Filed pursuant to Rule 424(b)(3)
Registrantion No. 333-171792
PROSPECTUS SUPPLEMENT
to Prospectus dated
February 14, 2011
5,918,894
Common Units Representing Class B Limited Liability Company Interests
This prospectus supplement relates to 5,918,894 common units representing Class B limited liability company interests in us that may be
offered and sold by the selling unitholder named in this prospectus supplement. We are not selling any common units under this prospectus supplement and will not receive any proceeds from the sale of common units by the selling unitholder. The
common units to which this prospectus supplement relates may be offered and sold from time to time directly from the selling unitholder or alternatively through underwriters or broker-dealers or agents. The selling unitholder may sell the common
units in one or more transactions, at fixed prices, at prevailing market prices at the time of sale or at negotiated prices. Because all of the common units being offered under this prospectus supplement are being offered by the selling unitholder,
we cannot currently determine the price or prices at which our common units may be sold under this prospectus supplement.
Our common
units are traded on the NYSE MKT under the trading symbol CEP.
Each time the selling unitholder offers to sell securities
under this prospectus supplement and the accompanying prospectus, the selling unitholder may provide an additional prospectus supplement that will contain specific information about the terms of that offering. Such additional prospectus supplement
also may add, update or change information contained in this prospectus supplement and accompanying prospectus. You should read this prospectus supplement, the accompanying prospectus and any additional prospectus supplement carefully before you
invest. You should also read the documents we refer to in the Where You Can Find More Information section of this prospectus for information on us and our financial statements.
Investing in our securities involves risks. See
Risk Factors
beginning on page 2.
Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or
passed upon the adequacy or accuracy of this prospectus supplement or the accompanying prospectus. Any representation to the contrary is a criminal offense.
The date of
this prospectus supplement is February 5, 2014
TABLE OF CONTENTS
You should rely only on the information contained in this prospectus supplement and the accompanying prospectus. We have not
authorized anyone to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. You should assume that the information appearing in this prospectus supplement is accurate as
of the date on the front cover of this prospectus supplement only. Our business, financial condition, results of operations and prospects may have changed since that date.
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ABOUT THIS PROSPECTUS SUPPLEMENT
This prospectus supplement supplements the accompanying prospectus and is part of a registration statement on Form S-3 that we have filed with
the Securities and Exchange Commission, or SEC, using a shelf registration process. Under this shelf registration process, the selling unitholder named in this prospectus supplement may sell the common units described in this prospectus
supplement in one or more offerings. This prospectus supplement and the accompanying prospectus provides you with a general description of us and the common units the selling unitholder may offer under this prospectus supplement and the accompanying
prospectus.
Each time the selling unitholder sells common units under this prospectus supplement and the accompanying prospectus, the
selling unitholder may provide an additional prospectus supplement that will contain specific information about the terms of that offering. Such additional prospectus supplement also may add to, update, or change information in this prospectus
supplement and the accompanying prospectus. If there is any inconsistency between the information in this prospectus supplement or the accompanying prospectus and any additional prospectus supplement, you should rely on the information in the
additional prospectus supplement. You should read carefully this prospectus supplement, the accompanying prospectus, any additional prospectus supplement and the additional information described below under the heading Where You Can Find More
Information. We include a glossary of some of the terms used in this prospectus supplement in Appendix A.
References in this
prospectus supplement to Constellation Energy Partners, we, our, us, CEP, the company or like terms refer to Constellation Energy Partners LLC and its subsidiaries. References
in this prospectus supplement to CEPM are to Constellation Energy Partners Management, LLC, a Delaware limited liability company. References in this prospectus supplement to Sanchez are to Sanchez Energy Partners I, LP, a
Delaware limited partnership. We refer to our Class A limited liability company interests as the Class A units, our Class B limited liability company interests as the common units, and our Class C limited liability company interests as the
management incentive interests.
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ABOUT CONSTELLATION ENERGY PARTNERS LLC
We are a limited liability company that was formed in 2005 to acquire oil and natural gas reserves. We are focused on the acquisition,
development and production of oil and natural gas properties, as well as midstream assets. Our primary business objective is to create long-term value and to generate stable cash flows allowing us to invest in our business to grow our reserves and
production. Our proved reserves are located in Cherokee Basin in Oklahoma, the Woodford Shale in the Arkoma Basin in Oklahoma, the Central Kansas Uplift in Kansas and in Texas and Louisiana.
Our principal executive offices are located at 1801 Main Street, Suite 1300, Houston, TX 77002, and our telephone number is
(832) 308-3700. Our website is located at http://www.constellationenergypartners.com. We make our periodic reports and other information filed with or furnished to the SEC available, free of charge, through our website, as soon as reasonably
practicable after those reports and other information are electronically filed with or furnished to the SEC. Information on our website or any other website is not incorporated by reference into this prospectus supplement or the accompanying
prospectus and does not constitute a part of this prospectus supplement or the accompanying prospectus.
RISK
FACTORS
Limited liability company interests are inherently different from capital stock of a corporation, although many of the
business risks to which we are subject are similar to those that would be faced by a corporation engaged in a similar business. You should carefully consider the risk factors discussed in our Annual Report on Form 10-K for the year ended
December 31, 2012 and our quarterly reports on Form 10-Q for the quarters ended March 31, 2013, June 30, 2013 and September 30, 2013, together with all of the other information included in this prospectus supplement, the
accompanying prospectus, any additional prospectus supplement and the documents we have incorporated by reference into this prospectus supplement and the accompanying prospectus in evaluating an investment in our common units. The described risks
could materially and adversely affect our business, financial condition or results of operation. If any of the described risks actually were to occur, we may not be able to resume or pay quarterly distributions on our common units, the trading price
of our common units could decline and you could lose part or all of your investment in our company.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
Some information contained in this prospectus supplement, the accompanying prospectus, any additional prospectus supplement and the documents
we incorporate by reference herein and therein may contain forward-looking statements that are subject to a number of risks and uncertainties, many of which are beyond our control, which may include statements about:
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the volatility of realized oil and natural gas prices;
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the conditions of the capital markets, inflation, interest rates, availability of a credit facility to support business requirements, liquidity, and general economic and political conditions;
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the discovery, estimation, development and replacement of oil and natural gas reserves;
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our business, financial, and operational strategy;
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our drilling locations;
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our cash flow, liquidity, working capital and financial position;
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the level of our borrowing base under our reserve-based credit facility and our ability to refinance the debt outstanding under such facility prior to its maturity date;
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the resumption or amount of our cash distribution;
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our hedging program and our derivative positions;
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our production volumes;
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our lease operating expenses, general and administrative costs and finding and development costs;
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the availability of drilling and production equipment, labor and other services;
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our future operating results;
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our prospect development and property acquisitions;
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the marketing of oil and natural gas;
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competition in the oil and natural gas industry;
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the impact of the current global credit and economic environment;
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the impact of weather and the occurrence of natural disasters such as fires, floods, hurricanes, tornados, earthquakes, snow and ice storms and other catastrophic events and natural disasters;
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governmental regulation, including environmental regulation, and taxation of the oil and natural gas industry or publicly traded partnerships;
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developments in oil-producing and natural gas producing countries;
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lack of support from a sponsor;
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our strategic plans, objectives, expectations, forecasts, budgets, estimates and intentions for future operations; and
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our ability to integrate the assets assumed from Sanchez and the outcome of litigation arising from the transaction.
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All of these types of statements, other than statements of historical fact, are forward-looking statements. In some cases, forward-looking
statements can be identified by terminology such as may, could, should, expect, plan, project, intend, anticipate, believe,
estimate, predict, potential, pursue, target, continue, the negative of such terms or other comparable terminology.
The forward-looking statements are largely based on our expectations, which reflect estimates and assumptions made by our management. These
estimates and assumptions reflect our best judgment based on currently known market conditions and other factors. Although we believe such estimates and assumptions to be reasonable, they are inherently uncertain and involve a number of risks and
uncertainties that are beyond our control. In addition, managements assumptions about future events may prove to be inaccurate. Management cautions all readers that forward-looking statements are not guarantees of future performance, and we
cannot assure any reader that such statements will be realized or the forward-looking events and circumstances will occur. Actual results may differ materially from those anticipated or implied in the forward-looking statements due to factors listed
in the Risk Factors section and elsewhere in this prospectus supplement, the accompanying prospectus, any additional prospectus supplement and the documents incorporated herein and therein by reference. All forward-looking statements
speak only as of the date of this prospectus supplement or, in any document that we incorporate by reference, the date of that document. We do not intend to publicly update or revise any forward-looking statements as a result of new information,
future events or otherwise, other than as required under the securities laws. These cautionary statements qualify all forward-looking statements attributable to us or persons acting on our behalf.
USE OF PROCEEDS
We will not receive any proceeds from the sale of common units offered under this prospectus supplement and the accompanying prospectus. Any
proceeds from the sale of common units offered under this prospectus supplement and the accompanying prospectus will be received by the selling unitholder.
HOW WE MAKE CASH DISTRIBUTIONS
Initial Quarterly Distributions
The
amount of distributions paid under our cash distribution policy and the decision to make any distribution will be determined by our board of managers, taking into consideration the terms of our operating agreement. At our initial public offering in
November 2006, we set our initial quarterly distribution (IQD) at $0.4625 per each common and Class A unit, or $1.85 per year, subject to having sufficient available cash after we establish appropriate reserves and pay fees and
expenses. We have suspended our $0.13 per unit quarterly distributions to unitholders since the quarter ended June 30, 2009, as we have had no available cash (taking into account the cash reserves set by our board of managers for the proper
conduct of our business). We have used any excess operating cash flows to reduce our outstanding indebtedness. Our quarterly distribution is intended to reflect the level of cash that we expect to be available for distribution per common unit and
Class A unit each quarter from our productive assets. There is no guarantee we will pay a quarterly distribution in any quarter and we will be prohibited from making any distributions to unitholders if it would cause an event of default or an
event of default is existing under our reserve-based credit facility. Our board of managers has adopted a policy that it will resume our quarterly cash distribution only when it believes that (i) we have sufficient reserves and liquidity for
the proper conduct of our business, including the maintenance of our asset base, (ii) we can maintain such an increased distribution level for a sustained period, and (iii) we are compliant with the terms and conditions specified in our
reserve-based credit facility and our operating agreement. While this is our current policy, our board of managers may alter such policy in the future when and if it determines such alteration to be appropriate.
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Distributions of Available Cash
Overview
Our
operating agreement requires that, within 45 days after the end of each quarter, we distribute all of our available cash to unitholders of record on the applicable record date.
Definition of Available Cash
We define available cash in the glossary, and it generally means, for each fiscal quarter, all cash on hand at the end of the quarter:
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less the amount of cash reserves established by our board of managers to:
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provide for the proper conduct of our business (including reserves for future capital expenditures and credit needs);
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comply with applicable law, any of our debt instruments, or other agreements; or
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provide funds for distributions (1) to our unitholders for any one or more of the next four quarters or (2) in respect of our management incentive interests;
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plus all cash on hand on the date of determination of available cash for the quarter resulting from working capital borrowings made after the end of the quarter. Working capital borrowings are generally borrowings that
are made under our reserve-based credit facility or another arrangement and in all cases are used solely for working capital purposes or to pay distributions to unitholders.
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Operating Surplus and Capital Surplus
General
All cash
distributed to unitholders will be characterized as either operating surplus or capital surplus. Our operating agreement requires that we distribute available cash from operating surplus differently than available cash from
capital surplus.
Definition of Operating Surplus
We define operating surplus in the glossary, and for any period, it generally means:
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$20.0 million (as described below);
plus
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all of our cash receipts after the closing of our initial public offering, excluding cash from (1) borrowings that are not working capital borrowings, (2) sales of equity and debt securities, and
(3) sales or other dispositions of assets outside the ordinary course of business;
plus
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working capital borrowings made after the end of a quarter but before the date of determination of operating surplus for the quarter;
plus
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cash distributions paid on equity issued to finance all or a portion of the construction, replacement or improvement of a capital asset (such as equipment or reserves) during the period beginning on the date that we
enter into a binding obligation to commence the construction, acquisition or improvement of a capital improvement or replacement of a capital asset and ending on the earlier to occur of the date the capital improvement or capital asset is placed
into service or the date that it is abandoned or disposed of;
less
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our operating expenditures (as defined below);
less
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the amount of cash reserves established by our board of managers to provide funds for future operating expenditures;
less
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all working capital borrowings not repaid within twelve months after having been incurred.
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As
described above, operating surplus does not reflect actual cash on hand that is available for distribution to our unitholders. For example, it includes a provision that will enable us, if we choose, to distribute as operating surplus up to $20.0
million of cash we receive in the future from non-operating sources such as asset sales, issuances of securities and long-term borrowings that would otherwise be distributed as capital surplus. In addition, the effect of including, as described
above, certain cash distributions on equity securities in operating surplus would be to increase operating surplus by the amount of any such cash distributions. As a result, we may also distribute as operating surplus up to the amount of any such
cash distributions we receive from non-operating sources.
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If a working capital borrowing, which increases operating surplus, is not repaid during the
twelve-month period following the borrowing, it will be deemed repaid at the end of such period, thus decreasing operating surplus at such time. When such working capital borrowing is in fact repaid, it will not be treated as a reduction in
operating surplus because operating surplus will have been previously reduced by the deemed repayment.
We define operating expenditures
in the glossary, and it generally means all of our cash expenditures, including, but not limited to, taxes, payments made in the ordinary course of business under commodity hedge contracts, manager and officer compensation, repayment of working
capital borrowings, debt service payments and estimated maintenance capital expenditures, provided that operating expenditures will not include:
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repayment of working capital borrowings deducted from operating surplus pursuant to the last bullet point of the definition of operating surplus when such repayment actually occurs;
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payments (including prepayments and prepayment penalties) of principal of and premium on indebtedness, other than working capital borrowings;
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expansion capital expenditures;
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actual maintenance capital expenditures;
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investment capital expenditures;
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payment of transaction expenses relating to interim capital transactions; or
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distributions to our members (including distributions in respect of our management incentive interests).
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Capital Expenditures
For purposes of determining operating surplus, maintenance capital expenditures are those capital expenditures required to maintain, including
over the long-term, our asset base, and expansion capital expenditures are those capital expenditures that we expect will increase our asset base over the long-term. Examples of maintenance capital expenditures include capital expenditures
associated with the replacement of equipment and oil and natural gas reserves (including non-proved reserves attributable to undeveloped leasehold acreage), whether through the development, exploitation and production of an existing leasehold or the
acquisition or development of a new oil or natural gas property. Maintenance capital expenditures will also include interest (and related fees) on debt incurred and distributions on equity issued to finance all or any portion of a replacement asset
during the period from such financing until the earlier to occur of the date any such replacement asset is placed into service or the date that it is abandoned or disposed of. Plugging and abandonment costs will also constitute maintenance capital
expenditures. Capital expenditures made solely for investment purposes will not be considered maintenance capital expenditures.
Because
our maintenance capital expenditures can be very large and irregular, the amount of our actual maintenance capital expenditures may differ substantially from period to period, which could cause similar fluctuations in the amounts of operating
surplus, adjusted operating surplus and cash available for distribution to our unitholders if we subtracted actual maintenance capital expenditures from operating surplus. As a result, to eliminate the effect on operating surplus of these
fluctuations, our operating agreement requires that an estimate of the average quarterly maintenance capital expenditures (including estimated plugging and abandonment costs) necessary to maintain our asset base over the long term be subtracted from
operating surplus each quarter as opposed to the actual amounts spent. The amount of estimated maintenance capital expenditures deducted from operating surplus is subject to review and change by our board of managers at least once a year,
provided
that any change is approved by our conflicts committee. The estimate is made at least annually and whenever an event occurs that is likely to result in a material adjustment to the amount of our maintenance capital expenditures, such
as a major acquisition or the introduction of new governmental regulations that will impact our business. For purposes of calculating operating surplus, any adjustment to this estimate will be prospective only.
The use of estimated maintenance capital expenditures in calculating operating surplus has the following effects:
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it reduces the risk that maintenance capital expenditures in any one quarter will be large enough to render operating surplus less than the IQD to be paid on all the units for that quarter and subsequent quarters;
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it increases our ability to distribute as operating surplus cash we receive from non-operating sources;
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it is more difficult for us to raise our distribution above the IQD and pay management incentive distributions on our management incentive interests; and
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it reduces the likelihood that a large maintenance capital expenditure during the First MII Earnings Period (as defined in Management Incentive Interests below) or Later MII Earnings Period (as defined
in Management Incentive Interests below) will prevent the payment of a management incentive distribution in respect of the First MII Earnings Period or Later MII Earnings Period since the effect of an estimate is to spread the
expected expense over several periods, thereby mitigating the effect of the actual payment of the expenditure on any single period.
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Expansion capital expenditures are those capital expenditures that we expect will increase our
asset base. Examples of expansion capital expenditures include the acquisition of reserves or equipment, the acquisition of new leasehold interest, or the development, exploitation and production of an existing leasehold interest, to the extent such
expenditures are incurred to increase our asset base. Expansion capital expenditures will also include interest (and related fees) on debt incurred and distributions on equity issued to finance all or any portion of such capital improvement during
the period from such financing until the earlier to occur of the date any such capital improvement is placed into service or the date that it is abandoned or disposed of. Capital expenditures made solely for investment purposes will not be
considered expansion capital expenditures.
Investment capital expenditures are those capital expenditures that are neither maintenance
capital expenditures nor expansion capital expenditures. Investment capital expenditures largely will consist of capital expenditures made for investment purposes. Examples of investment capital expenditures include traditional capital expenditures
for investment purposes, such as purchases of securities, as well as other capital expenditures that might be made in lieu of such traditional investment capital expenditures, such as the acquisition of a capital asset for investment purposes or
development of our undeveloped properties in excess of maintenance capital expenditures, but which are not expected to expand for more than the short term our asset base.
As described above, none of actual maintenance capital expenditures, investment capital expenditures or expansion capital expenditures are
subtracted from operating surplus. Because actual maintenance capital expenditures, investment capital expenditures and expansion capital expenditures include interest payments (and related fees) on debt incurred and distributions on equity issued
to finance all of the portion of the construction, replacement or improvement of a capital asset (such as equipment or reserves) during the period from such financing until the earlier to occur of the date any such capital asset is placed into
service or the date that it is abandoned or disposed of, such interest payments and equity distributions are also not subtracted from operating surplus (except, in the case of maintenance capital expenditures, to the extent such interest payments
and distributions are included in estimated maintenance capital expenditures).
Capital expenditures that are made in part for maintenance
capital purposes and in part for investment capital or expansion capital purposes will be allocated as maintenance capital expenditures, investment capital expenditures or expansion capital expenditures by our board of managers, based upon its good
faith determination, subject to approval by our conflicts committee.
Definition of Capital Surplus
We also define capital surplus in the glossary, and it will generally be generated only by:
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borrowings other than working capital borrowings;
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sales of debt and equity securities; and
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sales or other disposition of assets for cash, other than inventory, accounts receivable and other current assets sold in the ordinary course of business or as part of normal retirements or replacements of assets.
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Characterization of Cash Distributions
We treat all available cash distributed as coming from operating surplus until the sum of all available cash distributed since we began
operations equals the operating surplus as of the most recent date of determination of available cash. We treat any amount distributed in excess of operating surplus, regardless of its source, as capital surplus. We do not anticipate that we will
make any distributions from capital surplus.
Distributions of Available Cash from Operating Surplus
We make distributions of available cash from operating surplus for any quarter in the following manner:
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first
, 98% to the common unitholders, pro rata, and 2% to the holder(s) of our Class A units, pro rata, until we distribute for each outstanding unit an amount equal to the Target Distribution (that is, our
$0.4625 IQD plus $0.0694), which aggregate amount we refer to as the Target Distribution, for that quarter; and
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thereafter
, any amount distributed in respect of such quarter in excess of the Target Distribution per unit will be distributed 98% to the holders of the common units, pro rata, and 2% to the holder(s) of our
Class A units until distributions become payable in respect of our management incentive interests as described in Management Incentive Interests below.
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The Class A units are entitled to 2% of all cash distributions from operating surplus, without any requirement for future capital
contributions by the holders of such Class A units, even if we issue additional common units or other senior or subordinated equity securities in the future. The percentage interests shown above for the Class A units assume they have not
been converted into common units. If the Class A units have been converted, the common units will receive the 2% of distributions originally allocated to the Class A units.
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Management Incentive Interests
Management incentive interests represent the right to receive 15% of quarterly distributions of available cash from operating surplus after the
Target Distribution has been achieved and certain other tests have been met. CEPM currently holds the management incentive interests, which are evidenced by the Class C limited liability company interests, but may transfer these rights separately
from its Class A units, subject to restrictions in our operating agreement. The earliest that we could be required to make distributions in respect of the management incentive interests is after a period of 12 consecutive quarters after we pay
per unit cash distributions from operating surplus to holders of Class A and common units in an amount equal to or greater than the Target Distribution. For the third quarter 2007, we increased our distribution rate to $0.5625 per unit. This
increase in the distribution rate commenced a management incentive interest vesting period under our operating agreement. Through December 31, 2008, a cash reserve of $0.7 million had been established to fund future distributions on the
management incentive interests. In February 2009, we reduced our distribution rate to $0.13 per unit. This decrease in the distribution rate terminated the initial management incentive interest vesting period. After the February 13, 2009
distribution was paid, the reserve was reduced to zero. For the nine months ended September 30, 2013, none of these applicable tests have been met, and, as a result, CEPM was not entitled to receive any management incentive interest
distributions. We are not able to predict the future amount of the distributions in respect of the management incentive interests.
Prior
to the end of the First MII Earnings Period or Later MII Earnings Period, which are defined below, we will not pay any management incentive distributions. To the extent, however, that during the First MII Earnings Period or Later MII Earnings Period
we distribute available cash from operating surplus in excess of the Target Distribution, our board of managers intends to cause us to reserve an amount for payment of the EP MID, which is defined below, earned during the First MII Earnings Period
or Later MII Earnings Period, as the case may be, after such period ends. If during the First MII Earnings Period or Later MII Earnings Period we fail to satisfy a condition specified in the next paragraph, our board of managers will cause any such
reserved amount to be released from that reserve and restored to available cash.
Payments to the holder of our management incentive
interests are subject to the satisfaction of certain requirements. The first requirement is the 12-Quarter Test, which requires that for the 12 full, consecutive, non-overlapping calendar quarters that begin with the first calendar quarter in
respect of which we pay per unit cash distributions from operating surplus to holders of Class A and common units in an amount equal to or greater than the Target Distribution (we refer to such 12-quarter period as the First MII Earnings
Period):
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we pay cash distributions from operating surplus to holders of our outstanding Class A and common units in an amount that on average exceeds the Target Distribution on all of the outstanding Class A units and
common units over the First MII Earnings Period;
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we generate adjusted operating surplus (which is summarized below and is defined in the glossary included as Appendix A) during the First MII Earnings Period that on average is in an amount at least equal to 100% of all
distributions on the outstanding Class A and common units up to the Target Distribution plus 117.65% of all such distributions in excess of the Target Distribution; and
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we do not reduce the amount distributed per unit in respect of any such 12 quarters.
