Defining a Pooling Agreement
A pooling agreement is a legal document that outlines the terms and conditions under which multiple parties agree to share costs and benefits related to a particular product or asset, such as an oil well or an oil and gas lease. This contract’s scope can easily grow to encompass more than just shared resources. A workable pooling agreement will go into detail on the amount each party contributes, and how resources and profits will be divided among them.
Pooling agreements are often part of a larger agreement called the joint operating agreement, into which these contracts are inserted several different times. It’s important to keep in mind that there are many different kinds of pooling agreements. In addition to covering various aspects of joint ventures, a pooling agreement can require participants to pay advances, covering their future obligations, towards the repair, modernization and replacement costs of the property before the project is even off the drawing board .
One essential factor to remember about pooling agreements is that they require participants to be in perfect accord with one another, making this the counterpart that a pro-rata right of first refusal is designed to avoid. The pooling party must consent to the sale of your interests in who owns the property, or else they risk being declared not to be a counter party to the provision.
While pro-rata rights of first refusal are the remedy for run away projects, more often parties use allocations as defined in the joint venture agreement and if that fails take the remaining interest to auction, inviting bids for whomever wishes to buy into the venture most. Problems arise when participants withhold any reference to their rights because they are confident the cost won’t result in a problem.
Categories of Pooling Agreements
In real estate and natural resource transactions, it is common to refer to a pooling agreement in connection with an agreement that combines the resources of two or more parties to achieve a common goal. Below, the term is elaborated and explained with three different types of pooling agreements: shareholder pooling agreements, oil and gas pooling agreements, and pooling agreements in general.
Shareholder Pooling Agreements. A pooling agreement with respect to shares is often entered into to allow an individual shareholder to align themselves with other shareholder(s) in controlling a private company (typically a small closely held corporation). A pooling agreement among shareholders will provide that all of the parties, or a specific subgroup of them, will co-operate in the exercise of their voting rights in a prescribed manner. For example, it may provide that they will vote a certain percentage of the shares to elect a specific number of directors, or to elect a specific director. Furthermore, such a pooling agreement may provide an option or right of first offer (or first refusal) to sell and/or rights to tag-along on the sale of shares by others.
Oil and Gas Pooling Agreements. Similarly, oil and gas pooling agreements are also used to combine the interests of a group of investors that have an interest in a specific piece of land for developing its natural resources. For example, the owners may want to consolidate the gas patches and develop them as a single unit even though the plots of land are not physically adjacent to one another. A pooling agreement may provide that the landowners may pool their site and jointly explore and further develop their collective land.
Pooling Agreements. Keywords are used to describe pooling arrangements. For example, taxpayers can combine income from more than one single source into a "pool" and derived from "pooling". Natural resource units such as gas, oil, and minerals are also described as "pooled" or created by these "pooling".
Advantages of Pooling Agreements
The advantageous elements of entering into a pooling agreement include efficiencies over operation alone. A pooling agreement, which may be a joint operating or similar agreement, also can address risks arising from intersecting operations and overlapping business issues. The pooling agreement of course will regulate the interactions among the pool members. A pooling agreement can resolve ambiguities as to the interplay between overlapping business issues that could lead to differences of opinion. And pooling provides marketing power. By combining resources to broadly pursue and retain coal delivery contracts, companies benefit from the ability to bid for larger contracts and thus obtain a better rate of return on capital investments.
Fundamentals of a Pooling Agreement
The very purpose of a pooling agreement is to set out and agree upon the various rights and obligations arising between the parties to the pooling arrangement. There are certain key features which are commonly included in most pooling agreements that are relatively explicit and/or are particularly important. These include:
The parties’ rights and obligations. The parties to a pooling agreement (being the parties in a pooled share or pooled loan arrangement) have certain rights and obligations under a pooling agreement. For example, in the case of a mortgage backed securities arrangement (or a residential mortgage backed products arrangement), the rights of the parties may, amongst other things, specify the extent to which a pool of mortgagees will be serviced and managed by the servicer, as well as the rights of the parties in relation to distributions/entitlements to income generated by the pool. One party may have certain further obligations such as reporting obligations and the delivery of financial information to the other parties. In some cases, it may also be necessary for the pooling agreement to set out how the parties are to deal with the costs, expenses and taxes incurred as a result of establishing and maintaining the pooled share/pooled loan arrangements.
Decision making. The decision making mechanisms which the parties will follow in the event they differ from each other in relation to a matter of significance or importance which is raised under the pooling arrangement are commonly addressed in a pooling agreement. For example, to what extent are the parties required to seek the consent of the other parties under the pooling agreement before (i) making a change to the pooling arrangements, (ii) amending or terminating the pooling arrangements, or (iii) taking any other particular action under the pooling arrangements? Some pooling arrangements will require consent of the parties on a unanimous basis, while others may only require consent on a majority basis. There may also be specific qualifications or restrictions on the ability of a party to vote at all if a party has a conflict of interest relating to the matter under consideration.
