking environmental obligations.

5. Seek ongoing buyer protection.

Typically a well-crafted sale agreement will provide protection for the vendor for post-completion liabilities, including under environmental law. From the vendor’s perspective, this post-completion protection, which by its terms should protect the vendor from a liability imposed on it under CORA, should be available:

• for an extended period of time; and
• from credit-worthy entities.

Protection for the first two years post exit is, for the reasons given above, particularly important.

It may, in appropriate circumstances, be reasonable to seek further protections during this period – for example, a regime that provides the vendor with protection if the new owner themselves seek to sell the project within this period.

6. Consider the broad approvals process.

In some divestment transactions a purchaser will be required to obtain various regulatory and other approvals, for example:

• from the Commonwealth Treasurer on the recommendation of the Foreign Investment Review Board (FIRB);
• Ministerial approval to the transfer of tenements and the “swapping out” of financial assurances in the case of divestments structured as asset sales;
• from financiers where a project has external project level debt;
• joint venture partners in the case of joint ventures; or
• as a consequence of any other change of control consents arising under permits or contracts.

All of these approvals, to a greater or lesser degree, provide a level of ‘diligence’ or independent assessment in relation to the question of the ‘quality of the buyer’. For example, FIRB will consider the ‘corporate integrity’ of the foreign buyer as part of its assessment procedure.

Conversely, the absence of a requirement to obtain any external approvals will place the onus more squarely on the shoulders of the vendor to satisfy itself about the identity of the person to whom it has selected to sell the project.

Conclusion

Potential liability under CORA is, for the moment in Queensland, a fact of life (its operation will be reviewed in late 2018). To our knowledge it has only been used once. It seems to us that in some circumstances an M&A transaction pursued by a vendor will raise questions about potential legacy liability issues coming back to them – but the risks should be able to be managed through a sensibly run sale process.

This article was originally co-authored by Bruce Adkins.