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The
second requirement is the 4-Quarter Test, which requires that for each of the last four full, consecutive, non-overlapping calendar quarters in the First MII Earnings Period:
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we pay cash distributions from operating surplus to the holders of our outstanding Class A and common units that exceed the Target Distribution on all of the outstanding Class A and common units;
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we generate adjusted operating surplus in an amount at least equal to 100% of all distributions on the outstanding Class A and common units up to the Target Distribution plus 117.65% of all such distributions in
excess of the Target Distribution; and
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we do not reduce the amount distributed per unit in respect of any such four quarters.
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If
both the 12-Quarter Test and the 4-Quarter Test have been met, then: (i) we will make a one-time management incentive distribution (contemporaneously with the distribution paid in respect of the Class A and common units for the twelfth
calendar quarter in the First MII Earnings Period) to the holder of our management incentive interests equal to 17.65% of the sum of the cumulative amounts, if any, by which quarterly cash distributions per unit on the outstanding Class A and
common units during the First MII Earnings Period exceeded the Target Distribution on all of the outstanding Class A and common units (we refer to this one-time management incentive distribution as an EP MID); and (ii) for each
calendar quarter after the First MII Earnings Period, the holders of our Class A units and common units and management incentive interests will receive 2%, 83% and 15%, respectively, of cash distributions from available cash from operating
surplus that we pay for such quarter in excess of the Target Distribution.
If the 12-Quarter Test is not met and except as described
below, management incentive distributions will not be payable in respect of the First MII Earnings Period and the holder of the management incentive interests will forfeit any and all rights to any
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management incentive distributions in respect of the First MII Earnings Period. An EP MID may become payable, however, with respect to a Later MII Earnings Period, if the 12-Quarter Test and the
4-Quarter Test are met in respect of such Later MII Earnings Period. A Later MII Earnings Period may begin with the first quarter following the quarter in which the 12-Quarter Test is not met, or, where we do not meet the 12-Quarter Test because we
reduced our cash distribution in a particular quarter, the Later MII Earnings Period may begin with the quarter in which such reduction is made. If both tests are met with respect to a Later MII Earnings Period, then for each calendar quarter after
the Later MII Earnings Period, the holders of the Class A units and common units and management incentive interests will receive 2%, 83% and 15%, respectively, of cash distributions from available cash from operating surplus that we pay for
such quarter in excess of the Target Distribution.
However, if (a) the 12-Quarter Test has been met in respect of the First MII
Earnings Period or any Later MII Earnings Period, but not the 4-Quarter Test; (b) the 4-Quarter Test has been met in any period of four full, consecutive and non-overlapping quarters occurring after the end of the First MII Earnings Period or
Later MII Earnings Period, as the case may be, up to three of which quarters can fall within the First MII Earnings Period or Later MII Earnings Period, as the case may be (we refer to such four-quarter period as the MII 4-Quarter Earnings
Period); and (c) we have paid at least the IQD in each calendar quarter occurring between the end of the First MII Earnings Period or Later MII Earnings Period, as the case may be, and the beginning of the MII 4-Quarter Earnings Period:
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the holders of our Class A units and common units and management incentive interests will receive 2%, 83% and 15%, respectively, of cash distributions from available cash from operating surplus that we pay in
excess of the Target Distribution for each calendar quarter after the MII 4-Quarter Earnings Period; and
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the holder of our management incentive interests will receive an EP MID with respect to the First MII Earnings Period or Later MII Earnings Period, as the case may be.
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Our board of managers has adopted a policy that it will raise our quarterly cash distribution only when it believes that (i) we have
sufficient reserves and liquidity for the proper conduct of our business, including the maintenance of our asset base, and (ii) we can maintain such increased distribution level for a sustained period. While this is our current policy, our
board of managers may alter such policy in the future when and if it determines such alteration to be appropriate.
Definition of
Adjusted Operating Surplus
We define adjusted operating surplus in the glossary and for any period it generally means:
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operating surplus generated with respect to that period less any amounts described in the fifth bullet point under Definition of Operating Surplus above; less
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any net increase in working capital borrowings with respect to that period; less
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any net reduction in cash reserves for operating expenditures with respect to that period not relating to an operating expenditure made with respect to that period; plus
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any net decrease in working capital borrowings with respect to that period; plus
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any net increase in cash reserves for operating expenditures made with respect to that period required by any debt instrument for the repayment of principal, interest or premium.
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Adjusted operating surplus is intended to reflect the cash generated from our operations during a particular period and therefore excludes net
increases in working capital borrowings and net drawdowns of reserves of cash generated in prior periods.
Percentage Allocations of Available Cash
from Operating Surplus
The following table illustrates the percentage allocations of the additional available cash from operating
surplus between the unitholders and CEPM as the owner of our management incentive interests up to various distribution levels. The amounts set forth under Marginal Percentage Interest in Distributions are the percentage interests of our
Class A unitholders and common unitholders and the holders of our management incentive interests in any available cash from operating surplus we distribute up to and including the corresponding amount in the column Quarterly Distribution
Level, until available cash from operating surplus we distribute reaches the next distribution level, if any. The percentage interests shown for the IQD are also applicable to quarterly distribution amounts that are less than the IQD. The
percentage interests shown in the table below assume that the Class A units have not been converted into common units as described herein.
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Marginal Percentage Interest in
Distributions
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Quarterly Distribution
Level
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Class A
Unitholders
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Common
Unitholders
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Management
Incentive
Interests
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IQD
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$0.4625
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2
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%
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98
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%
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0
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%
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Target Distribution
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above $0.4625 up to $0.5319
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2
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%
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98
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%
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0
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%
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Thereafter*
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above $0.5319
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2
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%
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83
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%
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15
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%
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*
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Assumes the management incentive interests have met the 12-Quarter Test and the 4-Quarter Test. Until the 12-Quarter Test and the 4-Quarter Test are met and distributions in respect of the management incentive interests
become payable, quarterly distributions in excess of the $0.5319 Target Distribution will be made 2% to the holder of the Class A units and 98% to the holders of common units, pro rata.
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Distributions from Capital Surplus
How Distributions from Capital Surplus Are Made
We make distributions of available cash from capital surplus, if any, in the following manner:
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first
, 2% to the holder of our Class A units and 98% to all common unitholders, pro rata, until we distribute for each common unit that was issued in our initial public offering an amount of available cash
from capital surplus equal to the initial public offering price; and
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thereafter
, we will make all distributions of available cash from capital surplus as if they were from operating surplus.
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Effect of a Distribution from Capital Surplus
Our operating agreement treats a distribution of capital surplus as the repayment of the initial common unit price from our initial public
offering, which is a return of capital. The initial public offering price less any distributions of capital surplus per common unit is referred to as the unrecovered capital per initial common unit. Each time a distribution of capital
surplus is made, the IQD and the Target Distribution will be reduced in the same proportion as the corresponding reduction in the unrecovered capital per common unit. Because distributions of capital surplus will reduce the IQD, after any of these
distributions are made, it may be easier for CEPM to receive management incentive distributions. However, any distribution of capital surplus before the unrecovered capital per common unit is reduced to zero cannot be applied to the payment of the
IQD.
Once we distribute capital surplus on a common unit in an amount equal to the unrecovered capital per common unit, we will reduce
the IQD and the Target Distribution to zero. We will then make all future distributions from operating surplus, with 2% being distributed to the holder of our Class A units, 83% being distributed to our common unitholders, pro rata, and 15%
being distributed to the holder of our management incentive interests. The percentage interests shown above for the Class A units assume they have not been converted into common units. If the Class A units have been converted, the common
units will receive the 2% of distributions originally allocated to the Class A units.
Adjustment to the IQD and Target
Distribution
In addition to adjusting the IQD and Target Distribution to reflect a distribution of capital surplus, if we combine
our common units into fewer common units or subdivide our common units into a greater number of common units, we will proportionately adjust:
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the Target Distribution; and
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the unrecovered capital per common unit.
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For example, if a two-for-one split of the common
units should occur, the Target Distribution and the unrecovered capital per common unit would each be reduced to 50% of its initial level. We will not make any adjustment by reason of the issuance of additional units for cash or property.
In addition, if legislation is enacted or if existing law is modified or interpreted by a court of competent jurisdiction, so that we become
taxable as a corporation or otherwise subject to taxation as an entity for federal, state or local income tax purposes, we will reduce the IQD and the Target Distribution for each quarter by multiplying each by a fraction, the numerator of which is
available cash for that quarter (after deducting our board of managers estimate of our aggregate liability for the quarter for such income taxes payable by reason of such legislation or interpretation) and the denominator of which is the sum
of available cash for that quarter plus our board of managers estimate of our aggregate liability for the quarter for such income taxes payable by reason of such legislation or interpretation. To the extent that the actual tax liability
differs from the estimated tax liability for any quarter, the difference will be accounted for in subsequent quarters.
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Distributions of Cash Upon Liquidation
General
If we
dissolve in accordance with our operating agreement, we will sell or otherwise dispose of our assets in a process called liquidation. We will first apply the proceeds of liquidation to the payment of our creditors. We will distribute any remaining
proceeds to the unitholders in accordance with their capital account balances, as adjusted to reflect any gain or loss upon the sale or other disposition of our assets in liquidation.
Manner of Adjustments for Gain
The manner of the adjustment for gain is set forth in our operating agreement, and requires that we will allocate any gain to the unitholders
and holders of the Class A units in the following manner:
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first
, to the holders of common units who have negative balances in their capital accounts to the extent of and in proportion to those negative balances;
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second
, 2% to the holder of our Class A units and 98% to the common unitholders, pro rata, until the capital account for each common unit is equal to the sum of:
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(1)
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the unrecovered initial common unit price; and
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(2)
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the amount of the IQD for the quarter during which our liquidation occurs; and
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third
, 2% to the holder of our Class A units and 98% to the common unitholders, pro rata, until the capital account for each common unit is equal to the sum of:
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(1)
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the amount described above under the second bullet point of this paragraph; and
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(2)
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the excess of (I) over (II), where
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(I)
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equals the sum of the excess of the Target Distribution per common unit over the IQD for each quarter of our existence; and
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(II)
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equals the cumulative amount per common unit of any distributions of available cash from operating surplus in excess of the IQD per common unit that we distributed 98% to our common unitholders, pro rata, for each
quarter of our existence; and
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thereafter
, 2% to the holder of our Class A units, 83% to all common unitholders, pro rata, and 15% to the holder of our management incentive interests.
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Manner of Adjustments for Losses
Upon our liquidation, we will generally allocate any loss 2% to the holder of the Class A units and 98% to the holders of the outstanding
common units, pro rata.
Adjustments to Capital Accounts
We will make adjustments to capital accounts upon the issuance of additional common units. In doing so, we will allocate any unrealized and,
for tax purposes, unrecognized gain or loss resulting from the adjustments to the holder of the Class A units, the common unitholders and the holders of the management incentive interests in the same manner as we allocate gain or loss upon
liquidation. In the event that we make positive adjustments to the capital accounts upon the issuance of additional common units, we will allocate any later negative adjustments to the capital accounts resulting from the issuance of additional
common units or upon our liquidation in a manner which results, to the extent possible, in the capital account balances of the holders of the management incentive interests equaling the amount which they would have been if no earlier positive
adjustments to the capital accounts had been made.
CONFLICTS OF INTEREST AND FIDUCIARY DUTIES
Conflicts of Interest
CEPM owns 484,505
of our Class A units, 5,918,894 common units and our management incentive interests; and Sanchez owns 1,130,512 of our Class A units, 4,724,407 of our common units and one Class Z unit. Conflicts of interest exist and may arise in the
future as a result of the relationships between us and our unaffiliated unitholders and our board of managers and executive officers and CEPM and Sanchez. These potential conflicts may relate to the divergent interests of these parties.
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Whenever a conflict arises between CEPM or Sanchez and its respective affiliates, on the one
hand, and us or any other unitholder, on the other hand, our board of managers will resolve that conflict. Our operating agreement limits the remedies available to unitholders in the event a unitholder has a claim relating to conflicts of interest.
No breach of obligation will occur under our operating agreement in respect of any conflict of interest if the resolution of the conflict
is:
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approved by the conflicts committee of our board of managers, although our board of managers is not obligated to seek such approval;
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approved by the vote of a majority of the outstanding units, excluding any common or Class A units owned by the unaffiliated unitholder or any of its affiliates, although our board of managers is not obligated to
seek such approval;
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on terms no less favorable to us than those generally provided to or available from unaffiliated third parties; or
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fair and reasonable to us, taking into account the totality of the relationships between the parties involved, including other transactions that may be particularly favorable or advantageous to us.
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We anticipate that our board of managers will submit for review and approval by our conflicts committee any acquisitions of properties or
other assets that we propose to acquire from CEPM, Sanchez or any of their affiliates.
If our board of managers does not seek approval
from the conflicts committee of our board of managers and our board determines that the resolution or course of action taken with respect to the conflict of interest satisfies either of the standards set forth in the third and fourth bullet points
above, then it will be presumed that, in making its decision, the board of managers, including board members affected by the conflict of interest, acted in good faith, and in any proceeding brought by or on behalf of any member or the company, the
person bringing or prosecuting such proceeding will have the burden of overcoming such presumption. Unless the resolution of a conflict is specifically provided for in our operating agreement, our board of managers or its conflicts committee may
consider any factors in good faith when resolving a conflict. When our operating agreement requires someone to act in good faith, it requires that person to reasonably believe that he is acting in our best interests, unless the context otherwise
requires.
Conflicts of interest could arise in the situations described below, among others.
CEPM, Sanchez and their affiliates may compete with us and have no obligations to offer us the opportunity to purchase or own interests
in any assets.
None of CEPM, Sanchez or any of their affiliates is restricted from competing with us. CEPM, Sanchez and their
affiliates may acquire, invest in or dispose of exploration and production or other assets, including those that might be in direct competition with us. In addition, neither CEPM, Sanchez nor their affiliates has any obligation to offer us the
opportunity to purchase or own interests in any assets.
As the majority owner of the Class A units, affiliates of Sanchez not
only have the exclusive right to elect two members of our board of managers but also may influence the election of the other three members of our board of managers.
As the majority owner of the Class A units, Sanchez will have the exclusive right to elect two members of our board of managers, and CEPM
and Sanchez, as the largest holders of our common units, may be able to influence any vote of common unitholders, including the election of the three members of our board of managers that are elected by the common unitholders. In turn, our board of
managers shall have the power to appoint our officers. Situations in which the interests of our management and CEPM, Sanchez and their affiliates may differ from interests of our unaffiliated unitholders include the following situations:
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our operating agreement gives our board of managers broad discretion in establishing cash reserves for the proper conduct of our business, which will affect the amount of cash available for distribution. For example,
our management will use its reasonable discretion to establish and maintain cash reserves sufficient to fund our drilling program;
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our management team determines the timing and extent of our drilling program and related capital expenditures, asset purchases and sales, borrowings, issuances of additional membership interests and reserve adjustments,
all of which will affect the amount of cash that we distribute to our unitholders;
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our board of managers may cause us to borrow funds in order to permit us to pay cash distributions to our unitholders, even if the purpose or effect of the borrowing is to make management incentive distributions; and
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our board of managers is allowed to take into account the interest of parties other than us, such as CEPM, Sanchez and their affiliates, in resolving conflicts of interest, which has the effect of limiting the fiduciary
duty to our unaffiliated unitholders.
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11
Our Class A managers may also serve as managers, directors, officers, employees or
contractors of Sanchez or its other affiliates as a result of which conflicts of interest may exist and may arise in the future.
Our Class A managers may also be managers, directors, officers, employees or contractors of Sanchez or its affiliates (other than us). In
making decisions in such persons capacity as a manager, director, officer, employee or contractor of Sanchez or such affiliate, such person may make a decision that favors the interests of Sanchez or such affiliate over your interests and may
be to our detriment, notwithstanding that in making decisions in such persons capacity as our manager such person is required to act in good faith and in accordance with the standards set forth in our operating agreement. If in resolving a
conflict of interest any of our Class A managers satisfies the applicable standards set forth in our operating agreement for resolving a conflict of interest, you will not be able to assert that such resolution constituted a breach of fiduciary
duty owed to us or to you by such Class A manager.
We may compete for the time and effort of our managers who are also
managers, directors, officers employees or contractors of Sanchez and its affiliates.
Sanchez and its affiliates conduct business
and activities of their own in which we have no economic interest. Certain of our managers may serve as managers, directors, officers, employees or contractors of Sanchez and its affiliates. Our managers are not required to work full time on our
business and affairs and may devote significant time to the affairs of Sanchez and its affiliates. There could be material competition for the time and effort of our managers who provide services to Sanchez and its affiliates.
Unitholders will have no right to enforce obligations of CEPM, Sanchez and their affiliates under agreements with us.
Any agreements between us, on the one hand, and CEPM, Sanchez and their affiliates, on the other hand, will not grant to our unitholders any
right to enforce the obligations of CEPM, Sanchez and their affiliates in our favor.
Contracts between us, on the one hand, and
CEPM, Sanchez and their affiliates, on the other, will not be the result of arms-length negotiations.
Neither our operating
agreement nor any of the other contracts or arrangements between us and CEPM, Sanchez and their affiliates are or will be the result of arms-length negotiations.
Fiduciary Duties
Our operating agreement
provides that our business and affairs shall be managed under the direction of our board of managers, which shall have the power to appoint our officers. Our operating agreement further provides that the authority and function of our board of
managers and officers shall be identical to the authority and functions of a board of directors and officers of a corporation organized under the Delaware General Corporation Law (DGCL). However, our managers and officers do not owe us
the same duties that the directors and officers of a corporation organized under the DGCL would owe to that corporation. Rather, our operating agreement provides that the fiduciary duties and obligations owed to us and to our members by our managers
and officers is generally to act in good faith in the performance of their duties on our behalf. Our operating agreement permits affiliates of our managers to invest or engage in other businesses or activities that compete with us. In addition, if
our conflicts committee approves a transaction involving potential conflicts, or if a transaction is on terms generally available from unaffiliated third parties or an action is taken that is fair and reasonable to the company, unitholders will not
be able to assert that such approval constituted a breach of fiduciary duties owed to them by our managers and officers.
DESCRIPTION OF THE COMMON UNITS
The Common Units
The common units represent limited liability company interests in us. The holders of common units are entitled to participate in distributions
and exercise the rights or privileges provided under our operating agreement. For a description of the relative rights and preferences of holders of common units in and to distributions, please read this section and How We Make Cash
Distributions. For a description of the rights and privileges of holders of common units under our operating agreement, including voting rights, please read The Operating Agreement.
Transfer Agent and Registrar
Computershare Trust Company, N.A. serves as registrar and transfer agent for the common units. We pay all fees charged by the transfer agent
for transfers of common units, except the following fees that will be paid by holders of common units:
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surety bond premiums to replace lost or stolen certificates, taxes and other governmental charges;
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special charges for services requested by a holder of a common unit; and
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other similar fees or charges.
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There is no charge to unitholders for disbursements of our cash distributions. We will indemnify
the transfer agent, its agents and each of their shareholders, managers, officers and employees against all claims and losses that may arise out of acts performed or omitted in that capacity, except for any liability due to any gross negligence or
intentional misconduct of the indemnified person or entity.
The transfer agent may at any time resign, by notice to us, or be removed by
us. The resignation or removal of the transfer agent will become effective upon our appointment of a successor transfer agent and registrar and its acceptance of the appointment. If no successor has been appointed and has accepted the appointment
within 30 days after notice of the resignation or removal, we are authorized to act as the transfer agent and registrar until a successor is appointed.
Transfer of Common Units
By transfer of
common units in accordance with our operating agreement, each transferee of common units shall be admitted as a unitholder of our company with respect to the common units transferred when such transfer and admission is reflected on our books and
records. Additionally, each transferee of common units:
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becomes the record holder of the common units;
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automatically agrees to be bound by the terms and conditions of, and is deemed to have executed our operating agreement;
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represents that the transferee has the capacity, power and authority to enter into the operating agreement;
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grants powers of attorney to our officers and any liquidator of our company as specified in the operating agreement; and
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makes the consents and waivers contained in our operating agreement.
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A transferee will become
a unitholder of our company for the transferred common units upon the recording of the name of the transferee on our books and records.
Until a common unit has been transferred on our books, we and the transfer agent, notwithstanding any notice to the contrary, may treat the
record holder of the common unit as the absolute owner for all purposes, except as otherwise required by law or stock exchange regulations.
THE OPERATING AGREEMENT
The following is a summary of the material provisions of our operating agreement. Our operating agreement is incorporated by reference as an
exhibit to the registration statement of which this prospectus supplement and accompanying prospectus constitute a part. We will provide prospective investors with a copy of the form of this agreement upon request at no charge.
We summarize the following provisions of our operating agreement elsewhere in this prospectus supplement:
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with regard to distributions of available cash, please read How We Make Cash Distributions.
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with regard to the transfer of common units, please read Description of the Common UnitsTransfer of Common Units; and
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with regard to allocations of taxable income and taxable loss, please read Material Tax Consequences.
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Organization
Our company was formed in
February 2005 and will remain in existence until dissolved in accordance with our operating agreement.
Purpose
Under our operating agreement, we are permitted to engage, directly or indirectly, in any activity that our board of managers approves and that
a limited liability company organized under Delaware law lawfully may conduct;
provided
, that our board of managers shall not cause us to engage, directly or indirectly, in any business activities that it determines would cause us to be
treated as an association taxable as a corporation or otherwise taxable as an entity for federal income tax purposes.
Although our board
of managers has the ability to cause us and our operating subsidiaries to engage in activities other than the acquisition, development and exploitation of oil and natural gas properties and related midstream assets, our board of managers has no
current plans to do so. Our board of managers is authorized in general to perform all acts it deems to be necessary or appropriate to carry out our purposes and to conduct our business.
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Fiduciary Duties
Our operating agreement provides that the fiduciary duties and obligations owed to us and to our members by our managers and officers is
generally limited to their acting in good faith in the performance of their duties on our behalf. For a description of fiduciary duties, please read Conflicts of Interest and Fiduciary Duties.
Agreement to be Bound by Operating Agreement; Power of Attorney
By purchasing a common unit in us, you will be admitted as a member of our company and will be deemed to have agreed to be bound by the terms
of our operating agreement. Pursuant to this agreement, each holder of common units and each person who acquires a common unit from a holder of common units grants to our board of managers (and, if appointed, a liquidator) a power of attorney to,
among other things, execute and file documents required for our qualification, continuance or dissolution. The power of attorney also grants our board of managers the authority to make certain amendments to, and to make consents and waivers under
and in accordance with, our operating agreement.
Capital Contributions
Unitholders (including holders of common units) are not obligated to make additional capital contributions, except as described below under
Limited Liability.
Limited Liability
Unlawful Distributions
The Delaware Limited Liability Company Act (the Delaware Act) provides that any unitholder who receives a distribution and knew at
the time of the distribution that the distribution was in violation of the Delaware Act shall be liable to the company for the amount of the distribution for three years. Under the Delaware Act, a limited liability company may not make a
distribution to any unitholder if, after the distribution, all liabilities of the company, other than liabilities to unitholders on account of their limited liability company interests and liabilities for which the recourse of creditors is limited
to specific property of the company, would exceed the fair value of the assets of the company. For the purpose of determining the fair value of the assets of a company, the Delaware Act provides that the fair value of property subject to liability
for which recourse of creditors is limited shall be included in the assets of the company only to the extent that the fair value of that property exceeds the nonrecourse liability. Under the Delaware Act, an assignee who becomes a substituted
unitholder of a company is liable for the obligations of his assignor to make contributions to the company, except the assignee is not obligated for liabilities unknown to him at the time he became a unitholder and that could not be ascertained from
the operating agreement.