Dispute resolution mechanisms. In the event a dispute arises between the parties in relation to the pooling arrangements, a pooling agreement should normally contain a dispute resolution procedure to assist in facilitating the resolution of any such dispute. This may involve, for example, the provision of a process to refer the dispute to mediation, or alternatively to refer the dispute to arbitration. Some pooling agreements may be drafted in such a way as to provide parties with an option as to whether they wish to refer the matter to either mediation or arbitration.
As parties to a pooling arrangement often have ongoing relationships with each other (i.e. both before and after entering into a pooling agreement), it is advisable that the parties take the opportunity to clearly set out the terms of their respective relationships in a suitable pooling agreement, and consider the key components of such an agreement as outlined above. This will help ensure that the parties are aware of the key issues to address in negotiating the terms of the pooling arrangements, and ensure that the parties’ interests are adequately protected by the terms of the pooling agreement.
Legal Aspects and Abidance
Pooling agreements are commonly employed by large and small broker-dealers in the over-the-counter ("OTC") derivatives markets. The nature of the OTC derivatives markets – involving trading of non-exchange traded and non-standardized products – provides opportunities for broker-dealers to negotiate and enter into private custom contracts but also raises a number of legal considerations, particularly with respect to the use and treatment of confidential information. Commissioner Aguilar of the SEC recently discussed a variety of legal issues that arise in connection with pooling arrangements, and we have discussed these at our March 17, 2010 ASIMR Conference presentation.
Legal Considerations. When drafting a pooling agreement, the parties should ensure that they clearly state the material terms of the contract, the performance obligations and the potential remedies. The pooling agreement should also carefully define the different types of information being exchanged, including, sensitive business or potentially non-public information, which may be considered Confidential Information, as well as the manner in which certain business information may affect the pricing of derivatives being transacted between the parties (Information). A pooling agreement should also ensure that Information obtained from a counterparty with respect to a specific transaction with that counterparty is not misused by the other party to trade on its own account or to conduct a derivative transaction with a third party that reflects the counterparty’s Information.
Both market participants and regulators should understand that pooling arrangements give rise to a number of legal issues. For example, there are legal risks depending on how a counterparty uses Information received from another counterparty. Legal risks also arise when a counterparty’s use of Information creates the opportunity for perceived or actual unfair compensation between the counterparties or gives rise to a perception of a possible abuse of Information.
An example of such a legal issue is found in the CFTC’s Report on In General CFTC Rulemaking Exempting Derivatives Clearing Organizations from Registration Pursuant to Section 712(d) of the Dodd-Frank Act. The CFTC rulemaking specifically calls out the claw-back provision in a pooling arrangement which permits one party to recoup a portion of its fees and/or costs from another party under certain prescribed conditions. Specifically, the CFTC has noted that "[g]iven that the rules governing the proposed pooling arrangements appear to allow for potentially unrestricted payments from [proposed exempt entity] market intermediaries to each other through a mechanism…that may be available to all counterparties in settlement of their respective obligations…, the principles of simplicity and transparency would seem to counsel against the inclusion of the claw-back provision in the proposed pooling arrangements." The CFTC further noted that the claw-back provision could be utilized in a manner that may amount to discrimination among market participants. The CFTC has therefore requested that the proposed exempt entity clarify how the claw-back provision will operate to avoid exclusion from the enumerated exceptions to the registration requirements of the Dodd-Frank.
Regulatory. A pooling agreement should consider the relevant regulatory requirements. In particular, when negotiating and executing a pooling agreement, the parties should ensure that they are not restricted by provisions in CFTC regulations 1.57 and 1.80, as discussed below. The parties should also ensure that they are not exchanging non-public swap information other than in accordance with CFTC rule 23.451 (Swap Data Repository Privacy), and that they notify relevant global regulators of data breaches involving non-public swap information in accordance with the CFTC’s swap data repository Privacy Rule 23.150.
Section 4s(e). Section 4s(e) requires each covered entity to adopt written policies and procedures reasonably designed to (i) establish risk management controls and systems reasonably designed to manage the risks associated with its business activities, (ii) ensure that risk management systems and procedures are actively monitored and evaluated for effectiveness and appropriateness, and (iii) annually review, at a minimum, such policies and procedures to determine their continued applicability, effectiveness and reasonableness. Moreover, covered entities must engage in risk analysis, including stress testing, on an annual basis, and ensure that the policies, procedures and systems address applicable risks and are modified accordingly to account for changes in conditions.
Rules 1.57 and 1.80. Rule 1.57 is a codification of the "functional definition" of the term "swap" adopted in Commodity Exchange Act ("CEA") Amendments Act, Public Law No. 92-482, which generally incorporates products that any commodity pool or hedge fund would typically enter into, but that are more complicated than a plain vanilla derivative. Exchange rules only apply to 1.57 swaps to a limited extent, whereas most other regulations do not apply to such swaps. Rule 1.80 expanded the existing Regulation 1.80 to cover certain swaps with "other" counterparties by application of the Tester Test; thus, if the swap with a non-FCM or non-DCO counterparty is entered into at a time when the overall portfolio of the swap trading operations was less than 10% of the broker/dealer’s net capital and the swap is 10% or greater than the shown dealer’s consolidated net capital, then the swap will be treated like a swap falling under the definitions in Rules 1.57 and 151. This means, for pools and commodity pools that deal mostly in the traditional futures market, this rule will bring them under the scope of 1.57 in addition to Rule 4.31(b) Applicable to commodity pools that engage in trading futures contracts which, as indicated in the CFTC Exemption Letter, does not permit certain pools to engage in swaps.
