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Finance and securities law complement each other. Bankers evaluate companies and price risk; lawyers make sure that the terms of an agreement reflect the risks that bankers want to take, or don't. Think about a debt financing– the fewer covenants in a bond, the higher the interest rate needed to compensate the bond investor for assuming additional risk.
This isn't always obvious to clients, or to lawyers, but that doesn't make it untrue. In theory, one side of a negotiation during, say, a $5,000 Sunday night phone call spent negotiating a comma in some obscure closing condition, could pay the other side $5,000 for that comma and skip the phone call altogether. However, this would require pricing the risk of failing to meet that obscure, but potentially closing, condition correctly, and pricing the likelihood of a company failing to meet some odd but potentially catastrophic closing condition isn't easy. Sometimes, it's easier to get the wording right than the price.
This negotiation over risk is what makes Elkwater Resources' combination plan-of-arrangement with Exoro Energy Inc and bought deal financing so much fun. It's a happy story about how risks get chopped up and passed around so that deals can close, even in terrible market conditions.
In short, Elkwater wants to buy Exoro and to do so it needs to raise money. To raise money, Elkwater has entered into a $100-million bought deal equity financing with a syndicate of banks. The thing is, a bought deal financing – at least in theory – involves shifting the risk that there are no buyers for Elkwater from the company to the banks themselves, who commit to buying Elkwater's equity and assuming the risk of finding buyers for it (or bearing the losses should they need to dump the shares at a loss). This is opposed to a best efforts deal, where unsold shares are returned to Elkwater. During good times, this financing arrangement represents a risk to the banks; in one of the worst resource markets in recent memory, however, the banks face a significant risk that they either won't be able to find buyers for the equity, or that buyers will back out.
So, there are ways in which the banks can deal with this risk– legal, or financial.
The legal solution would be, first, to condition the financing on the completion of the Exoro acquisition. And, indeed, the financing is conditioned on the completion of the transaction. This only makes sense; the financing isn't useful to Elkwater without the acquisition, and the risk that investors would pull out greatly increases. The second step would be to negotiate, either in the financing documents or the acquisition document, a clause that terminates the transaction in the event that the resource market spirals out of control.
If such a term existed, it would likely be found in a Material Adverse Change (MAC) clause. And yes, there is a MAC clause in the bought deal , but it's a fairly cookie cutter version of a common clause. It ends the transaction in the event of something catastrophic happening to Elkwater, but not if that catastrophic thing happens because of a general, negative turn in the market for oil and gas, or the stock market generally. Moreover, there isn't even a long shot legal argument that the clause could cover such an event; the Ontario Superior Court of Justice last year in the case of Stetson v. Stifel shut down the idea that a MAC clause, without specifically negotiated language, allows an underwriter to walk away from a bought deal in the event of a general downturn in the market.
In this case, the risk mitigation is happening through finance. Elkwater announced the bought deal at a discount to the market price. So, for 37.5 cents, a nearly 14 cent discount relative to the opening market price the day before the deal was announced, buyers get a subscription warrant worth one Elkwater share, plus a half-share warrant exercisable at 65 cents. That means that a buyer of one of these subscription units, including the underwriter, can sell Elkwater's shares short by buying them at the market price when the deal was announced, guaranteeing himself the difference when the trade settles. And it appears that this is what the underwriters did – as soon as the deal was announced, Elkwater's price plummeted to just above the 37 cent offer price.
In short, Elkwater's price structure significantly limited the underwriter's price risk, even during the kind of industry or market wide crash that doesn't trigger the MAC clause. If Elkwater craters, the underwriter's gain may be capped – because he is settling his trade at 37.5 cents and not an even lower price – but it will still profit.
Meanwhile, there's little risk to hedge funds buying from the underwriter as long as the market price is above the offering price and the funds are short their shares when they receive their allocation. And, even if the funds aren't short, they are presumably buying the deal because they like it. Plus, they retain the potential upside from the warrant. Elkwater gets its funds regardless, while retaining the certainty that if things go really bad for either Elkwater or Exoro, the MAC clause will kick in and terminate the whole thing.
Isn't that fun? I mean, sure, Elkwater would rather it hadn't been forced to sell its shares at a discount, but it can't be that sorry – it's going to get its deal done in a very bad market. But it's always a heartwarming Bay Street story when bankers, lawyers, hedge funds, short sellers and junior oil and gas companies get together to get hard deals done. Think of it like a terrible pun on a Bruce Cockburn song: finance in a dangerous time.
Adrian Myers