Failure to Comply with the Limited Liability Provisions of Jurisdictions in Which We Do Business
Our subsidiaries may be deemed to conduct business in Kansas, Louisiana, Oklahoma and Texas. We may decide to conduct business in
other states, and maintenance of limited liability for us, as a member of our operating subsidiaries, may require compliance with legal requirements in the jurisdictions in which the operating subsidiaries conduct business, including qualifying our
subsidiaries to do business there. Limitations on the liability of unitholders for the obligations of a limited liability company have not been clearly established in many jurisdictions. We will operate in a manner that our board of managers
considers reasonable and necessary or appropriate to preserve the limited liability of our unitholders.
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Voting Rights
Holders of our common units and our Class A units have voting rights on most matters. The following matters require the unitholder vote
specified below:
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Election of members of the board of managers
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Our board of managers consists of five members, as required by our operating agreement. Except as set forth below, at each annual meeting of our unitholders, Class A unitholders, voting as a single class, will elect two managers and
the holders of our common units, voting together as a single class, will elect the remaining three managers. Please read Election of Members of Our Board of Managers, Removal of Members of Our Board of Managers
and Elimination of Special Voting Rights of Class A Units.
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Issuance of additional securities including common units
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No approval right.
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Amendment of the operating agreement
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Certain amendments may be made by our board of managers without unitholder approval. Other amendments generally require the approval of both a common unit majority and Class A unit majority. Please read Amendment of Our
Operating Agreement.
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Merger of our company or the sale of all or substantially all of our assets
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Common unit majority and Class A unit majority. Please read
Merger, Sale or Other Disposition of Assets.
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Dissolution of our company
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Common unit majority and Class A unit majority. Please read
Termination and Dissolution.
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Matters requiring the approval of a common unit majority require the approval of at least a
majority of the outstanding common units voting together as a single class. In addition, matters requiring the approval of a Class A unit majority require the approval of at least a majority of the outstanding Class A units voting
together as a single class.
In addition, the holder of our Class Z unit has no voting rights other than (i) until March 31,
2015 (or one year later if we enter into a master services agreement with Sanchez or its affiliate), in connection with our issuance of additional securities (other than Class B units), (ii) with respect to any matter that adversely affects the
rights or preferences of the Class Z unit in relation to other classes of our member interests or (iii) as required by law.
Issuance of
Additional Securities
Our operating agreement authorizes us to issue an unlimited number of additional securities and authorizes us to
buy securities for the consideration and on the terms and conditions determined by our board of managers without the approval of our unitholders, except that the holder of our Class Z unit has the right until March 31, 2015 (or one year later
if a master services agreement is entered into with Sanchez or its affiliates) to approve the issuance of any additional equity securities other than Class B units. Upon request of the holder of the Class Z unit, we will seek approval from the
holders of Class A units and Class B units of an amendment to operating agreement to require that the holders of the Class A units must approve the issuance of any equity securities (other than Class B units) before the issuance thereof.
It is possible that we will fund acquisitions through the issuance of additional common units or other equity securities. Holders of any
additional common units we issue will be entitled to share equally with the then-existing holders of common units, Class A units and management incentive interests in our distributions of available cash. Also, the issuance of additional common
units or other equity securities may dilute the value of the interests of the then-existing holders of common units in our net assets.
In
accordance with Delaware law and the provisions of our operating agreement, we may also issue additional securities that, as determined by our board of managers, may have special voting or other rights to which the common and Class A units are
not entitled.
The holders of common and Class A units will not have preemptive or preferential rights to acquire additional units or
other securities.
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Election of Members of Our Board of Managers
At our first annual meeting of the holders of our Class A units and our common unitholders following our initial public offering:
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two members of our board of managers were elected by the holders of our Class A units; and
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three members of our board of managers were elected by our common unitholders.
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The board of managers will be
subject to re-election on an annual basis in this manner at our annual meeting of the holders of our Class A units and our common unitholders.
Removal of Members of Our Board of Managers
Any manager elected by the holders of our Class A units may be removed, with or without cause, by the holders of 66 2/3% of the
outstanding Class A units then entitled to vote at an election of managers. Any manager elected by the holders of our common units may be removed, with or without cause, by the holders of at least a majority of the outstanding common units then
entitled to vote at an election of managers.
Increase in the Size of Our Board of Managers
The size of our board of managers may increase only with the approval of the holders of 66 2/3% outstanding Class A units. If the size of
our board of managers is so increased, the vacancy created thereby shall be filled by a person appointed by our board of managers or a nominee approved by a majority vote of our common unitholders, unless such vacancy is specified by an amendment to
our operating agreement as a vacancy to be filled by our Class A unitholders, in which case such vacancy shall be filled by a person approved by our Class A unitholders.
Elimination of Special Voting Rights of Class A Units
The holders of our Class A units have the right, voting as a separate class, to elect two of the five members of our board of managers and
any replacement of either of such members, subject to the matters described under Election of Members of Our Board of ManagersIncrease in the Size of Our Board of Managers above. This right can be eliminated only upon a
proposal submitted by or with the consent of our board of managers and the vote of the holders of not less than 66 2/3% of our outstanding common units. If such elimination is so approved and a Class A unitholder and its affiliates do not vote
their common units in favor of such elimination, the Class A units of such unitholder will be converted into common units on a one-for-one basis and CEPM will have the right to convert its management incentive interests into common units based
on the then-fair market value of such interests.
Amendment of Our Operating Agreement
General
Amendments
to our operating agreement may be proposed only by or with the consent of our board of managers. To adopt a proposed amendment, other than the amendments discussed below, our board of managers is required to seek written approval of the holders of
the number of units required to approve the amendment or call a meeting of our unitholders to consider and vote upon the proposed amendment. Except as described below, an amendment must be approved by a common unit majority and a Class A unit
majority.
Prohibited Amendments
No amendment may be made that would:
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enlarge the obligations of any unitholder without its consent, unless approved by at least a majority of the type or class of member interests so affected;
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provide that we are not dissolved upon an election to dissolve our company by our board of managers that is approved by a common unit majority and a Class A unit majority;
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entitle members holding common units and/or Class A units to more or less than one vote per unit;
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prohibit the holders of Class A units from acting without a meeting;
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change the procedures for notice to members of business to be brought before a meeting and nominations to board of managers;
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require some percentage other than a majority of votes cast affirmatively or negatively by members holding units for approval of matters submitted for a member vote;
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allow the calling of a special meeting by other than a majority of the board of managers;
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change the term of existence of our company;
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give any person the right to dissolve our company other than our board of managers right to dissolve our company with the approval of a common unit majority and a Class A unit majority; or
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enlarge the size of our board of managers without the approval of the holders of 66 2/3% of our Class A units.
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The provision of our operating agreement preventing the amendments having the effects described in any of the clauses above can be amended
upon the approval of the holders of at least 75% of the outstanding common units, voting together as a single class, and 75% of the outstanding Class A units, voting together as a single class.
No Unitholder Approval
Our board of managers may generally make amendments to our operating agreement without unitholder approval to reflect:
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a change in our name, the location of our principal place of our business, our registered agent or our registered office;
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the admission, substitution, withdrawal or removal of members in accordance with our operating agreement;
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a change that our board of managers determines to be necessary or appropriate for us to qualify or continue our qualification as a company in which our members have limited liability under the laws of any state or to
ensure that neither we, our operating subsidiaries nor any of its subsidiaries will be treated as an association taxable as a corporation or otherwise taxed as an entity for federal income tax purposes;
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the merger of our company or any of its subsidiaries into, or the conveyance of all of our assets to, a newly formed entity if the sole purpose of that merger or conveyance is to effect a mere change in our legal form
into another limited liability entity;
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an amendment that is necessary, in the opinion of our counsel, to prevent us, members of our board, or our officers, agents or trustees from in any manner being subjected to the provisions of the Investment Company Act
of 1940, the Investment Advisors Act of 1940, or plan asset regulations adopted under the Employee Retirement Income Security Act of 1974 (ERISA) whether or not substantially similar to plan asset regulations currently
applied or proposed;
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an amendment that our board of managers determines to be necessary or appropriate for the authorization of additional securities or rights to acquire securities;
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any amendment expressly permitted in our operating agreement to be made by our board of managers acting alone;
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an amendment effected, necessitated or contemplated by a merger agreement that has been approved under the terms of our operating agreement;
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any amendment that our board of managers determines to be necessary or appropriate for the formation by us of, or our investment in, any corporation, partnership or other entity, as otherwise permitted by our operating
agreement;
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a change in our fiscal year or taxable year and related changes;
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a merger, conversion or conveyance effected in accordance with the operating agreement; and
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any other amendments substantially similar to any of the matters described in the clauses above.
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In addition, our board of managers may make amendments to our operating agreement without unitholder approval if our board of managers
determines that those amendments:
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do not adversely affect the unitholders (including any particular class of unitholders as compared to other classes of unitholders) in any material respect;
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are necessary or appropriate to satisfy any requirements, conditions or guidelines contained in any opinion, directive, order, ruling or regulation of any federal or state agency or judicial authority or contained in
any federal or state statute;
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are necessary or appropriate to facilitate the trading of common units or to comply with any rule, regulation, guideline or requirement of any securities exchange on which the common units are or will be listed for
trading, compliance with any of which our board of managers deems to be in the best interests of us and our common unitholders;
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are necessary or appropriate for any action taken by our board of managers relating to splits or combinations of units under the provisions of our operating agreement; or
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are required to effect the intent expressed in our prospectus used in connection with our initial public offering or the intent of the provisions of our operating agreement or are otherwise contemplated by our operating
agreement.
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Opinion of Counsel and Unitholder Approval
Our board of managers will not be required to obtain an opinion of counsel that an amendment will not result in a loss of limited liability to
our unitholders or result in our being treated as an entity for federal income tax purposes if one of the amendments described above under No Unitholder Approval should occur. No other amendments to our operating agreement will
become effective without the approval of holders of at least 90% of the common units and Class A units unless we obtain an opinion of counsel to the effect that the amendment will not affect the limited liability under applicable law of any
unitholder of our company.
Any amendment that would have a material adverse effect on the rights or preferences of any type or class of
outstanding units in relation to other classes of units will require the approval of at least a majority of the type or class of units so affected. Any amendment that reduces the voting percentage required to take any action is required to be
approved by the affirmative vote of unitholders whose aggregate outstanding units constitute not less than the voting requirement sought to be reduced.
Merger, Sale or Other Disposition of Assets; Conversion
Our board of managers is generally prohibited, without the prior approval of a common unit majority and a Class A unit majority from
causing us to, among other things, sell, exchange or otherwise dispose of all or substantially all of our assets in a single transaction or a series of related transactions, including by way of merger, consolidation or other combination, or
approving on our behalf the sale, exchange or other disposition of all or substantially all of the assets of our subsidiaries, provided that our board of managers may mortgage, pledge, hypothecate or grant a security interest in all or substantially
all of our assets without that approval. Our board of managers may also sell all or substantially all of our assets under a foreclosure or other realization upon the encumbrances above without that approval.
If the conditions specified in the operating agreement are satisfied, our board of managers may merge our company or any of its subsidiaries
into, or convey all of our assets to, a newly formed entity if the sole purpose of that merger or conveyance is to effect a mere change in our legal form into another limited liability entity. Additionally, the company may convert into any
other entity as defined in the Delaware Limited Liability Company Act, whether such entity is formed under the laws of the State of Delaware or any other state in the United States of America. Our unitholders are not entitled to
dissenters rights of appraisal under the operating agreement or applicable Delaware law in the event of a merger or consolidation, a sale of all or substantially all of our assets or any other transaction or event.
Termination and Dissolution
We will
continue as a company until terminated under our operating agreement. We will dissolve upon: (1) the election of our board of managers to dissolve us, if approved by a common unit majority and a Class A unit majority; (2) the sale,
exchange or other disposition of all or substantially all of the assets and properties of our company and our subsidiaries; or (3) the entry of a decree of judicial dissolution of our company.
Liquidation and Distribution of Proceeds
Upon our dissolution, the liquidator authorized to wind up our affairs will, acting with all of the powers of our board of managers that the
liquidator deems necessary or desirable in its judgment, liquidate our assets and apply the proceeds of the liquidation as provided in How We Make Cash DistributionsDistributions of Cash Upon Liquidation. The liquidator may defer
liquidation or distribution of our assets for a reasonable period of time or distribute assets to unitholders in kind if it determines that a sale would be impractical or would cause undue loss to our unitholders.
Anti-Takeover Provisions
Our operating
agreement contains specific provisions that are intended to discourage a person or group from attempting to take control of our company without the approval of our board of managers. Specifically, our operating agreement provides that we will elect
to have Section 203 of the DGCL apply to transactions in which an interested common unitholder (as described below) seeks to enter into a merger or business combination with us. Under this provision, such a holder will not be permitted to enter
into a merger or business combination with us unless:
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prior to such time, our board of managers approved either the business combination or the transaction that resulted in the common unitholders becoming an interested common unitholder;
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upon consummation of the transaction that resulted in the common unitholder becoming an interested common unitholder, the interested common unitholder owned at least 85% of our outstanding common units at the time the
transaction commenced, excluding for purposes of determining the number of common units outstanding those common units owned:
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by persons who are managers and also officers; and
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by employee common unit plans in which employee participants do not have the right to determine confidentially whether common units held subject to the plan will be tendered in a tender or exchange offer; or
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at or subsequent to such time the business combination is approved by our board of managers and authorized at an annual or special meeting of our common unitholders, and not by written consent, by the affirmative vote
of the holders of at least 66 2/3% of our outstanding voting common units that are not owned by the interested common unitholder.
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Section 203 of the DGCL defines business combination to include:
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any merger or consolidation involving the company and the interested common unitholder;
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any sale, transfer, pledge or other disposition of 10% or more of the assets of the company involving the interested common unitholder;
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subject to certain exceptions, any transaction that results in the issuance or transfer by the company of any common units of the company to the interested common unitholder;
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any transaction involving the company that has the effect of increasing the proportionate share of the units of any class or series of the company beneficially owned by the interested common unitholder; or
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the receipt by the interested common unitholder of the benefit of any loans, advances, guarantees, pledges or other financial benefits provided by or through the company.
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In general, by reference to Section 203, an interested common unitholder is any person or entity that beneficially owns (or
within three years did own) 15% or more of the outstanding common units of the company and any entity or person affiliated with or controlling or controlled by such entity or person.
The existence of this provision would be expected to have an anti-takeover effect with respect to transactions not approved in advance by our
board of managers, including discouraging attempts that might result in a premium over the market price for common units held by common unitholders.
Our limited liability agreement also restricts the voting rights of common unitholders by providing that any units held by a person that owns
20% or more of any class of units then outstanding, other than CEPM, Sanchez, their affiliates and persons who acquire such units with the prior approval of the board of managers, cannot vote on any matter.
Limited Call Right
If at any time any
person owns more than 80% of the then-issued and outstanding common units, it will have the right, which it may assign in whole or in part to any of its affiliates or to us, to acquire all, but not less than all, of the remaining common units held
by unaffiliated persons as of a record date to be selected by our board of managers, on at least 10 days but not more than 60 days notice. The common unitholders are not entitled to dissenters rights of appraisal under the operating agreement
or applicable Delaware law if this limited call right is exercised. The purchase price in the event of this purchase is the greater of:
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the highest cash price paid by such person for any common units purchased within the 90 days preceding the date on which such person first mails notice of its election to purchase the remaining common units; and
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the closing market price of the common units as of the date three days before the date the notice is mailed.
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As a result of this limited call right, a holder of common units may have his limited liability company interests purchased at an undesirable
time or price. The tax consequences to a common unitholder of the exercise of this call right are the same as a sale by that common unitholder of his common units in the market. Please read Material Tax ConsequencesDisposition of
Units.
Meetings; Voting
All
notices of meetings of unitholders shall be sent or otherwise given in accordance with Sections 11.4 and 14.1 of our operating agreement not less than 10 days nor more than 60 days before the date of the meeting. The notice shall specify the place,
date and hour of the meeting and (i) in the case of a special meeting, the general nature of the business to be transacted (no business other than that specified in the notice may be transacted) or (ii) in the case of the annual meeting,
those matters which the board of managers, at the time of giving the notice, intends to present for action by the unitholders (but any proper matter may be presented at the meeting for such action). The notice of any meeting at which managers are to
be elected shall include the name of any nominee or nominees who, at the time of the notice, the board of managers intends to present for election. Any previously scheduled meeting of the unitholders may be postponed, and any special meeting of the
unitholders may be cancelled, by resolution of the board of managers upon public notice given prior to the date previously scheduled for such meeting of unitholders.
Units that are owned by an assignee who is a record holder, but who has not yet been admitted as a member, shall be voted at the written
direction of the record holder by a proxy designated by our board of managers. Absent direction of this kind, the units will not be voted, except that units held by us on behalf of non-citizen assignees shall be voted in the same ratios as the votes
of unitholders on other units are cast.
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Any action required or permitted to be taken by our common unitholders must be effected at a duly
called annual or special meeting of unitholders and may not be effected by any consent in writing by such common unitholders.
Special
meetings of the unitholders may only be called by a majority of our board of managers. Unitholders may vote either in person or by proxy at meetings. The holders of a majority of the outstanding units for which a meeting has been called represented
in person or by proxy shall constitute a quorum unless any action by the unitholders requires approval by holders of a greater percentage of the units, in which case the quorum shall be the greater percentage.
Each record holder of a unit has a vote according to his percentage interest in us, although additional units having special voting rights
could be issued. Please read Issuance of Additional Securities. Units held in nominee or street name accounts will be voted by the broker or other nominee in accordance with the instruction of the beneficial owner unless the
arrangement between the beneficial owner and its nominee provides otherwise.
Any notice, demand, request, report or proxy material
required or permitted to be given or made to record holders of units under our operating agreement will be delivered to the record holder by us or by the transfer agent.
Our limited liability agreement also restricts the voting rights of common unitholders by providing that any units held by a person that owns
20% or more of any class of units then outstanding, other than CEPM, Sanchez, their affiliates or transferees and persons who acquire such units with the prior approval of the board of managers, cannot vote on any matter.
Non-Citizen Assignees; Redemption
If we
or any of our subsidiaries are or become subject to federal, state or local laws or regulations that, in the reasonable determination of our board of managers, create a substantial risk of cancellation or forfeiture of any property that we have an
interest in because of the nationality, citizenship or other related status of any unitholder or assignee, we may redeem, upon 30 days advance notice, the units held by the unitholder or assignee at their current market price. To avoid any
cancellation or forfeiture, our board of managers may require each unitholder or assignee to furnish information about his nationality, citizenship or related status. If a unitholder or assignee fails to furnish information about his nationality,
citizenship or other related status within 30 days after a request for the information or our board of managers determines after receipt of the information that the unitholder or assignee is not an eligible citizen, the unitholder or assignee may be
treated as a non-citizen assignee. In addition to other limitations on the rights of an assignee who is not a substituted unitholder, a non-citizen assignee does not have the right to direct the voting of his units and may not receive distributions
in kind upon our liquidation.
Indemnification
Under our operating agreement and subject to specified limitations, we will indemnify to the fullest extent permitted by law from and against
all losses, claims, damages or similar events any person who is or was our manager or officer, or while serving as our manager or officer, is or was serving as a tax matters member or, at our request, as a manager, officer, tax matters member,
employee, partner, fiduciary or trustee of us or any of our subsidiaries. Additionally, we shall indemnify to the fullest extent permitted by law and authorized by our board of managers, from and against all losses, claims, damages or similar
events, any person who is or was an employee or agent (other than an officer) of our company.
Any indemnification under our operating
agreement will only be out of our assets. We are authorized to purchase insurance against liabilities asserted against and expenses incurred by persons for our activities, regardless of whether we would have the power to indemnify the person against
liabilities under our operating agreement.
Books and Reports
We are required to keep appropriate books of our business at our principal offices. The books will be maintained for both tax and financial
reporting purposes on an accrual basis. For tax and fiscal reporting purposes, our fiscal year is the calendar year.
We will furnish or
make available to record holders of units, within 120 days after the close of each fiscal year, an annual report containing audited financial statements and a report on those financial statements by our independent public accountants. Except for our
fourth quarter, we will also furnish or make available summary financial information within 90 days after the close of each quarter.
We
will furnish each record holder of a unit with information reasonably required for tax reporting purposes within 90 days after the close of each calendar year. This information is expected to be furnished in summary form so that some complex
calculations normally required of unitholders can be avoided. Our ability to furnish this summary information to unitholders will depend on the cooperation of unitholders in supplying us with specific information. Every unitholder will receive
information to assist him in determining his federal and state tax liability and filing his federal and state income tax returns, regardless of whether he supplies us with information.
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Right To Inspect Our Books and Records
Our operating agreement provides that a unitholder can, for a purpose reasonably related to his interest as a unitholder, upon reasonable
demand and at his own expense, have furnished to him:
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a current list of the name and last known address of each unitholder;
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a copy of our tax returns;
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information as to the amount of cash, and a description and statement of the agreed value of any other property or services, contributed or to be contributed by each unitholder and the date on which each became a
unitholder;
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copies of our operating agreement, the certificate of formation of the company, related amendments and powers of attorney under which they have been executed;
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information regarding the status of our business and financial condition; and
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any other information regarding our affairs as is just and reasonable.
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Our board of managers
may, and intends to, keep confidential from our unitholders information that it believes to be in the nature of trade secrets or other information, the disclosure of which our board of managers believes in good faith is not in our best interests,
information that could damage our company or our business, or information that we are required by law or by agreements with a third-party to keep confidential.
Registration Rights
We have agreed to
register for sale under the Securities Act of 1933, as amended (Securities Act) and applicable state securities laws any common units or other of our securities held by CEPM or any of their affiliates if an exemption from the
registration requirements is not otherwise available. These registration rights continue for two years following any termination of the special voting rights of the holders of our Class A units. We have also agreed to include any of our
securities held by CEPM or their affiliates in any registration statement that we file to offer our securities for cash, except an offering relating solely to an employee benefit plan, for the same period. We are obligated to pay all expenses
incidental to the registration, excluding underwriting discounts and commissions.
MATERIAL TAX CONSEQUENCES
This section is a discussion of the material U.S. federal tax consequences that may be relevant to prospective common unitholders who
are individual citizens or residents of the United States and, unless otherwise noted in the following discussion, is the opinion of Andrews Kurth LLP, counsel to us, insofar as it relates to matters of U.S. federal income tax law and legal
conclusions with respect to those matters. This section is based on current provisions of the Internal Revenue Code of 1986, as amended (the Internal Revenue Code), existing and proposed Treasury regulations and current administrative
rulings and court decisions, all of which are subject to change. Later changes in these authorities may cause the tax consequences to vary substantially from the consequences described below. Unless the context otherwise requires, references in this
section to us or we are references to Constellation Energy Partners LLC and our limited liability company operating subsidiaries.
This section does not address all U.S. federal income tax matters that affect us or common unitholders. Furthermore, this section focuses on
common unitholders who are individual citizens or residents of the United States whose functional currency is the U.S. dollar and who hold units as a capital asset (generally, property that is held as an investment) and has only limited application
to corporations, partnerships (and entities treated as partnerships for U.S. federal income tax purposes), estates, trusts, non-resident aliens or other common unitholders subject to specialized tax treatment, such as tax-exempt institutions,
foreign persons, individual retirement accounts (IRAs), employee benefit plans, real estate investment trusts (REITs) or mutual funds. Accordingly, we urge each prospective common unitholder to consult with his own tax advisor in analyzing the U.S.
federal, state, local and foreign tax consequences particular to him of the ownership or disposition of our units.