Typical Drawbacks of Pooling Agreements
One of the most typical challenges encountered in dealing with pooling agreements is conflicts between parties. Especially in larger joint venture agreements, conflicts may not be among the developers but instead between developers and lenders; for example, local laws may prevent extractions on certain days or at certain times, while lending documentation prohibits these maneuvers. For a number of reasons, it is also common for parties to have different preferences for the order in which the development process is undertaken. Typically, before resources can be extracted, a related deposit of that resource may have to be removed. To the extent that one market can’t support all of the different methods of extraction, it may be necessary for a single resource to be extracted under different pools. Finding an acceptable solution requires an agreement on the technological basis of resource extraction. There is no single definition in which all parties can agree — costs , risk, the duration of each method can all affect the outcome anyway. One possible approach is to agree to combine different methods to make up for possible failures by a single technological approach at any particular time. Another approach is to keep to one method and protect all parties with arrangements or clauses that obligate parties to indemnify each other for possible problems. In addition to conflicts, enforcing terms is often a struggle. Parties must not only have a mutually satisfactory solution, they must enforce that solution; otherwise, risk exists that one particular party might remove resources to the detriment of other parties. A solution to this issue is to hold resources by a third independent party who will oversee the extraction procedure. The third party must be someone more likely to decide objectively and fairly, with a minimum of personal conflict of interest.
Pooling Agreements in Practice: Case Examinations
To see the pooling agreement at work in the real world, we can turn to two landmark cases: the first is Troice v Proskauer Rose LLP, where a group of plaintiffs entered into an over-secured lending transaction with a bank. As a consequence, they structured a return of principal into the transaction, and then allocated the return of principal into various pools. Although the Troice plaintiffs were able to achieve payout from other investment vehicles, they failed to get a return of principal from the particular pool in which they were invested, because the political turmoil in Egypt negatively impacted the real estate collateral. When they filed a securities fraud case, the issuing bank successfully moved to dismiss. Ultimately, the case was dismissed not just because the investment carrier had always been marginally risky, but also because the plaintiffs had no power to change the risk – i.e., after the pooling was established, they were hands-off investors whose investing decisions were a thing of the past.
Pooling agreements are not limited to countries that have proven unstable in the past. The other case to keep in mind is Merrill Lynch v Dabit. In this particular instance, Merrill Lynch had set up a pooling agreement with its clients. However, instead of purchasing securities through the parent company, these pooling agreements were made through several subsidiaries of Merrill Lynch. After the corporation collapsed due to securities fraud, the advisors and financial planners who had worked closely with the families and children in question, attempted to sue Merrill Lynch for damages. However, the court found that the generalization of these pooling agreements left no room for redress; in essence, the pooling agreements had diluted the damages across so many accounts that individual investors were unlikely to get any compensation through court-mandated means.
The bottom line: pooling agreements are not always as innocent as they sound.
Creating a Pooling Agreement: Advice and Optimal Practices
Considerations for Drafting the Pooling Agreement
When drafting a pooling agreement, it is imperative to work with an attorney who is knowledgeable in both the rules and mechanisms utilized by the particular agency to ensure compliance with all applicable rules.
When drafting a pooling agreement, the pooling agents must ensure that:
Pooling agents should be required to meet the following criteria to be accepted into the program:
The pooling agreement should include the following, at a minimum:
The pooling agreement is then filed and approved by all the member towns.
Courts have ruled that pooling agreements are contracts, and while there are exceptions, such agreements must conform to Common Law and Statutory Law. If private parties choose to include special provisions that may not be authorized under law, these provisions may be limited to those persons or entity and not binding on the parties.
Upcoming Developments in Pooling Agreements
Emerging trends suggest that pooling agreements will continue to be a dependable and strategically sound way for parties to collaborate on real estate developments. As property, land use, and capital market considerations converge, developers are likely to face greater challenges in assessing how best to structure new developments. Pooling may provide significant answers, particularly if pooling agreements are seen as more flexible than other joint arrangements like condominiums.
Pooling agreements will undoubtedly become even more important when a single property is not developed independently, which happens all too often in high-density areas with rapidly-growing populations . Some banks are already starting to reject loans if their attorney cannot negotiate a pooling agreement for their client. A pooling agreement could allow lenders to pool adjacent or nearby sites for greater leverage.
With more parties in play and no clear pattern for how pooling agreements will be used, it is likely that some states will seek to regulate the approach. Like a matrix of unit buyers and sellers, the success of pooling starts with a clear understanding of how and when to use an agreement.