No ruling has been or
will be requested from the IRS regarding any matter that affects our characterization as partnership for U.S. federal income tax purposes. Instead, we rely on opinions and advice of Andrews Kurth LLP. Unlike a ruling, an opinion of counsel
represents only that counsels best legal judgment and does not bind the IRS or the courts. Accordingly, the opinions and statements made in this discussion may not be sustained by a court if contested by the IRS. Any contest of this sort with
the IRS may materially and adversely impact the market for our units and the prices at which our units trade. In addition, the costs of any contest with the IRS, principally legal, accounting and related fees, will result in a reduction in cash
available for distribution to our common unitholders and thus will be borne directly by our common unitholders. Furthermore, the tax treatment of us, or of an investment in us, may be significantly modified by future legislative or administrative
changes or court decisions. Any modifications may or may not be retroactively applied.
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All statements regarding matters of law and legal conclusions set forth below, but not as to
factual matters, unless otherwise noted, are the opinion of Andrews Kurth LLP and are based on the accuracy of the representations made by us.
For the reasons described below, Andrews Kurth LLP has not rendered an opinion with respect to the following specific U.S. federal income tax
issues:
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the treatment of a common unitholder whose units are loaned to a short seller to cover a short sale of units (please read Tax Consequences of Unit OwnershipTreatment of Short Sales);
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whether our monthly convention for allocating taxable income and losses is permitted by existing Treasury Regulations (please read Disposition of UnitsAllocations Between Transferors and
Transferees); and
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whether our method for depreciating Section 743 adjustments is sustainable in certain cases (please read Tax Consequences of Unit OwnershipSection 754 Election and Uniformity of
Units).
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Partnership Status
Except as discussed in the following paragraph, a limited liability company that has more than one member and that has not elected to be
treated as a corporation is treated as a partnership for U.S. federal income tax purposes and, therefore, is not a taxable entity and incurs no U.S. federal income tax liability. Instead, each partner is required to take into account his respective
share of items of our income, gain, loss and deduction of the partnership in computing his U.S. federal income tax liability, even if no cash distributions are made to him. Distributions by a partnership to a partner are generally not taxable to the
partner unless the amount of cash distributed to him is in excess of his adjusted basis in his partnership interest.
Section 7704 of
the Internal Revenue Code provides that publicly traded partnerships will, as a general rule, be taxed as corporations. However, an exception, referred to in this discussion as the Qualifying Income Exception, exists with respect to
publicly traded partnerships for which 90% or more of the gross income for every taxable year consists of qualifying income. Qualifying income includes income and gains derived from the exploration, development, mining or production,
processing, transportation and marketing of natural resources, including oil, natural gas, and products thereof. Other types of qualifying income include interest (other than from a financial business), dividends, gains from the sale of real
property and gains from the sale or other disposition of capital assets held for the production of income that otherwise constitutes qualifying income. We estimate that less than 3% of our current gross income does not constitute qualifying income;
however, this estimate could change from time to time. Based on and subject to this estimate, the factual representations made by us, and a review of the applicable legal authorities, Andrews Kurth LLP is of the opinion that more than 90% of our
current gross income constitutes qualifying income. The portion of our income that is qualifying income can change from time to time.
No
ruling has been or will be sought from the IRS, and the IRS has made no determination as to our status or the status of our operating subsidiaries for U.S. federal income tax purposes or whether our operations generate qualifying income
under Section 7704 of the Internal Revenue Code. Instead, we will rely on the opinion of Andrews Kurth LLP on such matters. Andrews Kurth LLP is of the opinion, based upon the Internal Revenue Code, its regulations, published revenue rulings,
court decisions and factual representations made by us, that we are and will continue to be classified as a partnership, and each of our operating subsidiaries will be disregarded as an entity separate from us, for U.S. federal income tax purposes.
In rendering its opinion, Andrews Kurth LLP has relied on factual representations made by us. The representations made by us upon which
Andrews Kurth LLP has relied include, without limitation:
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Neither we nor any of our limited liability company subsidiaries have elected or will elect to be treated as a corporation; and
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For each taxable year, more than 90% of our gross income has been and will be income that Andrews Kurth LLP has opined or will opine is qualifying income within the meaning of Section 7704(d) of the
Internal Revenue Code.
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We believe that these representations have been true in the past and expect that these
representations will continue to be true in the future.
If we fail to meet the Qualifying Income Exception, other than a failure that is
determined by the IRS to be inadvertent and that is cured within a reasonable time after discovery, we will be treated as if we had transferred all of our assets, subject to liabilities, to a newly formed corporation, on the first day of the year in
which we fail to meet the Qualifying Income Exception, in return for stock in that corporation and then distributed that stock to common unitholders in liquidation of their interests in us. This deemed contribution and liquidation would be tax-free
to common unitholders and us so long as we, at that time, do not have liabilities in excess of the tax basis of our assets. Thereafter, we would be treated as a corporation for U.S. federal income tax purposes.
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If we were taxable as a corporation for U.S. federal income tax purposes in any taxable year,
either as a result of a failure to meet the Qualifying Income Exception or otherwise, our items of income, gain, loss and deduction would be reflected only on our tax return rather than being passed through to common unitholders, and our net income
would be taxed to us at corporate rates. In addition, any distribution made to a common unitholder would be treated as taxable dividend income to the extent of our current or accumulated earnings and profits, or, in the absence of earnings and
profits, a nontaxable return of capital to the extent of the common unitholders tax basis in his units, or taxable capital gain, after the common unitholders tax basis in his units is reduced to zero. Accordingly, taxation as a
corporation would result in a material reduction in a common unitholders cash flow and after-tax return and thus would likely result in a substantial reduction of the value of the units.
The remainder of this section assumes that we are and will continue to be classified as a partnership for U.S. federal income tax purposes.
Common Unitholder Status
Common
unitholders who become members of CEP will be treated as partners of CEP for U.S. federal income tax purposes. Also, common unitholders whose units are held in street name or by a nominee and who have the right to direct the nominee in the exercise
of all substantive rights attendant to the ownership of their units will be treated as partners of CEP for U.S. federal income tax purposes. A beneficial owner of units whose units have been transferred to a short seller to complete a short sale
would appear to lose his status as a partner with respect to those units for U.S. federal income tax purposes. Please read Tax Consequences of Unit OwnershipTreatment of Short Sales. As there is no direct or indirect
controlling authority addressing assignees of common units who are entitled to execute and deliver transfer applications and thereby become entitled to direct the exercise of attendant rights, but who fail to execute and deliver transfer
applications, Andrews Kurth LLPs opinion does not extend to these persons. Furthermore, a purchaser or other transferee of common units who does not execute and deliver a transfer application may not receive some U.S. federal income tax
information or reports furnished to record holders of common units unless the common units are held in a nominee or street name account and the nominee or broker has executed and delivered a transfer application for those common units.
Items of our income, gain, loss, or deduction are not reportable by a common unitholder who is not a partner for U.S. federal income tax
purposes, and any cash distributions received by a common unitholder who is not a partner for U.S. federal income tax purposes would therefore be fully taxable as ordinary income. These common unitholders are urged to consult their own tax advisors
with respect to their status as partners in us for U.S. federal income tax purposes.
The references to common unitholders in
the discussion that follows are to persons who are treated as partners in CEP for U.S. federal income tax purposes.
Tax Consequences of Unit Ownership
Flow-Through of Taxable Income
Subject to the discussion below under Entity-Level Collections, neither we nor our subsidiaries pay any U.S. federal income
tax. Instead, each common unitholder is be required to report on his income tax return his share of our income, gains, losses and deductions without regard to whether corresponding cash distributions are received by him. Consequently, we may
allocate income to a common unitholder even if he has not received a cash distribution. Each common unitholder is required to include in income his share of our income, gain, loss and deduction for our taxable year or years ending with or within his
taxable year. Our taxable year ends on December 31.
Treatment of Distributions
Distributions made by us to a common unitholder generally are not be taxable to the common unitholder for U.S. federal income tax purposes to
the extent of his tax basis in his units immediately before the distribution. Cash distributions made by us to a common unitholder in an amount in excess of his tax basis in his units generally are considered to be gain from the sale or exchange of
those units, taxable in accordance with the rules described under Disposition of Units below. To the extent that cash distributions made by us cause a common unitholders at risk amount to be less than zero at the
end of any taxable year, the common unitholder must recapture any losses deducted in previous years. Please read Limitations on Deductibility of Losses.
Any reduction in a common unitholders share of our liabilities for which no partner bears the economic risk of loss, known as
nonrecourse liabilities, will be treated as a distribution of cash to that common unitholder.
A decrease in a common
unitholders percentage interest in us because of our issuance of additional common units will decrease his share of our nonrecourse liabilities and thus will result in a corresponding deemed distribution of cash, which may constitute a non-pro
rata distribution. A non-pro rata distribution of money or property may result in ordinary income to a common unitholder, regardless of his tax basis in his units, if the distribution reduces the common unitholders share of our
unrealized receivables, including recapture of intangible drilling and development costs, depletion and depreciation recapture, and/or substantially appreciated
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inventory items, both as defined in Section 751 of the Internal Revenue Code, and collectively, Section 751 Assets. To that extent, he will be treated as having
received his proportionate share of the Section 751 Assets and having exchanged those assets with us in return for the non-pro rata portion of the actual distribution made to him. This latter deemed exchange will generally result in the common
unitholders realization of ordinary income. That income will equal the excess of (1) the non-pro rata portion of that distribution over (2) the common unitholders tax basis (generally zero) for the share of Section 751
Assets deemed relinquished in the exchange.
Basis of Units
A common unitholders initial tax basis in his units will be the amount he paid for the units plus his share of our nonrecourse
liabilities. That basis will be increased by his share of our income and by any increases in his share of our nonrecourse liabilities. That basis generally will be decreased, but not below zero, by distributions to him from us, by his share of our
losses, by depletion deductions taken by him to the extent such deductions do not exceed his proportionate share of the adjusted tax basis of the underlying producing properties, by any decreases in his share of our nonrecourse liabilities and by
his share of our expenditures that are not deductible in computing taxable income and are not required to be capitalized. A common unitholders share of our nonrecourse liabilities will generally be based on his share of our profits. Please
read Disposition of UnitsRecognition of Gain or Loss.
Limitations on Deductibility of Losses
The deduction by a common unitholder of his share of our losses is limited to his tax basis in his units and, in the case of an individual,
estate, trust or corporate common unitholder (if more than 50% of the value of its stock is owned directly or indirectly by or for five or fewer individuals or some tax-exempt organizations) to the amount for which the common unitholder is
considered to be at risk with respect to our activities, if that amount is less than his tax basis. A common unitholder subject to these limitations must recapture losses deducted in previous years to the extent that distributions cause
his at risk amount to be less than zero at the end of any taxable year. Losses disallowed to a common unitholder or recaptured as a result of these limitations will carry forward and will be allowable as a deduction in a later year to the extent
that his tax basis or at risk amount, whichever is the limiting factor, is subsequently increased. Upon the taxable disposition of a unit, any gain recognized by a common unitholder can be offset by losses that were previously suspended by the at
risk limitation but may not be offset by losses suspended by the basis limitation. Any loss previously suspended by the at risk limitation in excess of that gain is no longer utilizable.
In general, a common unitholder will be at risk to the extent of his tax basis in his units, excluding any portion of that basis attributable
to his share of our nonrecourse liabilities, reduced by (i) any portion of that basis representing amounts otherwise protected against loss because of a guarantee, stop loss agreement, or other similar arrangement and (ii) any amount of
money the common unitholder borrows to acquire or hold his units, if the lender of those borrowed funds owns an interest in us, is related to another common unitholder or can look only to the units for repayment. A common unitholders at risk
amount will increase or decrease as the tax basis of another common unitholders common units increases or decreases, other than tax basis increases or decreases attributable to increases or decreases in his share of our nonrecourse
liabilities.
The at risk limitation applies on an activity-by-activity basis, and in the case of oil and natural gas properties, each
property is treated as a separate activity. Thus, a taxpayers interest in each oil or gas property is generally required to be treated separately so that a loss from any one property would be limited to the at risk amount for that property and
not the at risk amount for all the taxpayers oil and natural gas properties. It is uncertain how this rule is implemented in the case of multiple oil and natural gas properties owned by a single entity treated as a partnership for U.S. federal
income tax purposes. However, for taxable years ending on or before the date on which further guidance is published, the IRS will permit aggregation of oil or gas properties we own in computing a common unitholders at risk limitation with
respect to us. If a common unitholder must compute his at risk amount separately with respect to each oil or gas property we own, he may not be allowed to utilize his share of losses or deductions attributable to a particular property even though he
has a positive at risk amount with respect to his units as a whole.
The passive loss limitation generally provides that individuals,
estates, trusts and some closely held corporations and personal service corporations are permitted to deduct losses from passive activities, which are generally defined as trade or business activities in which the taxpayer does not materially
participate, only to the extent of the taxpayers income from those passive activities. The passive loss limitation is applied separately with respect to each publicly traded partnership. Consequently, any passive losses we generate will be
available to offset only our passive income generated in the future and will not be available to offset income from other passive activities or investments, including our investments, a common unitholders investments in other publicly traded
partnerships, or a common unitholders salary or active business income. Passive losses that are not deductible because they exceed a common unitholders share of income we generate may only be deducted by the common unitholder in full
when he disposes of his entire investment in us in a fully taxable transaction with an unrelated party. The passive activity loss limitations are applied after certain other applicable limitations on deductions, including the at risk rules and the
tax basis limitation.
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A common unitholders share of our net income may be offset by any of our suspended passive
losses, but it may not be offset by any other current or carryover losses from other passive activities, including those attributable to other publicly traded partnerships.
Limitation on Interest Deductions
The deductibility of a non-corporate taxpayers investment interest expense is generally limited to the amount of that
taxpayers net investment income. Investment interest expense includes:
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interest on indebtedness properly allocable to property held for investment;
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our interest expense attributable to portfolio income; and
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the portion of interest expense incurred to purchase or carry an interest in a passive activity to the extent attributable to portfolio income.
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The computation of a common unitholders investment interest expense will take into account interest on any margin account borrowing or
other loan incurred to purchase or carry a common unit.
Net investment income includes gross income from property held for investment and
amounts treated as portfolio income under the passive loss limitations, less deductible expenses, other than interest, directly connected with the production of investment income, but generally does not include gains attributable to the disposition
of property held for investment. The IRS has indicated that net passive income earned by a publicly traded partnership will be treated as investment income to its common unitholders for purposes of the investment interest expense limitations. In
addition, the common unitholders share of our portfolio income will be treated as investment income.
Entity-Level Collections
If we are required or elect under applicable law to pay any federal, state or local income tax on behalf of any common unitholder
or any former common unitholder, we are authorized to pay those taxes from our funds. That payment, if made, will be treated as a distribution of cash to the common unitholder on whose behalf the payment was made. If the payment is made on behalf of
a common unitholder whose identity cannot be determined, we are authorized to treat the payment as a distribution to all current common unitholders. We are authorized to amend our operating agreement in the manner necessary to maintain uniformity of
intrinsic tax characteristics of units and to adjust later distributions, so that after giving effect to these distributions, the priority and characterization of distributions otherwise applicable under our operating agreement is maintained as
nearly as is practicable. Payments by us as described above could give rise to an overpayment of tax on behalf of a common unitholder in which event the common unitholder would be required to file a claim in order to obtain a credit or refund.
Allocation of Income, Gain, Loss and Deduction
In general, if we have a net profit, our items of income, gain, loss and deduction will be allocated among the common unitholders in accordance
with their percentage interests in us. If we have a net loss for an entire year, the loss will be allocated to our common unitholders according to their percentage interests in us to the extent of their positive capital account balances.
Specified items of our income, gain, loss and deduction will be allocated under Section 704(c) of the Internal Revenue Code to account
for the difference between the tax basis and fair market value of our assets at the time we issue common units in an offering, which assets are referred to in this discussion as Contributed Property. These allocations are required to
eliminate the difference between a partners book capital account, credited with the fair market value of Contributed Property, and the tax capital account, credited with the tax basis of Contributed Property, referred
to in this discussion as the book-tax disparity. The effect of these allocations to a common unitholder who purchases common units in such an offering will be essentially the same as if the tax basis of our assets were equal to their
fair market value at the time of the offering. In the event we issue additional common units or engage in certain other transactions in the future, Section 704(c) allocations will be made to all holders of common units to account for the
difference between the book basis for purposes of maintaining capital accounts and the fair market value of all property held by us at the time of the future transaction. In addition, items of recapture income will be allocated to the
extent possible to the common unitholder who was allocated the deduction giving rise to the treatment of that gain as recapture income in order to minimize the recognition of ordinary income by other common unitholders.
An allocation of items of our income, gain, loss or deduction, other than an allocation required by Section 704(c), will generally be
given effect for U.S. federal income tax purposes in determining a common unitholders share of an item of income, gain, loss or deduction only if the allocation has substantial economic effect. In any other case, a common unitholders
share of an item will be determined on the basis of his interest in us, which will be determined by taking into account all the facts and circumstances, including:
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his relative contributions to us;
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the interests of all the common unitholders in profits and losses;
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the interest of all the common unitholders in cash flow; and
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the rights of all the common unitholders to distributions of capital upon liquidation.
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Treatment of Short Sales
A common unitholder whose units are loaned to a short seller to cover a short sale of units may be considered as having disposed of
those units. If so, he would no longer be a partner for tax purposes with respect to those units during the period of the loan and may recognize gain or loss from the disposition. As a result, during this period:
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none of our income, gain, loss or deduction with respect to those units would be reportable by the common unitholder;
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any cash distributions received by the common unitholder with respect to those units would be fully taxable; and
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all of these distributions would appear to be ordinary income.
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Because there is no direct or
indirect controlling authority on the issue relating to partnership interests, Andrews Kurth LLP has not rendered an opinion regarding the treatment of a common unitholder whose common units are loaned to a short seller. Therefore, common
unitholders desiring to assure their status as partners and avoid the risk of gain recognition are urged to modify any applicable brokerage account agreements to prohibit their brokers from borrowing and loaning their common units. The IRS has
announced that it is studying issues relating to the tax treatment of short sales of partnership interests. Please also read Disposition of UnitsRecognition of Gain or Loss.
Alternative Minimum Tax
Each common unitholder is required to take into account his distributive share of any items of our income, gain, loss or deduction for purposes
of the alternative minimum tax. The current minimum tax rate for non-corporate taxpayers is 26% on the first $182,500 of alternative minimum taxable income in excess of the exemption amount and 28% on any additional alternative minimum taxable
income. Prospective common unitholders are urged to consult their tax advisors with respect to the impact of an investment in our common units on their liability for the alternative minimum tax.
Tax Rates
Under
current law, the highest effective U.S. federal income tax rate applicable to ordinary income of individuals currently is 39.6% and the maximum U.S. federal income tax rate for net long-term capital gains (generally, gains from the sale of certain
investment assets held for more than one year) of an individual is 20%. Such rates are subject to change by new legislation at any time.
In addition, a 3.8% net investment income tax (NIIT) is imposed on certain net investment income earned by individuals, estates,
and trusts. For these purposes, net investment income generally includes a common unitholders allocable share of our income and gain realized by a common unitholder from a sale of common units. In the case of an individual, the tax is imposed
on the lesser of (i) the common unitholders net investment income from all investments, or (ii) the amount by which the common unitholders modified adjusted gross income exceeds $250,000 (if the common unitholder is married and
filing jointly or a surviving spouse) or $200,000 (if the common unitholder is unmarried). In the case of an estate or trust, the tax is imposed on the lesser of (i) undistributed net investment income, or (ii) the excess adjusted gross
income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.
Section 754
Election
We have made the election permitted by Section 754 of the Internal Revenue Code. That election is irrevocable
without the consent of the IRS. That election will generally permit us to adjust a unit purchasers tax basis in our assets (inside basis) under Section 743(b) of the Internal Revenue Code to reflect his purchase price. The
Section 743(b) adjustment applies to a person who purchases common units in an offering from the selling unitholder, but does not apply to a person who purchases common units directly from us, and it belongs only to the purchaser and not to
other common unitholders. Please also read, however, Allocation of Income, Gain, Loss and Deduction above. For purposes of this discussion, a common unitholders inside basis in our assets has two components: (1) his
share of our tax basis in our assets (common basis) and (2) his Section 743(b) adjustment to that basis.
The timing
and calculation of deductions attributable to Section 743(b) adjustments to our common basis will depend upon a number of factors, including the nature of the assets to which the adjustment is allocable, the extent to which the adjustment
offsets any Internal Revenue Code Section 704(c) type gain or loss with respect to an asset and certain elections we make as to the manner in which we apply Internal Revenue Code Section 704(c) principles with respect to an asset to which
the adjustment is applicable. Please read Allocation of Income, Gain, Loss and Deduction.
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The timing of these deductions may affect the uniformity of our common units. Under our operating
agreement, our board is authorized to take a position to preserve the uniformity of common units even if that position is not consistent with these and any other Treasury Regulations or if the position would result in lower annual depreciation or
amortization deductions than would otherwise be allowable to some common unitholders. Please read Uniformity of Units. Andrews Kurth LLP is unable to opine as to the validity of any such alternate tax positions because there is no
clear applicable authority. A common unitholders basis in a common unit is reduced by his share of our deductions (whether or not such deductions were claimed on an individual income tax return) so that any position that we take that
understates deductions will overstate the common unitholders basis in his common units and may cause the common unitholder to understate gain or overstate loss on any sale of such common units. Please read Uniformity of
Units.
A Section 754 election is advantageous if the transferees tax basis in his common units is higher than the
units share of the aggregate tax basis of our assets immediately prior to the transfer. In that case, as a result of the election, the transferee would have, among other items, a greater amount of depletion and depreciation deductions and the
transferees share of any gain or loss on a sale of our assets would be less. Conversely, a Section 754 election is disadvantageous if the transferees tax basis in his common units is lower than those units share of the
aggregate tax basis of our assets immediately prior to the transfer. Thus, the fair market value of the common units may be affected either favorably or unfavorably by the election. A basis adjustment is required regardless of whether a
Section 754 election is made in the case of a transfer of an interest in us if we have a substantial built-in loss immediately after the transfer, or if we distribute property and have a substantial basis reduction. Generally a built-in loss or
a basis reduction is substantial if it exceeds $250,000.
The calculations involved in the Section 754 election are complex and will
be made on the basis of assumptions as to the fair market value of our assets and other matters. For example, the allocation of the Section 743(b) adjustment among our assets must be made in accordance with the Internal Revenue Code. The IRS
could seek to reallocate some or all of any Section 743(b) adjustment we allocated to our tangible assets to goodwill instead. Goodwill, as an intangible asset, is generally either non-amortizable or amortizable over a longer period of time or
under a less accelerated method than our tangible assets. We cannot assure you that the determinations we make will not be successfully challenged by the IRS or that the resulting deductions will not be reduced or disallowed altogether. Should the
IRS require a different basis adjustment to be made, and should, in our opinion, the expense of compliance exceeds the benefit of the election, we may seek permission from the IRS to revoke our Section 754 election. If permission is granted, a
subsequent purchaser of common units may be allocated more income than such purchaser would have been allocated had the election not been revoked.
Tax
Treatment of Operations
Accounting Method and Taxable Year
We use the year ending December 31 as our taxable year and the accrual method of accounting for U.S. federal income tax purposes. Each
common unitholder is required to include in income his share of our income, gain, loss and deduction for our taxable year ending within or with his taxable year. In addition, a common unitholder who has a taxable year ending on a date other than
December 31 and who disposes of all of his common units following the close of our taxable year but before the close of his taxable year must include his share of our income, gain, loss and deduction in income for his taxable year, with the
result that he will be required to include in income for his taxable year his share of more than twelve months of our income, gain, loss and deduction. Please read Disposition of UnitsAllocations Between Transferors and
Transferees.
Depletion Deductions
Subject to the limitations on deductibility of losses discussed above, common unitholders are entitled to deductions for the greater of either
cost depletion or (if otherwise allowable) percentage depletion with respect to our oil and natural gas interests. Although the Internal Revenue Code requires each common unitholder to compute his own depletion allowance and maintain records of his
share of the adjusted tax basis of the underlying property for depletion and other purposes, we intend to furnish each of our common unitholders with information relating to this computation for U.S. federal income tax purposes. Each common
unitholder, however, remains responsible for calculating his own depletion allowance and maintaining records of his share of the adjusted tax basis of the underlying property for depletion and other purposes.
Percentage depletion is generally available with respect to common unitholders who qualify under the independent producer exemption contained
in Section 613A(c) of the Internal Revenue Code. For this purpose, an independent producer is a person not directly or indirectly involved in the retail sale of oil, natural gas, or derivative products or the operation of a major refinery.
Percentage depletion is calculated as an amount generally equal to 15% (and, in the case of marginal production, potentially a higher percentage) of the common unitholders gross income from the depletable property for the taxable year. The
percentage depletion deduction with respect to any property is limited to 100% of the taxable income of the common unitholder from the property for each taxable year, computed without the depletion allowance. A common unitholder that qualifies as an
independent producer may deduct percentage depletion only to the extent the common unitholders average net daily production of domestic crude oil, or the natural gas equivalent, does not exceed 1,000 barrels. This depletable amount may be
allocated between oil and natural gas production, with 6,000 cubic feet of domestic natural gas production regarded as equivalent to one barrel of crude oil. The 1,000 barrel limitation must be allocated among the independent producer and controlled
or related persons and family members in proportion to the respective production by such persons during the period in question.
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In addition to the foregoing limitations, the percentage depletion deduction otherwise available
is limited to 65% of a common unitholders total taxable income from all sources for the year, computed without the depletion allowance, net operating loss carrybacks, or capital loss carrybacks. Any percentage depletion deduction disallowed
because of the 65% limitation may be deducted in the following taxable year if the percentage depletion deduction for such year plus the deduction carryover does not exceed 65% of the common unitholders total taxable income for that year. The
carryover period resulting from the 65% net income limitation is unlimited.
Common unitholders that do not qualify under the independent
producer exemption are generally restricted to depletion deductions based on cost depletion. Cost depletion deductions are calculated by (i) dividing the common unitholders share of the adjusted tax basis in the underlying mineral
property by the number of mineral units (barrels of oil and thousand cubic feet, or Mcf, of natural gas) remaining as of the beginning of the taxable year and (ii) multiplying the result by the number of mineral units sold within the taxable
year. The total amount of deductions based on cost depletion cannot exceed the common unitholders share of the total adjusted tax basis in the property.
All or a portion of any gain recognized by a common unitholder as a result of either the disposition by us of some or all of our oil and
natural gas interests or the disposition by the common unitholder of some or all of his common units may be taxed as ordinary income to the extent of recapture of depletion deductions, except for percentage depletion deductions in excess of the
basis of the property. The amount of the recapture is generally limited to the amount of gain recognized on the disposition.
The
foregoing discussion of depletion deductions does not purport to be a complete analysis of the complex legislation and Treasury Regulations relating to the availability and calculation of depletion deductions by the common unitholders. Further,
because depletion is required to be computed separately by each common unitholder and not by us, no assurance can be given, and Andrews Kurth LLP is unable to express any opinion, with respect to the availability or extent of percentage
depletion deductions to the common unitholders for any taxable year. Moreover, the availability of percentage depletion may be reduced or eliminated if recently proposed (or similar) tax legislation is enacted. For a discussion of such legislative
proposals, please read Recent Legislative Developments. We encourage each prospective common unitholder to consult his tax advisor to determine whether percentage depletion would be available to him.
Deductions for Intangible Drilling and Development Costs
We elect to currently deduct intangible drilling and development costs (IDCs). IDCs generally include our expenses for wages, fuel,
repairs, hauling, supplies and other items that are incidental to, and necessary for, the drilling and preparation of wells for the production of oil, natural gas or geothermal energy. The option to currently deduct IDCs applies only to those items
that do not have a salvage value.
Although we elect to currently deduct IDCs, each common unitholder will have the option of either
currently deducting IDCs or capitalizing all or part of the IDCs and amortizing them on a straight-line basis over a 60-month period, beginning with the taxable month in which the expenditure is made. If a common unitholder makes the election to
amortize the IDCs over a 60-month period, no IDC preference amount in respect of those IDCs will result for alternative minimum tax purposes.
Integrated oil companies must capitalize 30% of all their IDCs (other than IDCs paid or incurred with respect to oil and natural gas wells
located outside of the United States) and amortize these IDCs over 60 months beginning in the month in which those costs are paid or incurred. If the taxpayer ceases to be an integrated oil company, it must continue to amortize those costs as long
as it continues to own the property to which the IDCs relate. An integrated oil company is a taxpayer that has economic interests in oil and natural gas properties and also carries on substantial retailing or refining operations. An oil
or gas producer is deemed to be a substantial retailer or refiner if it is subject to the rules disqualifying retailers and refiners from taking percentage depletion. In order to qualify as an independent producer that is not subject to
these IDC deduction limits, a common unitholder, either directly or indirectly through certain related parties, may not be involved in the refining of more than 75,000 barrels of oil (or the equivalent amount of natural gas) on average for any day
during the taxable year or in the retail marketing of oil and natural gas products exceeding $5 million per year in the aggregate.
IDCs
previously deducted that are allocable to property (directly or through ownership of an interest in a partnership) and that would have been included in the adjusted basis of the property had the IDC deduction not been taken are recaptured to the
extent of any gain realized upon the disposition of the property or upon the disposition by a common unitholder of interests in us. Recapture is generally determined at the common unitholder level. Where only a portion of the recapture property is
sold, any IDCs related to the entire property are recaptured to the extent of the gain realized on the portion of the property sold. In the case of a disposition of an undivided interest in a property, a proportionate amount of the IDCs with respect
to the property is treated as allocable to the transferred undivided interest to the extent of any gain recognized. Please read Disposition of UnitsRecognition of Gain or Loss.
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The election to currently deduct IDCs may be restricted or eliminated if recently proposed (or
similar) tax legislation is enacted. For a discussion of such legislative proposals, please read - Recent Legislative Developments.
Deduction for United States Production Activities
Subject to the limitations on the deductibility of losses discussed above and the limitation discussed below, common unitholders will be
entitled to a deduction, herein referred to as the Section 199 deduction, equal to 9% of our qualified production activities income that is allocated to such common unitholder but not to exceed 50% of such common unitholders actual or
deemed IRS Form W-2 wages for the taxable year allocable to domestic production gross receipts.
Qualified production activities income is
generally equal to gross receipts from domestic production activities reduced by cost of goods sold allocable to those receipts, other expenses directly associated with those receipts, and a share of other deductions, expenses and losses that are
not directly allocable to those receipts or another class of income. The products produced must be manufactured, produced, grown or extracted in whole or in significant part by the taxpayer in the United States.
For a partnership, the Section 199 deduction is determined at the partner level. To determine his Section 199 deduction, each common
unitholder will aggregate his share of the qualified production activities income allocated to him from us with the common unitholders qualified production activities income from other sources. Each common unitholder must take into account his
distributive share of the expenses allocated to him from our qualified production activities regardless of whether we otherwise have taxable income. However, our expenses that otherwise would be taken into account for purposes of computing the
Section 199 deduction are only taken into account only if and to the extent the common unitholders share of losses and deductions from all of our activities is not disallowed by the basis rules, the at-risk rules or the passive activity
loss rules. Please read Tax Consequences of Unit OwnershipLimitations on Deductibility of Losses.
The amount of a
common unitholders Section 199 deduction for each year is limited to 50% of the IRS Form W-2 wages actually or deemed paid by the common unitholder during the calendar year that are deducted in arriving at qualified production activities
income. Each common unitholder is treated as having been allocated IRS Form W-2 wages from us equal to the common unitholders allocable share of our wages that are deducted in arriving at our qualified production activities income for that
taxable year. It is not anticipated that we or our subsidiaries will pay material wages that will be allocated to our common unitholders, and thus a common unitholders ability to claim the Section 199 deduction may be limited.
This discussion of the Section 199 deduction does not purport to be a complete analysis of the complex legislation and Treasury authority
relating to the calculation of domestic production gross receipts, qualified production activities income, or IRS Form W-2 Wages, or how such items are allocated by us to common unitholders. Further, because the Section 199 deduction is
required to be computed separately by each common unitholder, no assurance can be given, and Andrews Kurth LLP is unable to express any opinion, as to the availability or extent of the Section 199 deduction to the common unitholders. Moreover,
the availability of Section 199 deductions may be reduced or eliminated if recently proposed (or similar) tax legislation is enacted. For a discussion of such legislative proposals, please read Recent Legislative Developments.
Each prospective common unitholder is encouraged to consult his tax advisor to determine whether the Section 199 deduction would be available to him.
Lease Acquisition Costs
The cost of acquiring oil and natural gas leaseholder or similar property interests is a capital expenditure that must be recovered through
depletion deductions if the lease is productive. If a lease is proved worthless and abandoned, the cost of acquisition less any depletion claimed may be deducted as an ordinary loss in the year the lease becomes worthless. Please read Tax
Treatment of OperationsDepletion Deductions. The amortization period for certain geological and geographical expenditures may be extended if recently proposed (or similar) tax legislation is enacted. For a discussion of such legislative
proposal, please read Recent Legislative Developments.
Geophysical Costs
Geophysical costs paid or incurred in connection with the exploration for, or development of, oil or gas within the United States are allowed
as a deduction ratably over the 24-month period beginning on the date that such expense was paid or incurred.
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Operating and Administrative Costs
Amounts paid for operating a producing well are deductible as ordinary business expenses, as are administrative costs to the extent they
constitute ordinary and necessary business expenses which are reasonable in amount.
Tax Basis, Depreciation and Amortization
The tax basis of our assets, such as casing, tubing, tanks, pumping units and other similar property, will be used for purposes of
computing depreciation and cost recovery deductions and, ultimately, gain or loss on the disposition of these assets. The U.S. federal income tax burden associated with the difference between the fair market value of our assets and their tax basis
immediately prior to (i) this offering will be borne by our existing common unitholders, and (ii) any other offering will be borne by our common unitholders as of that time. Please read Tax Consequences of Unit
OwnershipAllocation of Income, Gain, Loss and Deduction.
To the extent allowable, we may elect to use the depreciation and
cost recovery methods that will result in the largest deductions being taken in the early years after assets are placed in service. Property we subsequently acquire or construct may be depreciated using accelerated methods permitted by the Internal
Revenue Code.
If we dispose of depreciable property by sale, foreclosure, or otherwise, all or a portion of any gain, determined by
reference to the amount of depreciation previously deducted and the nature of the property, may be subject to the recapture rules and taxed as ordinary income rather than capital gain. Similarly, a common unitholder who has taken cost recovery or
depreciation deductions with respect to property we own will likely be required to recapture some or all of those deductions as ordinary income upon a sale of his interest in us. Please read Tax Consequences of Unit
OwnershipAllocation of Income, Gain, Loss and Deduction and Disposition of UnitsRecognition of Gain or Loss.
The costs incurred in selling our units (called syndication expenses) must be capitalized and cannot be deducted currently,
ratably or upon our termination. There are uncertainties regarding the classification of costs as organization expenses, which we may be able to amortize, and as syndication expenses, which we may not amortize. The underwriting discounts and
commissions we incur will be treated as syndication expenses.
Valuation and Tax Basis of Our Properties
The U.S. federal income tax consequences of the ownership and disposition of common units will depend in part on our estimates of the relative
fair market values and the tax bases of our assets. Although we may from time to time consult with professional appraisers regarding valuation matters, we will make many of the relative fair market value estimates ourselves. These estimates and
determinations of basis are subject to challenge and will not be binding on the IRS or the courts. If the estimates of fair market value or basis are later found to be incorrect, the character and amount of items of income, gain, loss or deduction
previously reported by common unitholders might change, and common unitholders might be required to adjust their tax liability for prior years and incur interest and penalties with respect to those adjustments.
Disposition of Units
Recognition
of Gain or Loss
Gain or loss will be recognized on a sale of common units equal to the difference between the common
unitholders amount realized and the common unitholders tax basis for the common units sold. A common unitholders amount realized will equal the sum of the cash or the fair market value of other property he receives plus his share
of our nonrecourse liabilities. Because the amount realized includes a common unitholders share of our nonrecourse liabilities, the gain recognized on the sale of common units could result in a tax liability in excess of any cash received from
the sale.
Prior distributions from us in excess of cumulative net taxable income for a common unit that decreased a common
unitholders tax basis in that unit will, in effect, become taxable income if the common unit is sold at a price greater than the common unitholders tax basis in that unit, even if the price received is less than his original cost.
Except as noted below, gain or loss recognized by a common unitholder, other than a dealer in units, on the sale or exchange of a
common unit held for more than one year will generally be taxable as capital gain or loss. A portion of this gain or loss, which will likely be substantial, however, will be separately computed and taxed as ordinary income or loss under
Section 751 of the Internal Revenue Code to the extent attributable to assets giving rise to unrealized receivables or inventory items that we own. The term unrealized receivables includes potential recapture
items, including depreciation, depletion, and IDC recapture. Ordinary income attributable to unrealized receivables and inventory items may exceed net taxable gain realized on the sale of a common unit and may be recognized even if there is a net
taxable loss realized on the sale of a common unit. Thus, a common unitholder may recognize both ordinary income and a capital loss upon a sale of common units. Net capital loss may offset capital gains and no more than $3,000 of ordinary income, in
the case of individuals, and may only be used to offset capital gain in the case of corporations. For individuals, trusts and estates, both ordinary income and capital gain recognized on a sale of common units may be subject to NIIT in certain
circumstances. Please read Tax Consequences of Unit Ownership Tax Rates.
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The IRS has ruled that a partner who acquires interests in a partnership in separate transactions
must combine those interests and maintain a single adjusted tax basis for all those interests. Upon a sale or other disposition of less than all of those interests, a portion of that tax basis must be allocated to the interests sold using an
equitable apportionment method. Treasury Regulations under Section 1223 of the Internal Revenue Code allow a selling common unitholder who can identify common units transferred with an ascertainable holding period to elect to use
the actual holding period of the common units transferred. Thus, according to the ruling, a common unitholder will be unable to select high or low basis common units to sell as would be the case with corporate stock, but, according to the
regulations, may designate specific common units sold for purposes of determining the holding period of common units transferred. A common unitholder electing to use the actual holding period of common units transferred must consistently use that
identification method for all subsequent sales or exchanges of common units. A common unitholder considering the purchase of additional common units or a sale of common units purchased in separate transactions is urged to consult his tax advisor as
to the possible consequences of this ruling and application of the Treasury Regulations.
Specific provisions of the Internal Revenue Code
affect the taxation of some financial products and securities, including partnership interests, by treating a taxpayer as having sold an appreciated partnership interest, one in which gain would be recognized if it were sold, assigned or
terminated at its fair market value, if the taxpayer or related persons enter(s) into:
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an offsetting notional principal contract; or
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a futures or forward contract with respect to the partnership interest or substantially identical property.
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Moreover, if a taxpayer has previously entered into a short sale, an offsetting notional principal contract or a futures or forward contract
with respect to the partnership interest, the taxpayer will be treated as having sold that position if the taxpayer or a related person then acquires the partnership interest or substantially identical property. The Secretary of the Treasury is also
authorized to issue regulations that treat a taxpayer who enters into transactions or positions that have substantially the same effect as the preceding transactions as having constructively sold the financial position.
Allocations Between Transferors and Transferees
In general, our taxable income or loss will be determined annually, will be prorated on a monthly basis and will be subsequently apportioned
among the common unitholders in proportion to the number of units owned by each of them as of the opening of the applicable exchange on the first business day of the month (the Allocation Date). However, gain or loss realized on a sale
or other disposition of our assets other than in the ordinary course of business will be allocated among the common unitholders on the Allocation Date in the month in which that gain or loss is recognized. As a result, a common unitholder
transferring common units may be allocated income, gain, loss and deduction realized after the date of transfer.
Although simplifying
conventions are contemplated by the Code and most publicly traded partnerships use similar simplifying conventions, the use of this method may not be permitted under existing Treasury Regulations. Recently, however, the Department of the Treasury
and the IRS issued proposed Treasury Regulations that provide a safe harbor pursuant to which a publicly-traded partnership may use a similar monthly simplifying convention to allocate tax items among transferor and transferee unitholders, although
such tax items must be prorated on a daily basis. Nonetheless, the proposed regulations do not specifically authorize the use of the proration method we have adopted. Existing publicly-traded partnerships are entitled to rely on those proposed
Treasury Regulations; however, they are not binding on the IRS and are subject to change until the final Treasury Regulations are issued. Accordingly, Andrews Kurth LLP is unable to opine on the validity of this method of allocating income and
deductions between common unitholders. If this method is not allowed under the Treasury Regulations, or only applies to transfers of less than all of the common unitholders interest, our taxable income or losses might be reallocated among the
common unitholders. We are authorized to revise our method of allocation between common unitholders, as well as among common unitholders whose interests vary during a taxable year, to conform to a method permitted under future Treasury Regulations.
A common unitholder who owns units at any time during a quarter and who disposes of them prior to the record date set for a cash
distribution for that quarter will be allocated items of our income, gain, loss and deductions attributable to that quarter but will not be entitled to receive that cash distribution.
Notification Requirements
A common unitholder who sells any of his common units, other than through a broker, generally is required to notify us in writing of that sale
within 30 days after the sale (or, if earlier, January 15 of the year following the sale). A purchaser of common units who purchases units from another common unitholder is also generally required to notify us in writing of that purchase within
30 days
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after the purchase. Upon receiving such notifications, we are required to notify the IRS of that transaction and to furnish specified information to the transferor and transferee. Failure to
notify us of a transfer of common units may, in some cases, lead to the imposition of penalties. However, these reporting requirements do not apply to a sale by an individual who is a citizen of the United States and who effects the sale or exchange
through a broker who will satisfy such requirements.
Constructive Termination
We will be considered to have constructively terminated for federal income tax purposes if there is a sale or exchange of 50% or more of the
total interests in our capital and profits within a twelve-month period. A constructive termination results in the closing of our taxable year for all common unitholders. In the case of a common unitholder reporting on a taxable year other than a
fiscal year ending December 31, the closing of our taxable year may result in more than 12 months of our taxable income or loss being includable in his taxable income for the year of termination. A constructive termination occurring on a date
other than December 31 will result in us filing two tax returns for one calendar year and the cost of the preparation of these returns will be borne by all common unitholders. However, pursuant to an IRS relief procedure for publicly traded
partnerships that have technically terminated, the IRS may allow, among other things, that we provide a single Schedule K-1 for the tax year in which a termination occurs. We would be required to make new tax elections after a constructive
termination, including a new election under Section 754 of the Internal Revenue Code, and a constructive termination would result in a deferral of our deductions for depreciation. A constructive termination could also result in penalties if we
were unable to determine that the constructive termination had occurred. Moreover, a constructive termination might either accelerate the application of, or subject us to, any tax legislation enacted before the constructive termination.
Uniformity of Units
Because we cannot
match transferors and transferees of common units, we must maintain uniformity of the economic and tax characteristics of the units to a purchaser of these units. In the absence of uniformity, we may be unable to completely comply with a number of
U.S. federal income tax requirements, both statutory and regulatory. A lack of uniformity can result from a literal application of Treasury Regulation Section 1.167(c)-1(a)(6) and Treasury Regulation Section 1.197-2(g)(3), neither of which
is anticipated to apply to a material portion of our assets. Any non-uniformity could have a negative impact on the value of the common units. Please read Tax Consequences of Unit OwnershipSection 754 Election.
Our operating agreement permits us to take positions in filing our tax returns that preserve the uniformity of our common units even under
circumstances like those described above. These positions may include reducing for some common unitholders the depreciation, amortization or loss deductions to which they would otherwise be entitled or reporting a slower amortization of
Section 743(b) adjustments for some common unitholders than that to which they would otherwise be entitled. Andrews Kurth LLP is unable to opine as to validity of such filing positions. A common unitholders basis in common units is
reduced by his share of our deductions (whether or not such deductions were claimed on an individual income tax return) so that any position that we take that understates deductions will overstate the common unitholders basis in his common
units, and may cause the common unitholder to understate gain or overstate loss on any sale of such common units. Please read Disposition of Units Recognition of Gain or Loss and Tax Consequences of Unit
Ownership Section 754 Election. The IRS may challenge one or more of any positions we take to preserve the uniformity of common units. If such a challenge were sustained, the uniformity of common units might be affected, and,
under some circumstances, the gain from the sale of common units might be increased without the benefit of additional deductions.
Tax-Exempt
Organizations and Other Investors
Ownership of units by employee benefit plans, other tax-exempt organizations, non-resident aliens,
foreign corporations and other foreign persons raises issues unique to those investors and, as described below, may have substantially adverse tax consequences to them. Prospective common unitholders who are tax-exempt entities or non-U.S. persons
should consult their tax advisor before investing in our common units.
Employee benefit plans and most other organizations exempt from
U.S. federal income tax, including individual retirement accounts and other retirement plans, are subject to U.S. federal income tax on unrelated business taxable income. Virtually all of our income allocated to a common unitholder that is a
tax-exempt organization will be unrelated business taxable income and will be taxable to them.
Non-resident aliens and foreign
corporations, trusts or estates that own units will be considered to be engaged in business in the United States because of the ownership of units. As a consequence they will be required to file federal tax returns to report their share of our
income, gain, loss or deduction and pay U.S. federal income tax at regular rates on their share of our net income or gain. Under rules applicable to publicly traded partnerships, we will withhold tax, at the highest effective applicable rate, from
cash distributions made quarterly to foreign common unitholders. Each foreign common unitholder must obtain a taxpayer identification number from the IRS and submit that number to our transfer agent on a Form W-8 BEN or applicable substitute form in
order to obtain credit for these withholding taxes. A change in applicable law may require us to change these procedures.
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In addition, because a foreign corporation that owns units will be treated as engaged in a United
States trade or business, that corporation may be subject to the United States branch profits tax at a rate of 30%, in addition to regular U.S. federal income tax, on its share of our income and gain, as adjusted for changes in the foreign
corporations U.S. net equity, which is effectively connected with the conduct of a United States trade or business. That tax may be reduced or eliminated by an income tax treaty between the United States and the country in which
the foreign corporate common unitholder is a qualified resident. In addition, this type of common unitholder is subject to special information reporting requirements under Section 6038C of the Internal Revenue Code.
A foreign common unitholder who sells or otherwise disposes of a common unit will be subject to U.S. federal income tax on gain realized on
the sale or disposition of that unit to the extent the gain is effectively connected with a United States trade or business of the foreign common unitholder. Under a ruling published by the IRS interpreting the scope of effectively connected
income, a foreign unitholder would be considered to be engaged in business in the United States by virtue of the ownership of common units, and part or all of that common unitholders gain would be effectively connected with that
unitholders indirect U.S. trade or business. Moreover, under the Foreign Investment in Real Property Tax Act, a foreign common unitholder generally will be subject to U.S. federal income tax upon the sale or disposition of a unit if
(i) he owned (directly or constructively applying certain attribution rules) more than 5% of our units at any time during the five-year period ending on the date of such disposition and (ii) 50% or more of the fair market value of all of
our assets consisted of U.S. real property interests at any time during the shorter of the period during which such common unitholder held the units or the 5-year period ending on the date of disposition. Currently, more than 50% of our assets
consist of U.S. real property interests and we do not expect that to change in the foreseeable future. Therefore, foreign common unitholders may be subject to U.S. federal income tax on gain from the sale or disposition of their common units.
Administrative Matters
Information Returns and Audit Procedures
We intend to furnish to each common unitholder, within 90 days after the close of each calendar year, specific tax information, including a
Schedule K-1, which describes his share of our income, gain, loss and deduction for our preceding taxable year. In preparing this information, which will not be reviewed by counsel, we will take various accounting and reporting positions, some of
which have been mentioned earlier, to determine each common unitholders share of income, gain, loss and deduction.
We cannot assure
you that those positions will yield a result that conforms to the requirements of the Internal Revenue Code, Treasury Regulations or administrative interpretations of the IRS. Neither we nor Andrews Kurth LLP can assure prospective common
unitholders that the IRS will not successfully contend in court that those positions are impermissible. Any challenge by the IRS could negatively affect the value of the units.
The IRS may audit our U.S. federal income tax information returns. Adjustments resulting from an IRS audit may require each common unitholder
to adjust a prior years tax liability and possibly may result in an audit of his own return. Any audit of a common unitholders return could result in adjustments not related to our returns as well as those related to our returns.
Partnerships generally are treated as separate entities for purposes of federal tax audits, judicial review of administrative adjustments by
the IRS and tax settlement proceedings. The tax treatment of partnership items of income, gain, loss and deduction are determined in a partnership proceeding rather than in separate proceedings with the partners. The Internal Revenue Code requires
that one partner be designated as the Tax Matters Partner for these purposes. The operating agreement appoints CEPM as our Tax Matters Partner, subject to redetermination by our board of managers from time to time.
The Tax Matters Partner will make some elections on our behalf and on behalf of common unitholders. In addition, the Tax Matters Partner can
extend the statute of limitations for assessment of tax deficiencies against common unitholders for items in our returns. The Tax Matters Partner may bind a common unitholder with less than a 1% profits interest in us to a settlement with the IRS
unless that common unitholder elects, by filing a statement with the IRS, not to give that authority to the Tax Matters Partner. The Tax Matters Partner may seek judicial review, by which all the common unitholders are bound, of a final partnership
administrative adjustment and, if the Tax Matters Partner fails to seek judicial review, judicial review may be sought by any common unitholder having at least a 1% interest in profits or by any group of common unitholders having in the aggregate at
least a 5% interest in profits. However, only one action for judicial review will go forward, and each common unitholder with an interest in the outcome may participate in that action.
A common unitholder must file a statement with the IRS identifying the treatment of any item on his U.S. federal income tax return that is not
consistent with the treatment of the item on our return. Intentional or negligent disregard of this consistency requirement may subject a common unitholder to substantial penalties.
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Nominee Reporting
Persons who hold an interest in us as a nominee for another person are required to furnish to us:
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the name, address and taxpayer identification number of the beneficial owner and the nominee;
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a statement regarding whether the beneficial owner is:
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a person that is not a United States person,
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a foreign government, an international organization or any wholly-owned agency or instrumentality of either of the foregoing, or
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the amount and description of units held, acquired or transferred for the beneficial owner; and
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specific information including the dates of acquisitions and transfers, means of acquisitions and transfers, and acquisition cost for purchases, as well as the amount of net proceeds from sales.
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Brokers and financial institutions are required to furnish additional information, including whether they are United States persons and
specific information on units they acquire, hold or transfer for their own account. A penalty of $100 per failure, up to a maximum of $1,500,000 per calendar year, is imposed by the Internal Revenue Code for failure to report that information to us.
The nominee is required to supply the beneficial owner of the units with the information furnished to us.
Accuracy-related
Penalties
An additional tax equal to 20% of the amount of any portion of an underpayment of tax that is attributable to one or
more specified causes, including negligence or disregard of rules or regulations, substantial understatements of income tax and substantial valuation misstatements, is imposed by the Internal Revenue Code. No penalty will be imposed, however, for
any portion of an underpayment if it is shown that there was a reasonable cause for the underpayment of that portion and that the taxpayer acted in good faith regarding the underpayment of that portion.
For individuals, substantial understatement of income tax in any taxable year exists if the amount of the understatement exceeds the greater
of 10% of the tax required to be shown on the return for the taxable year or $5,000 ($10,000 for most corporations). The amount of any understatement subject to penalty generally is reduced if any portion is attributable to a position adopted on the
return:
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for which there is, or was, substantial authority, or
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as to which there is a reasonable basis and the relevant facts of that position are disclosed on the return.
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If any item of income, gain, loss or deduction included in the distributive shares of common unitholders could result in that kind of an
understatement of income for which no substantial authority exists, we must disclose the pertinent facts on our return. In addition, we will make a reasonable effort to furnish sufficient information for common unitholders to
make adequate disclosure on their returns to avoid liability for this penalty. More stringent rules would apply to an understatement of tax resulting from ownership of units if we were classified as a tax shelter, which we do not believe
includes us, or any of our investments, plans or arrangements.
A substantial valuation misstatement exists if (a) the value of any
property, or the tax basis of any property, claimed on a tax return is 150% or more of the amount determined to be the correct amount of the valuation or tax basis, (b) the price for any property or services (or for the use of property) claimed
on any such return with respect to any transaction between persons described in Section 482 of the Internal Revenue Code is 200% or more (or 50% or less) of the amount determined under Section 482 to be the correct amount of such price, or
(c) the net Section 482 transfer price adjustment for the taxable year exceeds the lesser of $5 million or 10% of the taxpayers gross receipts. No penalty is imposed unless the portion of the underpayment attributable to a
substantial valuation misstatement exceeds $5,000 ($10,000 for most corporations). The penalty is increased to 40% in the event of a gross valuation misstatement. We do not anticipate making any valuation misstatements.
Reportable Transactions
If we were to engage in a reportable transaction, we (and possibly you and others) would be required to make a detailed disclosure
of the transaction to the IRS. A transaction may be a reportable transaction based upon any of several factors, including the fact that it is a type of transaction publicly identified by the IRS as a listed transaction or that it
produces certain kinds of losses for partnerships, individuals, S corporations, and trusts in excess of $2 million in any single taxable year, or $4 million in any combination of six successive tax years. Our participation in a reportable
transaction could increase the likelihood that our U.S. federal income tax information return (and possibly a common unitholders tax return) is audited by the IRS. Please read Information Returns and Audit Procedures above.
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Moreover, if we were to participate in a reportable transaction with a significant purpose to
avoid or evade tax or a listed transaction, our common unitholders could be subject to the following provisions of the American Jobs Creation Act of 2004:
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accuracy-related penalties with a broader scope, significantly narrower exceptions, and potentially greater amounts than described above at Accuracy-related Penalties,
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for those persons otherwise entitled to deduct interest on federal tax deficiencies, non-deductibility of interest on any resulting tax liability, and
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in the case of a listed transaction, an extended statute of limitations.
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We do not expect to
engage in any reportable transactions.
The present U.S. federal income tax treatment of publicly traded partnerships, including us, or an
investment in our common units, may be modified by administrative, legislative or judicial interpretation at any time. For example, the Obama Administration and members of Congress have considered and continue to consider substantive changes to the
existing federal income tax laws that would affect the tax treatment of certain publicly traded partnerships, including proposals that would eliminate the qualifying income exception upon which we rely for our treatment as a partnership for U.S.
federal income tax purposes. We are unable to predict whether such changes, or other proposals, will ultimately be enacted. However, it is possible that a change in law could affect us and may be retroactively applied. Any such changes could
negatively impact the value of an investment in our common units
The Obama Administrations budget proposal for fiscal year 2014
includes proposals that would, among other things, eliminate or reduce certain key U.S. federal income tax incentives currently available to oil and natural gas exploration and production companies. These changes include, but are not limited to,
(i) the repeal of the percentage depletion allowance for oil and natural gas properties, (ii) the elimination of current deductions for intangible drilling and development costs, (iii) the elimination of the deduction for certain
domestic production activities, and (iv) an extension of the amortization period for certain geological and geophysical expenditures. It is unclear whether these or similar changes will be enacted and, if enacted, how soon any such changes
could become effective. The passage of any legislation as a result of these proposals or any other similar changes in U.S. federal income tax laws could eliminate or postpone certain tax deductions that are currently available with respect to oil
and natural gas exploration and development, and any such change could increase the taxable income allocable to our common unitholders and negatively impact the value of an investment in our common units.
State, Local and Other Tax Considerations
In addition to U.S. federal income taxes, you will be subject to other taxes, including state and local income taxes, unincorporated business
taxes, and estate, inheritance or intangible taxes that may be imposed by the various jurisdictions in which we do business or own property or in which you are a resident. We currently do business and own property in Nebraska, Kansas, Oklahoma and
Alabama. We are registered to do business in Texas. We may also own property or do business in other states in the future. Although an analysis of those various taxes is not presented here, each prospective common unitholder should consider their
potential impact on his investment in us. You may not be required to file a return and pay taxes in some states because your income from that state falls below the filing and payment requirement. You will be required, however, to file state income
tax returns and to pay state income taxes in many of the states in which we may do business or own property, and you may be subject to penalties for failure to comply with those requirements. In some states, tax losses may not produce a tax benefit
in the year incurred and also may not be available to offset income in subsequent taxable years. Some of the states may require us, or we may elect, to withhold a percentage of income from amounts to be distributed to a common unitholder who is not
a resident of the state. Withholding, the amount of which may be greater or less than a particular common unitholders income tax liability to the state, generally does not relieve a nonresident common unitholder from the obligation to file an
income tax return. Amounts withheld may be treated as if distributed to common unitholders for purposes of determining the amounts distributed by us. Please read Tax Consequences of Unit OwnershipEntity-Level Collections.
Based on current law and our estimate of our future operations, we anticipate that any amounts required to be withheld will not be material.
It is the responsibility of each common unitholder to investigate the legal and tax consequences, under the laws of pertinent states and
localities, of his investment in us. Andrews Kurth LLP has not rendered an opinion on the state local, or foreign tax consequences of an investment in us. We strongly recommend that each prospective common unitholder consult, and depend on, his own
tax counsel or other advisor with regard to those matters. It is the responsibility of each common unitholder to file all tax returns, that may be required of him.
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INVESTMENT IN OUR COMPANY BY EMPLOYEE BENEFIT PLANS
An investment in us by an employee benefit plan is subject to additional considerations because the investments of these plans are subject to
the fiduciary responsibility and prohibited transaction provisions of ERISA and restrictions imposed by Section 4975 of the Internal Revenue Code. For these purposes, the term employee benefit plan includes, but is not limited to,
qualified pension, profit-sharing and stock bonus plans, Keogh plans, simplified employee pension plans and tax deferred annuities or IRAs established or maintained by an employer or employee organization. Among other things, the person with
investment discretion with respect to the assets of an employee benefit plan, often called a fiduciary, should consider:
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whether the investment is prudent under Section 404(a)(1)(B) of ERISA;
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whether in making the investment, that plan will satisfy the diversification requirements of Section 404(a)(l)(C) of ERISA; and
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whether the investment will result in recognition of unrelated business taxable income by the plan and, if so, the potential after-tax investment return.
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A plan fiduciary should determine whether an investment in us is authorized by the appropriate governing instrument and is a proper investment
for the plan.
Section 406 of ERISA and Section 4975 of the Internal Revenue Code prohibits employee benefit plans, and IRAs
that are not considered part of an employee benefit plan, from engaging in specified transactions involving plan assets with parties that are parties in interest under ERISA or disqualified persons under the
Internal Revenue Code with respect to the plan.
In addition to considering whether the purchase of common units is a prohibited
transaction, a fiduciary of an employee benefit plan should consider whether the plan will, by investing in us, be deemed to own an undivided interest in our assets, with the result that CEPM also would be a fiduciary of the plan and our operations
would be subject to the regulatory restrictions of ERISA, including its prohibited transaction rules, as well as the prohibited transaction rules of the Internal Revenue Code.
The Department of Labor regulations and Section 3(42) of ERISA provide guidance with respect to whether the assets of an entity in which
employee benefit plans acquire equity interests would be deemed plan assets under some circumstances. Under these rules, an entitys assets would not be considered to be plan assets if, among other things:
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the equity interests acquired by employee benefit plans are publicly offered securitiesi.e., the equity interests are widely held by 100 or more investors independent of the issuer and each other, freely
transferable and registered under some provisions of the federal securities laws;
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the entity is an operating company,i.e., it is primarily engaged in the production or sale of a product or service other than the investment of capital either directly or through a majority owned
subsidiary or subsidiaries; or
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there is no significant investment by benefit plan investors, which is defined to mean that less than 25% of the value of each class of equity interest, disregarding some interests held by CEPM, its affiliates, and some
other persons, is held by employee benefit plans subject to Part 4 of Title I of ERISA, IRAs and other plans subject to Section 4975 of the Code and any entity whose underlying assets include plan assets by reason of such plans investment
in such entity.
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Our assets should not be considered plan assets under these regulations because it is expected
that the investment will satisfy the requirements in the first bullet above.
Plan fiduciaries contemplating a purchase of our common
units should consult with their own counsel regarding the consequences under ERISA and the Internal Revenue Code in light of the serious penalties imposed on persons who engage in prohibited transactions or other violations.
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PLAN OF DISTRIBUTION
We are registering the common units on behalf of the selling unitholder.
The common units may be sold from time to time by or for the account of the selling unitholder pursuant to this prospectus supplement and the
accompanying prospectus or pursuant to Rule 144 under the Securities Act. Sales of common units pursuant to this prospectus supplement and the accompanying prospectus may be made on the NYSE MKT, in the over-the-counter market or otherwise at prices
and on terms then prevailing or at prices related to the then-current market price (in each case as determined by the selling unitholder). Sales may be made directly or through agents designated from time to time, or through dealers or underwriters
to be designated or in negotiated transactions.
The common units may be sold by any one or more of the following methods:
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through a firm commitment or best efforts underwriting,
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through a block trade (which may involve crosses) in which the sellers broker or dealer will attempt to sell the common units as agent but may position and resell a portion of the block as principal to facilitate
the transaction,
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through purchases by a broker or dealer as principal and resale by the broker or dealer for their account pursuant to this prospectus supplement and the accompanying prospectus,
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through exchange distributions and/or secondary distributions in accordance with the rules of the NYSE MKT,
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through ordinary brokerage transactions and transactions in which the broker solicits purchasers,
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through privately negotiated transactions,
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through put or call option transactions,
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through short sales, or
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through any other method permitted by applicable law.
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Any selling agents, underwriters or
broker-dealers may receive compensation in the form of underwriting discounts, concessions or commissions from the selling unitholder, from purchasers of the common units for whom they act as agents, or from both sources.
The selling unitholder may pledge or grant a security interest in some or all of the common units and, if the selling unitholder defaults in
the performance of its secured obligations, the pledgees or secured parties may offer and sell the common units from time to time pursuant to a prospectus or any amendment to such prospectus under Rule 424(b)(3) or other applicable provision of the
Securities Act, amending, if necessary, the list of selling unitholders to include the pledgee, transferee or other successors in interest as selling unitholders under such prospectus. The selling unitholder also may transfer and donate the common
units in other circumstances, in which case the transferees, donees, pledgees or other successors in interest will be the selling beneficial owners for purposes of such prospectus.
We will pay the costs and expenses of the registration and offering of the common units offered hereby. We will not pay any underwriting fees,
discounts and selling commissions allocable to the selling unitholders sale of its securities, which will be paid by the selling unitholder.
To the extent required, the names of the specific managing underwriter or underwriters, if any, as well as other important information, will
be set forth in additional prospectus supplements. In that event, the discounts and commissions the selling unitholder will allow or pay to the underwriters, if any, and the discounts and commissions the underwriters may allow or pay to dealers or
agents, if any, will be set forth in, or may be calculated from, the additional prospectus supplements. Any underwriters, brokers, dealers and agents who participate in any sale of the securities may also engage in transactions with, or perform
services for, us or our affiliates in the ordinary course of their businesses.
We have agreed to indemnify the selling unitholder and
each underwriter, selling agent or other securities professional, if any, against certain liabilities to which they may become subject in connection with the sale of the common units owned by the selling unitholder and registered under this
prospectus supplement and accompanying prospectus, including liabilities arising under the Securities Act.
37
Because the Financial Industry Regulatory Authority (FINRA) views our common units as
interests in a direct participation program, any offering of common units under the registration statement of which this prospectus supplement and accompanying prospectus form a part will be made in compliance with Rule 2310 of the FINRA Conduct
Rules.
To the extent required, this prospectus supplement may be further amended or supplemented from time to time to describe a
particular plan of distribution. The place and time of delivery for the securities in respect of which this prospectus supplement and accompanying prospectus is delivered will be set forth in the accompanying additional prospectus supplement.
In connection with offerings of securities under the registration statement of which this prospectus supplement and the accompanying
prospectus form a part and in compliance with applicable law, underwriters, brokers or dealers may engage in transactions that stabilize or maintain the market price of the securities at levels above those that might otherwise prevail in the open
market. Specifically, underwriters, brokers or dealers may over-allot in connection with offerings, creating a short position in the securities for their own accounts. For the purpose of covering a syndicate short position or stabilizing the price
of the securities, the underwriters, brokers or dealers may place bids for the securities or effect purchases of the securities in the open market. Finally, the underwriters may impose a penalty whereby selling concessions allowed to syndicate
members or other brokers or dealers for distribution of the securities in offerings may be reclaimed by the syndicate if the syndicate repurchases previously distributed securities in transactions to cover short positions, in stabilization
transactions or otherwise. These activities may stabilize, maintain or otherwise affect the market price of the securities, which may be higher than the price that might otherwise prevail in the open market, and, if commenced, may be discontinued at
any time.
In compliance with FINRA guidelines, the maximum consideration or discount to be received by any FINRA member or independent
broker dealer may not exceed 8% of the aggregate amount of the securities offered pursuant to this prospectus and accompanying prospectus and any applicable additional prospectus supplement.
38
SELLING UNITHOLDER
This prospectus supplement covers the offer and sale of up to 5,918,894 common units by the selling unitholder identified below. These common
units represent securities acquired by the selling unitholder from Constellation Energy Partners Holdings, LLC, which acquired the common units upon conversion of its limited liability company interests in us immediately prior to the closing of our
initial public offering in November 2006. The total amount of common units that may be sold hereunder will not exceed the number of units offered hereby. Please read Plan of Distribution.
The following table sets forth information about the maximum number of common units that may be offered from time to time by the selling
unitholder under this prospectus supplement. The selling unitholder identified below may currently hold or acquire at any time common units in addition to those registered hereby. Accordingly, we cannot give an estimate as to the number of units
that will be held by the selling unitholder upon termination of this offering.
Information concerning the selling unitholder may change
from time to time and, if necessary, we will further supplement this prospectus supplement accordingly.
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Selling Unitholder
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Total Number of
Common Units
Beneficially Owned
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Percentage of
(2)
Units
Outstanding
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Number of
Units That May
Be Sold
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Number of Units
Beneficially Owned
After Offering(3)
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|
Constellation Energy Partners Management, LLC (1)
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5,918,894
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20.8
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%
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5,918,894
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(1)
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According to Schedule 13D/A dated July 30, 2013, filed jointly by Post Rock Energy Corporation (PostRock), CEPM, White Deer Energy L.P. (White Deer), White Deer Energy TE L.P. (White
Deer TE), White Deer Energy FI L.P. (White Deer FI and collectively with White Deer and White Deer TE, the White Deer Funds), Edelman & Guill Energy L.P. (GP LP), Edelman & Guill Energy
Ltd. (GP Ltd.), Thomas J. Edelman and Ben A. Guill. CEPM is the record and beneficial owner of 5,918,894 common units. PostRock is the sole member of CEPM and may be deemed to possess sole voting and dispositive power with respect to the
units. The White Deer Funds may be deemed to beneficially own approximately 68.2% of the shares of PostRock common stock outstanding on a pro forma basis (accounting for the exercise of warrants). By virtue of these relationships, the White Deer
Funds, who have, together with GP LP and GP Ltd. formed a group as defined in Section 13(d)(3) of the Exchange Act with respect to the shares of PostRock common stock owned by such persons, may be deemed to possess shared voting and
dispositive power with respect to the units owned of record by CEPM. By virtue of being the general partner of the White Deer Funds, GP LP may be deemed to possess shared voting and dispositive power with respect to the units owned of record by
CEPM. By virtue of being the general partner of GP LP, GP Ltd. may be deemed to possess shared voting and dispositive power with respect to the units owned of record by CEPM. By virtue of being the two directors of GP Ltd., Mr. Edelman and
Mr. Guill may be deemed to possess shared voting and dispositive power with respect to the units owned of record by CEPM.
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(2)
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Calculated based on 28,426,692 common units outstanding as of January 15, 2014.
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(3)
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Assumes all units are sold.
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Litigation
On August 30, 2013, a lawsuit was filed in the Chancery Court of the State of Delaware by CEPM, Gary M. Pittman and John R. Collins
against Messrs. Brunner, Langdon, Bachmann, Seitz, Sanchez and Willinger, Sanchez Oil & Gas Corporation (SOG), Sanchez Energy Partners I, LP (SEP) and CEP in connection with CEPs closing on August 9, 2013
of the purchase of oil and gas properties from SOG and the issuance of units to SEP in connection therewith. The plaintiffs contend, among other things, that the issuance of the units to SEP in connection with the acquisition was not permitted under
CEPs operating agreement, that Messrs. Pittman and Collins should not have been removed as the Class A managers of CEPs board of managers, and that SEP, SOG and Messrs. Sanchez and Willinger participated in the bad faith conduct of
the other defendants and interfered with CEPMs contractual rights under CEPs operating agreement. The plaintiffs allege claims against CEP and certain of its managers and officers relating to breach of contract, breach of the duty of
good faith, and breach of the implied covenant of good faith and fair dealing; the plaintiffs also allege aiding and abetting and tortuous interference claims against SOG, SEP and Messrs. Sanchez and Willinger. The plaintiffs seek, among other
things, declaratory relief reappointing Messrs. Pittman and Collins to CEPs board of managers and removing Messrs. Sanchez and Willinger therefrom, and an injunction against CEP taking any further action outside the ordinary course of business
during the pendency of the litigation, declaratory relief rescinding the units issued by CEP to SEP, declaratory relief that CEPM has sole voting power with respect to the outstanding Class A units, declaratory relief that Messrs. Brunner,
Langdon, Bachmann and Seitz have breached fiduciary and contractual duties and are not entitled to indemnification from CEP as a result thereof, and monetary damages. CEP believes that the allegations contained in the lawsuit are without merit and
intends to vigorously defend itself and Messrs. Brunner, Langdon, Bachmann and Seitz against the claims raised in the complaint. A ruling that the units issued to SEP should be rescinded or declared to be non-voting would reduce the number of units
outstanding and would give CEPM rather than Sanchez the ability to appoint two persons to our Board of Managers. A trial on the merits has been schedule for mid-February 2014.
39
LEGAL MATTERS
Certain legal matters in connection with the securities will be passed upon for us by Andrews Kurth LLP, Houston, Texas. If certain legal
matters in connection with an offering of the securities made by this prospectus supplement and accompanying prospectus and a related additional prospectus supplement are passed on by counsel for the underwriters of such offering, that counsel will
be named in the applicable prospectus supplement related to that offering.
EXPERTS
The consolidated financial statements and managements assessment of the effectiveness of internal control over financial reporting
(which is included in Managements Report on Internal Control over Financial Reporting) incorporated in this prospectus supplement by reference to the Annual Report on Form 10-K for the year ended December 31, 2012 have been so
incorporated in reliance on the report (which contains an emphasis of matter paragraph relating to the company entering into an asset sale transaction and extending its reserve based credit facility as discussed in Note 1 D and Note 16) of
PricewaterhouseCoopers LLP, an independent registered public accounting firm, given on the authority of said firm as experts in auditing and accounting.
Certain information included or incorporated by reference in this prospectus supplement regarding our estimated quantities of natural gas
reserves was prepared by Netherland, Sewell & Associates, Inc.
WHERE YOU CAN FIND MORE INFORMATION
We have filed a registration statement with the SEC under the Securities Act, that registers the offer and sale of the securities
covered by this prospectus supplement and accompanying prospectus. The registration statement, including the attached exhibits, contains additional relevant information about us. In addition, we file annual, quarterly and other reports and other
information with the SEC. You may read and copy any document we file with the SEC at the SECs Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information on the
operation of the SECs Public Reference Room. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Our SEC filings are
available on the SECs web site at http://www.sec.gov. You also can obtain information about us at the offices of the NYSE MKT LLC, 86 Trinity Place, New York, New York 10006.
The SEC allows us to incorporate by reference the information we have filed with the SEC. This means that we can disclose
important information to you without actually including the specific information in this prospectus supplement by referring you to other documents filed separately with the SEC. The information incorporated by reference is an important part of this
prospectus supplement. Information that we later provide to the SEC, and which is deemed to be filed with the SEC, will automatically update information previously filed with the SEC, and may replace information in this prospectus
supplement and information previously filed with the SEC.
We incorporate by reference in this prospectus supplement the following
documents that we have previously filed with the SEC:
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Annual Report on Form 10-K (File No. 1-33147) for the year ended December 31, 2012 filed on March 11, 2013, as amended April 18, 2013;
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Quarterly Reports on Form 10-Q (File No. 1-33147) for the quarter ended March 31, 2013 filed on May 15, 2013, for the quarter ended June 30, 2013 filed on August 14, 2013 and for the quarter
ended September 30, 2013 filed on November 14, 2013;
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Current Reports on Form 8-K (File No. 1-33147) filed on January 22, 2013, February 4, 2013, February 12, 2013, February 19, 2013, March 1, 2013, March 21,
2013, May 31, 2013, August 9, 2013 and September 5, 2013; and
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The description of our common units contained in our registration statement on Form 8-A (File No. 1-33147) filed on November 13, 2006, as amended on February 15, 2012.
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All documents that we file pursuant to Section 13(a), 13(c), 14 or 15(d) of the Securities Exchange Act of 1934, as amended, after the
date of the prospectus supplement and until the offerings hereunder have been completed will be deemed to be incorporated by reference into this prospectus supplement and will be a part of this prospectus supplement from the date of filing of the
document.
40
Nothing in this prospectus supplement shall be deemed to incorporate information furnished to, but not filed with, the SEC pursuant to Item 2.02 or Item 7.01 of Form 8-K (or
corresponding information furnished under Item 9.01 or included as an exhibit).
We make available free of charge on or through our
Internet website, http://www.constellationenergypartners.com, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of
the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Information contained on our Internet website is not part of this prospectus supplement or the accompanying prospectus.
You may obtain any of the documents incorporated by reference in this prospectus supplement from the SEC through the SECs website
at the address provided above. You also may request a copy of any document incorporated by reference in this prospectus supplement (excluding any exhibits to those documents, unless the exhibit is specifically incorporated by reference in this
document), at no cost, by visiting our Internet website at http://www.constellationenergypartners.com, or by writing or calling us at the following address:
Investor Relations
Constellation
Energy Partners LLC
1801 Main Street, Suite 1300
Houston, TX 77002
Telephone:
(877) 847-0009
You should rely only on the information incorporated by reference or provided in this prospectus supplement and the
accompanying prospectus. We have not authorized anyone else to provide you with any information. You should not assume that the information incorporated by reference or provided in this prospectus supplement or the accompanying prospectus is
accurate as of any date other than the date on the front of each document.
41
APPENDIX A
GLOSSARY OF TERMS
Adjusted Operating Surplus
for any period means:
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(a)
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Operating Surplus generated with respect to that period;
less
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(b)
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any net increase in working capital borrowings with respect to that period;
less
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(c)
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any net reduction in cash reserves for operating expenditures with respect to that period not relating to an operating expenditure made with respect to that period;
plus
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(d)
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any net decrease in working capital borrowings with respect to that period;
plus
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(e)
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any net increase in cash reserves for operating expenditures made with respect to that period required by any debt instrument for the repayment of principal, interest or premium.
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Available Cash
means, for any quarter ending prior to liquidation:
(i) all cash and cash equivalents of Constellation Energy
Partners LLC and its subsidiaries (or the companys proportionate share of cash and cash equivalents in the case of subsidiaries that are not wholly-owned) on hand at the end of that quarter; and
(ii) all additional cash and cash equivalents of Constellation Energy Partners LLC and its subsidiaries (or the
companys proportionate share of cash and cash equivalents in the case of subsidiaries that are not wholly-owned) on hand on the date of determination of available cash for that quarter resulting from working capital borrowings made subsequent
to the end of such quarter,
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(b)
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less the amount of any cash reserves established by the board of managers (or the companys proportionate share of cash reserves in the case of subsidiaries that are not wholly-owned) to
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(i) provide for the proper conduct of the business of Constellation Energy Partners LLC and its subsidiaries (including
reserves for future capital expenditures including drilling and acquisitions and for anticipated future credit needs) subsequent to such quarter,
(ii) comply with applicable law or any loan agreement, security agreement, mortgage, debt instrument or other agreement or
obligation to which Constellation Energy Partners LLC or any of its subsidiaries is a party or by which it is bound or its assets are subject; or
(iii) provide funds for distributions (1) to our unitholders or (2) in respect of our management incentive
interests with respect to any one or more of the next four quarters;
provided, however
, that the board of managers may not establish cash reserves
pursuant to (iii) above if the effect of such reserves would be that the company is unable to distribute the Initial Quarterly Distribution on all Common Units and Class A Units with respect to such Quarter; and
provided further
,
that disbursements made by us or any of our subsidiaries or cash reserves established, increased or reduced after the end of that quarter but on or before the date of determination of available cash for that quarter shall be deemed to have been
made, established, increased or reduced, for purposes of determining available cash, within that quarter if our board of managers so determines.
Capital Surplus
is generated by:
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(a)
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borrowings other than working capital borrowings;
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(b)
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sales of debt and equity securities; and
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(c)
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sales or other disposition of assets for cash, other than inventory, accounts receivable and other current assets sold in the ordinary course of business or as a part of normal retirements or replacements of assets.
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A-1
Operating expenditures
means all expenditures of Constellation Energy Partners LLC and its
subsidiaries (or Constellation Energy Partners LLCs proportionate share in the case of subsidiaries that are not wholly-owned), including taxes, payments made in the ordinary course of business under commodity hedge contracts (other than
payments in connection with termination of same prior to its termination date), provided that with respect to amounts paid in connection with the initial purchase or placing of a commodity hedge contract, such amounts shall be amortized over the
life of the applicable commodity hedge contract and upon its termination, if earlier, manager and officer compensation, compensation paid to our board of managers, repayment of working capital borrowings, debt service payments, and estimated
maintenance capital expenditures, provided that operating expenditures will not include:
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repayment of working capital borrowings deducted from operating surplus pursuant to subparagraph (h) of the definition of operating surplus when such repayment actually occurs;
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payments (including prepayments) of principal of and premium on indebtedness, other than working capital borrowings;
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capital expenditures made for acquisitions or for capital improvements, or expansion capital expenditures;
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actual maintenance capital expenditures;
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investment capital expenditures;
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payment of transaction expenses relating to interim capital transactions; or
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distributions to members (including distributions in respect of our management incentive interests).
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Where capital expenditures are made in part for acquisitions or for capital improvements and in part for other purposes, our board of
managers, with the concurrence of the conflicts committee, shall determine the allocation between the amounts paid for each.
Operating
surplus
for any period means:
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(a)
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$20.0 million (if we choose to distribute as operating surplus up to $20.0 million of cash we receive in the future from non-operating sources such as asset sales, issuances of securities and long-term borrowings); plus
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(b)
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all of our cash receipts, excluding cash from (1) borrowings that are not working capital borrowings, (2) sales of equity and debt securities and (3) sales or other dispositions of assets outside the
ordinary course of business; plus
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(c)
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working capital borrowings made after the end of a quarter but before the date of determination of operating surplus for the quarter; plus
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(d)
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cash distributions paid on equity issued to finance all or a portion of the construction, replacement or improvement of a capital asset (such as equipment or reserves) during the period beginning on the date that the
group member enters into a binding obligation to commence the construction, acquisition or improvement of a capital improvement or replacement of a capital asset and ending on the earlier to occur of the date the capital improvement or capital asset
commences commercial service or the date that it is abandoned or disposed of; less
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(e)
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our operating expenditures; less
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(f)
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the amount of cash reserves established by our board of managers to provide funds for future operating expenditures; less
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(g)
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all working capital borrowings not repaid within twelve months after having been incurred.
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Working capital borrowings
. Borrowings used solely for working capital purposes or to pay distributions to members made pursuant to a
credit facility, commercial paper facility or other similar financing arrangement, provided that when it is incurred it is the intent of the borrower to repay such borrowings within 12 months from other than Working Capital Borrowings.
A-2
PROSPECTUS
$500,000,000
Common Units Representing Class B Limited Liability Company Interests
Debt Securities
Warrants
Rights
We may offer, from time to time, in one or more series:
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common units and debt securities of Constellation Energy Partners LLC;
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warrants to purchase common units, rights or debt securities; and
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rights to purchase common units, warrants or debt securities.
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The securities we may offer:
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will have a maximum aggregate offering price of $500,000,000;
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will be offered at prices and on terms to be set forth in one or more accompanying prospectus supplements; and
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may be offered separately or together, or in separate series.
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Our common units are traded on the NYSE Arca, Inc. under the trading symbol CEP. We will provide information in the
prospectus supplement for the trading market, if any, for any debt securities we may offer.
The aggregate market value of our
outstanding common units held by
non-affiliates
is $50,885,845, based on 23,899,758 common units outstanding, of which 17,980,864 are held by
non-affiliates,
and a per
unit price of $2.83 based on the closing price of our common units on January 19, 2011. We have not offered any securities pursuant to General Instruction I.B.6 of Form
S-3
during the prior 12 calendar month
period that ends on and includes the date of this prospectus.
This prospectus provides you with a general description of the
securities we may offer. Each time we offer to sell securities we will provide a prospectus supplement that will contain specific information about those securities and the terms of that offering. The prospectus supplement also may add, update or
change information contained in this prospectus. This prospectus may be used to offer and sell securities only if accompanied by a prospectus supplement. You should read this prospectus and any prospectus supplement carefully before you invest. You
should also read the documents we refer to in the Where You Can Find More Information section of this prospectus for information on us and our financial statements.
Investing in our securities involves risks. See
Risk Factors
beginning on page 2.
Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of
these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.
The date of
this prospectus is February 14, 2011
TABLE OF CONTENTS
i
You should rely only on the information contained in this prospectus. We have not authorized anyone to
provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. You should assume that the information appearing in this prospectus is accurate as of the date on the front cover
of this prospectus only. Our business, financial condition, results of operations and prospects may have changed since that date.
ii
ABOUT THIS PROSPECTUS
This prospectus is part of a registration statement on Form
S-3
that we have filed with the
Securities and Exchange Commission, or SEC, using a shelf registration process. Under this shelf registration process, we may sell, in one or more offerings, up to $500,000,000 in total aggregate offering price of securities described in
this prospectus. This prospectus provides you with a general description of us and the securities offered under this prospectus.
Each time we sell securities under this prospectus, we will provide a prospectus supplement that will contain specific information about the terms of that offering and the securities being offered. The
prospectus supplement also may add to, update, or change information in this prospectus. If there is any inconsistency between the information in this prospectus and any prospectus supplement, you should rely on the information in the prospectus
supplement. You should read carefully this prospectus, any prospectus supplement and the additional information described below under the heading Where You Can Find More Information. We include a glossary of some of the terms used in
this prospectus in Appendix A.
References in this prospectus to Constellation Energy Partners, we,
our, us, CEP or like terms refer to Constellation Energy Partners LLC and its subsidiaries. References in this prospectus to CEPM are to Constellation Energy Partners Management, LLC, a Delaware
limited liability company. References in this prospectus to CCG are to Constellation Energy Commodities Group, Inc., a Delaware corporation. References in this prospectus to CEPH are to Constellation Energy Partners Holdings,
LLC, a Delaware limited liability company. References to CHI are to Constellation Holdings, Inc., a Delaware corporation. References in this prospectus to Constellation are to Constellation Energy Group, Inc., a Maryland
corporation. We refer to our Class A limited liability company interests as the Class A units, our Class B limited liability company interests as the common units, our Class C limited liability company interests as the management incentive
interests and our Class D limited liability company interests as the Class D interests.
1
ABOUT CONSTELLATION ENERGY PARTNERS LLC
We are a limited liability company that was formed by Constellation in 2005 to acquire oil and natural gas reserves. We are focused on
the acquisition, development and production of oil and natural gas properties as well as related midstream assets. Our primary business objective is to create long-term value and to generate stable cash flows allowing us to resume making quarterly
cash distributions to our unitholders and over time to increase the amount of our future quarterly distributions. Our proved reserves are located in the Black Warrior Basin in Alabama, the Cherokee Basin in Kansas and Oklahoma, the Woodford Shale in
the Arkoma Basin in Oklahoma, and the Central Kansas Uplift in Kansas and Nebraska.
Our principal executive offices are
located at 1801 Main Street, Suite 1300, Houston, TX 77002, and our telephone number is
(832) 308-3700.
Our website is located at
http://www.constellationenergypartners.com
. We make our periodic
reports and other information filed with or furnished to the SEC available, free of charge, through our website, as soon as reasonably practicable after those reports and other information are electronically filed with or furnished to the SEC.
Information on our website or any other website is not incorporated by reference into this prospectus and does not constitute a part of this prospectus.
RISK FACTORS
Limited liability company
interests are inherently different from capital stock of a corporation, although many of the business risks to which we are subject are similar to those that would be faced by a corporation engaged in a similar business. You should carefully
consider the risk factors discussed in our Annual Report on Form
10-K
for the year ended December 31, 2009 and our quarterly reports on Form
10-Q
for the quarters
ended March 31, 2010, June 30, 2010 and September 30, 2010, together with all of the other information included in this prospectus, any prospectus supplement and the documents we have incorporated by reference into this
prospectus in evaluating an investment in our securities. The described risks could materially and adversely affect our business, financial condition or results of operation. If any of the described risks actually were to occur, we may not be able
to resume or pay quarterly distributions on our common units or make principal or interest payments on our debt securities, the trading price of our common units or debt securities could decline and you could lose part or all of your investment in
our company. If applicable, we will include in any prospectus supplement a description of these significant factors that could make the offering described in this prospectus speculative or risky.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
Some information contained in this prospectus, any prospectus supplement and the documents we incorporate by reference herein and therein
may contain forward-looking statements that are subject to a number of risks and uncertainties, many of which are beyond our control, which may include statements about:
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the volatility of realized oil and natural gas prices;
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the conditions of the capital markets, inflation, interest rates, availability of credit facilities to support business requirements, liquidity, and
general economic conditions;
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the discovery, estimation, development and replacement of oil and natural gas reserves;
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our business, financial, and operational strategy;
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our drilling locations;
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2
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our cash flow, liquidity and financial position;
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the ability to extend or refinance our reserve-based credit facility;
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the level of our borrowing base under our reserve-based credit facility;
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the resumption, timing or amount of our cash distribution;
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the impact from any termination of the NPI sharing arrangement or any change in the calculation of the NPI;
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our hedging program and our derivative positions;
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our production volumes;
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our lease operating expenses, general and administrative costs, depletion rates and finding and development costs;
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the availability of drilling and production equipment, labor and other services;
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our future operating results;
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our prospect development and property acquisitions;
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the marketing of oil and natural gas;
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competition in the oil and natural gas industry;
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the impact of the current global credit and economic environment;
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the impact of weather and the occurrence of natural disasters such as fires, floods, hurricanes, tornados, earthquakes, snow and ice storms and other
catastrophic events and natural disasters;
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governmental regulation, including environmental regulation, and taxation of the oil and natural gas industry;
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developments in
oil-producing
and natural gas producing countries;
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support from our former sponsor or a change in any sponsor; and
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our strategic plans, objectives, expectations, forecasts, budgets, estimates and intentions for future operations.
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All of these types of statements, other than statements of historical fact, are forward-looking statements. In some cases,
forward-looking statements can be identified by terminology such as may, could, should, expect, plan, project, intend, anticipate, believe,
estimate, predict, potential, pursue, target, continue, the negative of such terms or other comparable terminology.
The forward-looking statements are largely based on our expectations, which reflect estimates and assumptions made by our management.
These estimates and assumptions reflect our best judgment based on currently known market conditions and other factors. Although we believe such estimates and assumptions to be reasonable, they are inherently uncertain and involve a number of risks
and uncertainties that are beyond our control. In addition, managements assumptions about future events may prove to be inaccurate. Management cautions all readers that forward-looking statements are not guarantees of future performance, and
we cannot assure any reader that such statements will be realized or the forward-looking events and circumstances will occur. Actual results may differ materially from those anticipated or implied in the forward-looking statements due to factors
listed in the Risk Factors section and elsewhere in this prospectus, any prospectus supplement and the documents incorporated herein and therein by reference. All forward-looking statements speak only as of the date of this prospectus
or, in any document that we incorporate by reference, the date of that document. We do not intend to publicly update or revise any forward-looking statements as a result of new information, future events or otherwise, other than as required under
the securities laws. These cautionary statements qualify all forward-looking statements attributable to us or persons acting on our behalf.
3
USE OF PROCEEDS
Unless we specify otherwise in any prospectus supplement, we will use the net proceeds we receive from the sale of securities covered by
this prospectus for general limited liability company purposes, which may include, among other things:
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paying or refinancing all or a portion of our indebtedness outstanding at the time; and
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funding working capital, capital expenditures or acquisitions.
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The actual application of proceeds from the sale of any particular offering of securities using this prospectus will be described in the
applicable prospectus supplement relating to such offering. The precise amount and timing of the application of these proceeds will depend upon our funding requirements and the availability and cost of other funds.
RATIO OF EARNINGS TO FIXED CHARGES
The following table sets forth the ratios of earnings to fixed charges for us and our predecessors for each of the periods indicated. All
dollar amounts are reported in thousands.
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Successor
Constellation Energy
Partners LLC
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Predecessor
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Everlast Energy LLC
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Nine Months
Ended
September 30,
2010
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Nine Months
Ended
September 30,
2009
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2009
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2008
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2007
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2006
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For the
period from
February
7,
2005
(inception) to
December 31,
2005
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For the
period from
January 1,
2005
to
June 12,
2005
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Net Income (loss)
(1)
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$
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(270,257
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)
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$
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(6,682
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)
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$
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(8,645
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)
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$
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7,418
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$
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14,447
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$
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15,989
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$
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11,941
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$
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(10,636
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)
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Fixed Charges:
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Total Fixed Charges
(2)
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10,247
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8,173
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12,127
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12,256
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6,930
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221
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3
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2,437
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Total
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10,247
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8,173
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12,127
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12,256
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6,930
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221
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3
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2,437
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Earnings (loss)
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$
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(260,010
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)
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$
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1,491
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$
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3,482
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$
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19,674
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$
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21,377
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$
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16,210
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$
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11,944
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$
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(8,199
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)
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Ratio of earnings (loss) to fixed charges
(3)
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1.6
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x
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3.08
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x
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73.35
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x
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3,981.33
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x
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(1)
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Net income is the equivalent of income from continuing operations, as CEP has no discontinued operations, minus income from equity affiliates that exceeded dividends
from these affiliates.
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(2)
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Fixed charges equal the sum of the following: interest expensed and capitalized; amortized premiums, discounts, and capitalized expenses related to indebtedness; and a
reasonable approximation of the interest within rent expense.
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(3)
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Earnings were inadequate to cover fixed charges in certain periods. The coverage deficiency totaled approximately $270.3 million for the nine months ended
September 30, 2010, $6.7 million for the nine months ended September 30, 2009, $8.7 million for the fiscal year ended December 31, 2009, and $10.6 million for the period from January 1, 2005 to June 12, 2005.
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4
HOW WE MAKE CASH DISTRIBUTIONS
Initial Quarterly Distributions
The amount of distributions paid under our cash distribution policy and the decision to make any distribution will be determined by our board of managers, taking into consideration the terms of our
limited liability company agreement. At our initial public offering in November 2006, we set our initial quarterly distribution (IQD) at $0.4625 per each common and Class A unit, or $1.85 per year, subject to having sufficient available
cash after we establish appropriate reserves and pay fees and expenses. We have suspended our $0.13 per unit quarterly distributions to unitholders since the quarter ended June 30, 2009, as we have had no available cash (taking into account the
cash reserves set by our board of managers for the proper conduct of our business). We have used any excess operating cash flows to reduce our outstanding indebtedness. Given our current focus on debt reduction, we anticipate that our distribution
will remain suspended through the fourth quarter of 2011. Our quarterly distribution is intended to reflect the level of cash that we expect to be available for distribution per common unit and Class A unit each quarter from our productive
assets. There is no guarantee we will pay a quarterly distribution in any quarter and we will be prohibited from making any distributions to unitholders if it would cause an event of default or an event of default is existing under our reserve-based
credit facility. Our board of managers has adopted a policy that it will resume our quarterly cash distribution only when it believes that (i) we have sufficient reserves and liquidity for the proper conduct of our business, including the
maintenance of our asset base, (ii) we can maintain such a distribution level for a sustained period, and (iii) we are compliant with the terms and conditions specified in our reserve-based credit facility and our operating agreement. While
this is our current policy, our board of managers may alter such policy in the future when and if it determines such alteration to be appropriate.
Distributions of Available Cash
Overview
Our limited liability company agreement requires that, within 45 days after the end of each quarter, we distribute all of our available
cash to unitholders of record on the applicable record date.
Definition of Available Cash
We define available cash in the glossary, and it generally means, for each fiscal quarter, all cash on hand at the end of the quarter:
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less the amount of cash reserves established by our board of managers to:
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provide for the proper conduct of our business (including reserves for future capital expenditures and credit needs);
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comply with applicable law, any of our debt instruments, or other agreements; or
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provide funds for distributions (1) to our unitholders for any one or more of the next four quarters or (2) in respect of our Class D
interests or management incentive interests;
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plus all cash on hand on the date of determination of available cash for the quarter resulting from working capital borrowings made after the end of
the quarter. Working capital borrowings are generally borrowings that are made under our reserve-based credit facility or another arrangement and in all cases are used solely for working capital purposes or to pay distributions to unitholders.
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Operating Surplus and Capital Surplus
General
All cash distributed to unitholders will be characterized
as either operating surplus or capital surplus. Our limited liability company agreement requires that we distribute available cash from operating surplus differently than available cash from capital surplus.
5
Definition of Operating Surplus
We define operating surplus in the glossary, and for any period, it generally means:
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$20.0 million (as described below);
plus
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all of our cash receipts after the closing of our initial public offering, excluding cash from (1) borrowings that are not working capital
borrowings, (2) sales of equity and debt securities, and (3) sales or other dispositions of assets outside the ordinary course of business;
plus
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working capital borrowings made after the end of a quarter but before the date of determination of operating surplus for the quarter;
plus
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cash distributions paid on equity issued to finance all or a portion of the construction, replacement or improvement of a capital asset (such as
equipment or reserves) during the period beginning on the date that we enter into a binding obligation to commence the construction, acquisition or improvement of a capital improvement or replacement of a capital asset and ending on the earlier to
occur of the date the capital improvement or capital asset is placed into service or the date that it is abandoned or disposed of;
plus
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if the right to receive distributions (other than distributions in liquidation) on the Class D interests terminates before December 31, 2012, the
excess of the amount of the $8.0 million contribution by CHI for the Class D interests over the cumulative cash distributions paid on the Class D interests before such termination shall be included in operating surplus, such inclusion to occur over
a series of quarters with the amount included in each quarter to be equal to the amount of the payment we make to the Torch Energy Royalty Trust (the Trust) in respect of the NPI for such quarter that would not have been paid but for
termination of the sharing arrangement;
less
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our operating expenditures (as defined below);
less
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the amount of cash reserves established by our board of managers to provide funds for future operating expenditures;
less
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all working capital borrowings not repaid within twelve months after having been incurred.
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As described above, operating surplus does not reflect actual cash on hand that is available for distribution to our unitholders. For
example, it includes a provision that will enable us, if we choose, to distribute as operating surplus up to $20.0 million of cash we receive in the future from
non-operating
sources such as asset sales,
issuances of securities and long-term borrowings that would otherwise be distributed as capital surplus. In addition, the effect of including, as described above, certain cash distributions on equity securities in operating surplus would be to
increase operating surplus by the amount of any such cash distributions. As a result, we may also distribute as operating surplus up to the amount of any such cash distributions we receive from
non-operating
sources.
If a working capital borrowing, which increases operating surplus, is not repaid during the twelve-month period
following the borrowing, it will be deemed repaid at the end of such period, thus decreasing operating surplus at such time. When such working capital borrowing is in fact repaid, it will not be treated as a reduction in operating surplus because
operating surplus will have been previously reduced by the deemed repayment.
6
We define operating expenditures in the glossary, and it generally means all of our cash
expenditures, including, but not limited to, taxes, payments made in the ordinary course of business under commodity hedge contracts, manager and officer compensation, repayment of working capital borrowings, debt service payments and estimated
maintenance capital expenditures, provided that operating expenditures will not include:
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repayment of working capital borrowings deducted from operating surplus pursuant to the last bullet point of the definition of operating surplus when
such repayment actually occurs;
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payments (including prepayments and prepayment penalties) of principal of and premium on indebtedness, other than working capital borrowings;
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expansion capital expenditures;
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actual maintenance capital expenditures;
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investment capital expenditures;
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payment of transaction expenses relating to interim capital transactions; or
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distributions to our members (including distributions in respect of our Class D interests and management incentive interests).
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Capital Expenditures
For purposes of determining operating surplus, maintenance capital expenditures are those capital expenditures required to maintain, including over the long term, our asset base, and expansion capital
expenditures are those capital expenditures that we expect will increase our asset base over the long term. Examples of maintenance capital expenditures include capital expenditures associated with the replacement of equipment and oil and natural
gas reserves (including
non-proved
reserves attributable to undeveloped leasehold acreage), whether through the development, exploitation and production of an existing leasehold or the acquisition or
development of a new oil or natural gas property. Maintenance capital expenditures will also include interest (and related fees) on debt incurred and distributions on equity issued to finance all or any portion of a replacement asset during the
period from such financing until the earlier to occur of the date any such replacement asset is placed into service or the date that it is abandoned or disposed of. Plugging and abandonment costs will also constitute maintenance capital
expenditures. Capital expenditures made solely for investment purposes will not be considered maintenance capital expenditures.
Because our maintenance capital expenditures can be very large and irregular, the amount of our actual maintenance capital expenditures
may differ substantially from period to period, which could cause similar fluctuations in the amounts of operating surplus, adjusted operating surplus and cash available for distribution to our unitholders if we subtracted actual maintenance capital
expenditures from operating surplus. As a result, to eliminate the effect on operating surplus of these fluctuations, our limited liability company agreement requires that an estimate of the average quarterly maintenance capital expenditures
(including estimated plugging and abandonment costs) necessary to maintain our asset base over the long term be subtracted from operating surplus each quarter as opposed to the actual amounts spent. The amount of estimated maintenance capital
expenditures deducted from operating surplus is subject to review and change by our board of managers at least once a year,
provided
that any change is approved by our conflicts committee. The estimate is made at least annually and whenever
an event occurs that is likely to result in a material adjustment to the amount of our maintenance capital expenditures, such as a major acquisition or the introduction of new governmental regulations that will impact our business. For purposes of
calculating operating surplus, any adjustment to this estimate will be prospective only.
7
The use of estimated maintenance capital expenditures in calculating operating surplus has
the following effects:
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it reduces the risk that maintenance capital expenditures in any one quarter will be large enough to render operating surplus less than the IQD to be
paid on all the units for that quarter and subsequent quarters;
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it increases our ability to distribute as operating surplus cash we receive from
non-operating
sources;
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it is more difficult for us to raise our distribution above the IQD and pay management incentive distributions on our management incentive interests;
and
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it reduces the likelihood that a large maintenance capital expenditure during the First MII Earnings Period (as defined in Management
Incentive Interests below) or Later MII Earnings Period (as defined in Management Incentive Interests below) will prevent the payment of a management incentive distribution in respect of the First MII Earnings Period or
Later MII Earnings Period since the effect of an estimate is to spread the expected expense over several periods, thereby mitigating the effect of the actual payment of the expenditure on any single period.
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Expansion capital expenditures are those capital expenditures that we expect will increase our asset base. Examples of expansion capital
expenditures include the acquisition of reserves or equipment, the acquisition of new leasehold interest, or the development, exploitation and production of an existing leasehold interest, to the extent such expenditures are incurred to increase our
asset base. Expansion capital expenditures will also include interest (and related fees) on debt incurred and distributions on equity issued to finance all or any portion of such capital improvement during the period from such financing until the
earlier to occur of the date any such capital improvement is placed into service or the date that it is abandoned or disposed of. Capital expenditures made solely for investment purposes will not be considered expansion capital expenditures.
Investment capital expenditures are those capital expenditures that are neither maintenance capital expenditures nor
expansion capital expenditures. Investment capital expenditures largely will consist of capital expenditures made for investment purposes. Examples of investment capital expenditures include traditional capital expenditures for investment purposes,
such as purchases of securities, as well as other capital expenditures that might be made in lieu of such traditional investment capital expenditures, such as the acquisition of a capital asset for investment purposes or development of our
undeveloped properties in excess of maintenance capital expenditures, but which are not expected to expand for more than the short term our asset base.
As described above, none of actual maintenance capital expenditures, investment capital expenditures or expansion capital expenditures are subtracted from operating surplus. Because actual maintenance
capital expenditures, investment capital expenditures and expansion capital expenditures include interest payments (and related fees) on debt incurred and distributions on equity issued to finance all of the portion of the construction, replacement
or improvement of a capital asset (such as equipment or reserves) during the period from such financing until the earlier to occur of the date any such capital asset is placed into service or the date that it is abandoned or disposed of, such
interest payments and equity distributions are also not subtracted from operating surplus (except, in the case of maintenance capital expenditures, to the extent such interest payments and distributions are included in estimated maintenance capital
expenditures).
Capital expenditures that are made in part for maintenance capital purposes and in part for investment capital
or expansion capital purposes will be allocated as maintenance capital expenditures, investment capital expenditures or expansion capital expenditures by our board of managers, based upon its good faith determination, subject to approval by our
conflicts committee.
8
Definition of Capital Surplus
We also define capital surplus in the glossary, and it will generally be generated only by:
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borrowings other than working capital borrowings;
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sales of debt and equity securities; and
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sales or other disposition of assets for cash, other than inventory, accounts receivable and other current assets sold in the ordinary course of
business or as part of normal retirements or replacements of assets.
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Characterization of Cash
Distributions
We treat all available cash distributed as coming from operating surplus until the sum of all available
cash distributed since we began operations equals the operating surplus as of the most recent date of determination of available cash. We treat any amount distributed in excess of operating surplus, regardless of its source, as capital surplus. We
do not anticipate that we will make any distributions from capital surplus.
Distributions of Available Cash from Operating Surplus
We make distributions of available cash from operating surplus for any quarter in the following manner:
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first
, 98% to the common unitholders, pro rata, and 2% to the holder(s) of our Class A units, pro rata, until we distribute for each
outstanding unit an amount equal to the Target Distribution (that is, our $0.4625 IQD plus $0.0694), which aggregate amount we refer to as the Target Distribution, for that quarter; and
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thereafter
, any amount distributed in respect of such quarter in excess of the Target Distribution per unit will be distributed 98% to the
holders of the common units, pro rata, and 2% to the holder(s) of our Class A units until distributions become payable in respect of our management incentive interests as described in Management Incentive Interests below.
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The Class A units are entitled to 2% of all cash distributions from operating surplus, without any
requirement for future capital contributions by the holders of such Class A units, even if we issue additional common units or other senior or subordinated equity securities in the future. The percentage interests shown above for the
Class A units assume they have not been converted into common units. If the Class A units have been converted, the common units will receive the 2% of distributions originally allocated to the Class A units.
Management Incentive Interests
Management incentive interests represent the right to receive 15% of quarterly distributions of available cash from operating surplus after the Target Distribution has been achieved and certain other
tests have been met. CEPM currently holds the management incentive interests, which are evidenced by the Class C limited liability company interests, but may transfer these rights separately from its Class A units,
9
subject to restrictions in our limited liability company agreement. The earliest that we could be required to make distributions in respect of the management incentive interests is after a period
of 12 consecutive quarters after we pay per unit cash distributions from operating surplus to holders of Class A and common units in an amount equal or greater than the Target Distribution. For the third quarter 2007, we increased our
distribution rate to $0.5625 per unit. This increase in the distribution rate commenced a management incentive interest vesting period under our operating agreement. Through December 31, 2008, a cash reserve of $0.7 million had been established
to fund future distributions on the management incentive interests. In February 2009, we reduced our distribution rate to $0.13 per unit. This decrease in the distribution rate terminated the initial management incentive interest vesting period.
After the February 13, 2009 distribution was paid, the reserve was reduced to zero. For the nine months ended September 30, 2010, none of these applicable tests have been met, and, as a result, CEPM was not entitled to receive any
management incentive interest distributions. We are not able to predict the future amount of the distributions in respect of the management incentive interests.
Prior to the end of the First MII Earnings Period or Later MII Earnings Period, which are defined below, we will not pay any management incentive distributions. To the extent, however, that during the
First MII Earnings Period or Later MII Earnings Period we distribute available cash from operating surplus in excess of the Target Distribution, our board of managers intends to cause us to reserve an amount for payment of the EP MID, which is
defined below, earned during the First MII Earnings Period or Later MII Earnings Period, as the case may be, after such period ends. If during the First MII Earnings Period or Later MII Earnings Period we fail to satisfy a condition specified in the
next paragraph, our board of managers will cause any such reserved amount to be released from that reserve and restored to available cash.
Payments to the holder of our management incentive interests are subject to the satisfaction of certain requirements. The first requirement is the
12-Quarter
Test,
which requires that for the 12 full, consecutive,
non-overlapping
calendar quarters that begin with the first calendar quarter in respect of which we pay per unit cash distributions from operating surplus to
holders of Class A and common units in an amount equal to or greater than the Target Distribution (we refer to such
12-quarter
period as the First MII Earnings Period):
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we pay cash distributions from operating surplus to holders of our outstanding Class A and common units in an amount that on average exceeds the
Target Distribution on all of the outstanding Class A units and common units over the First MII Earnings Period;
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we generate adjusted operating surplus (which is summarized below and is defined in the glossary included as Appendix A) during the First MII Earnings
Period that on average is in an amount at least equal to 100% of all distributions on the outstanding Class A and common units up to the Target Distribution plus 117.65% of all such distributions in excess of the Target Distribution; and
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we do not reduce the amount distributed per unit in respect of any such 12 quarters.
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The second requirement is the
4-Quarter
Test, which requires that for each of the last four full,
consecutive,
non-overlapping
calendar quarters in the First MII Earnings Period:
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we pay cash distributions from operating surplus to the holders of our outstanding Class A and common units that exceed the Target Distribution on
all of the outstanding Class A and common units;
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we generate adjusted operating surplus in an amount at least equal to 100% of all distributions on the outstanding Class A and common units up to
the Target Distribution plus 117.65% of all such distributions in excess of the Target Distribution; and
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we do not reduce the amount distributed per unit in respect of any such four quarters.
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10
If both the
12-Quarter
Test and the
4-Quarter
Test have been met, then: (i) we will make a
one-time
management incentive distribution (contemporaneously with the distribution paid in respect of the
Class A and common units for the twelfth calendar quarter in the First MII Earnings Period) to the holder of our management incentive interests equal to 17.65% of the sum of the cumulative amounts, if any, by which quarterly cash distributions
per unit part on the outstanding Class A and common units during the First MII Earnings Period exceeded the Target Distribution on all of the outstanding Class A and common units (we refer to this
one-time
management incentive distribution as an EP MID); and (ii) for each calendar quarter after the First MII Earnings Period, the holders of our Class A units and common units and
management incentive interests will receive 2%, 83% and 15%, respectively, of cash distributions from available cash from operating surplus that we pay for such quarter in excess of the Target Distribution.
If the
12-Quarter
Test is not met and except as described below, management incentive
distributions will not be payable in respect of the First MII Earnings Period and the holder of the management incentive interests will forfeit any and all rights to any management incentive distributions in respect of the First MII Earnings Period.
An EP MID may become payable, however, with respect to a Later MII Earnings Period, if the
12-Quarter
Test and the
4-Quarter
Test are met in respect of such Later MII
Earnings Period. A Later MII Earnings Period may begin with the first quarter following the quarter in which the
12-Quarter
Test is not met, or, where we do not meet the
12-Quarter
Test because we reduced our cash distribution in a particular quarter, the Later MII Earnings Period may begin with the quarter in which such reduction is made. If both tests are met with respect to
a Later MII Earnings Period, then for each calendar quarter after the Later MII Earnings Period, the holders of the Class A units and common units and management incentive interests will receive 2%, 83% and 15%, respectively, of cash
distributions from available cash from operating surplus that we pay for such quarter in excess of the Target Distribution.
However, if (a) the
12-Quarter
Test has been met in respect of the First MII Earnings Period
or any Later MII Earnings Period, but not the
4-Quarter
Test; (b) the
4-Quarter
Test has been met in any period of four full, consecutive and
non-overlapping
quarters occurring after the end of the First MII Earnings Period or Later MII Earnings Period, as the case may be, up to three of which quarters can fall within the First MII Earnings Period or
Later MII Earnings Period, as the case may be (we refer to such four-quarter period as the MII
4-Quarter
Earnings Period); and (c) we have paid at least the IQD in each calendar quarter
occurring between the end of the First MII Earnings Period or Later MII Earnings Period, as the case may be, and the beginning of the MII
4-Quarter
Earnings Period:
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the holders of our Class A units and common units and management incentive interests will receive 2%, 83% and 15%, respectively, of cash
distributions from available cash from operating surplus that we pay in excess of the Target Distribution for each calendar quarter after the MII
4-Quarter
Earnings Period; and
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the holder of our management incentive interests will receive an EP MID with respect to the First MII Earnings Period or Later MII Earnings Period, as
the case may be.
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Our board of managers has adopted a policy that it will raise our quarterly cash
distribution only when it believes that (i) we have sufficient reserves and liquidity for the proper conduct of our business, including the maintenance of our asset base, and (ii) we can maintain such increased distribution level for a
sustained period. While this is our current policy, our board of managers may alter such policy in the future when and if it determines such alteration to be appropriate.
11
Definition of Adjusted Operating Surplus
We define adjusted operating surplus in the glossary and for any period it generally means:
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operating surplus generated with respect to that period less any amounts described in the fifth bullet point under Definition of Operating
Surplus above; less
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any net increase in working capital borrowings with respect to that period (excluding any such borrowings to the extent the proceeds are distributed to
the record holder of our Class D interests); less
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any net reduction in cash reserves for operating expenditures with respect to that period not relating to an operating expenditure made with respect to
that period; plus
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any net decrease in working capital borrowings with respect to that period; plus
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any net increase in cash reserves for operating expenditures made with respect to that period required by any debt instrument for the repayment of
principal, interest or premium.
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Adjusted operating surplus is intended to reflect the cash generated from
our operations during a particular period and therefore excludes net increases in working capital borrowings and net drawdowns of reserves of cash generated in prior periods.
Percentage Allocations of Available Cash from Operating Surplus
The
following table illustrates the percentage allocations of the additional available cash from operating surplus between the unitholders and CEPM as the owner of our management incentive interests up to various distribution levels. The amounts set
forth under Marginal Percentage Interest in Distributions are the percentage interests of our Class A unitholders and common unitholders and the holders of our management incentive interests in any available cash from operating
surplus we distribute up to and including the corresponding amount in the column Quarterly Distribution Level, until available cash from operating surplus we distribute reaches the next distribution level, if any. The percentage
interests shown for the IQD are also applicable to quarterly distribution amounts that are less than the IQD. The percentage interests shown in the table below assume that the Class A units have not been converted into common units as described
herein.
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Marginal Percentage Interest in
Distributions
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Quarterly Distribution
Level
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Class A
Unitholders
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Common
Unitholders
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Management
Incentive
Interests
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IQD
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$0.4625
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2
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%
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98
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%
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0
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%
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Target Distribution
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above $0.4625 up to $0.5319
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2
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%
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98
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%
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0
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%
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Thereafter*
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above $0.5319
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2
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%
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83
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%
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15
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%
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*
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Assumes the management incentive interests have met the
12-Quarter
Test and the
4-Quarter
Test. Until the
12-Quarter
Test and the
4-Quarter
Test are met and distributions in respect of the management incentive
interests become payable, quarterly distributions in excess of the $0.5319 Target Distribution will be made 2% to the holder of the Class A units and 98% to the holders of common units, pro rata.
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Distributions from Capital Surplus
How Distributions from Capital Surplus Are Made
We make distributions of available cash from capital surplus, if any, in the following manner:
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first
, 2% to the holder of our Class A units and 98% to all common unitholders, pro rata, until we distribute for each common unit that was
issued in our initial public offering an amount of available cash from capital surplus equal to the initial public offering price; and
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thereafter
, we will make all distributions of available cash from capital surplus as if they were from operating surplus.
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Effect of a Distribution from Capital Surplus
Our limited liability company agreement treats a distribution of capital surplus as the repayment of the initial common unit price from
our initial public offering, which is a return of capital. The initial public offering price less any distributions of capital surplus per common unit is referred to as the unrecovered capital per initial common unit. Each time a
distribution of capital surplus is made, the IQD and the Target Distribution will be reduced in the same proportion as the corresponding reduction in the unrecovered capital per common unit. Because distributions of capital surplus will reduce the
IQD, after any of these distributions are made, it may be easier for CEPM to receive management incentive distributions. However, any distribution of capital surplus before the unrecovered capital per common unit is reduced to zero cannot be applied
to the payment of the IQD.
Once we distribute capital surplus on a common unit in an amount equal to the unrecovered capital
per common unit, we will reduce the IQD and the Target Distribution to zero. We will then make all future distributions from operating surplus, with 2% being distributed to the holder of our Class A units, 83% being distributed to our common
unitholders, pro rata, and 15% being distributed to the holder of our management incentive interests. The percentage interests shown above for the Class A units assume they have not been converted into common units. If the Class A units
have been converted, the common units will receive the 2% of distributions originally allocated to the Class A units.
Adjustment to the IQD and Target Distribution
In addition to adjusting the IQD and Target Distribution to reflect a distribution of capital surplus, if we combine our common units into fewer common units or subdivide our common units into a greater
number of common units, we will proportionately adjust:
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the Target Distribution; and
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the unrecovered capital per common unit.
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For example, if a
two-for-one
split of the common units should occur, the Target Distribution and the unrecovered capital
per common unit would each be reduced to 50% of its initial level. We will not make any adjustment by reason of the issuance of additional units for cash or property.
In addition, if legislation is enacted or if existing law is modified or interpreted by a court of competent jurisdiction, so that we become taxable as a corporation or otherwise subject to taxation as an
entity for federal, state or local income tax purposes, we will reduce the IQD and the Target Distribution for each quarter by multiplying each by a fraction, the numerator of which is available cash for that quarter (after deducting our board of
managers estimate of our aggregate liability for the quarter for such income taxes payable by reason of such legislation or interpretation) and the denominator of which is the sum of available cash for that quarter plus our board of
managers estimate of our aggregate liability for the quarter for such income taxes payable by reason of such legislation or interpretation. To the extent that the actual tax liability differs from the estimated tax liability for any quarter,
the difference will be accounted for in subsequent quarters.
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Quarterly Cash Distributions on Our Class D Interests
In order to address the risk of early termination, without the prior consent of board of managers, prior to December 31, 2012, of the
sharing arrangement under the gas purchase contract pertaining to the calculation of amounts payable to the Trust for the NPI, and the potential reduction in our revenues resulting therefrom, at the closing of our initial public offering CHI
contributed $8.0 million to us for all of our Class D interests. For each full calendar quarter during the period commencing January 1, 2007 and ending on December 31, 2012 that the sharing arrangement remains in effect, we will distribute
to the holder of the Class D interests $333,333.33, as a partial return of the $8.0 million capital contribution made for the Class D interests, which payment will be made concurrently with the quarterly cash distribution to our unitholders for that
quarter. The Class D interests will be cancelled upon the payment of the final distribution of $333,333.41 to CHI for the quarter ending December 31, 2012, unless the special distribution right has been terminated earlier. Such special
quarterly cash distributions will be made 45 days after the end of each calendar quarter.
If the amounts payable by us to the
Trust are not calculated based on the sharing arrangement through December 31, 2012, unless such change is approved in advance by our board of managers and our conflicts committee, the special distribution right for future quarters will
terminate and the remaining portion of the $8.0 million original contribution not so returned in special cash distributions will be retained by us to partially offset the reduction in our revenues resulting from termination of the sharing
arrangement. In the case of such termination of the special distribution right, CHI will have the right only under specific circumstances upon our liquidation to receive the unpaid portion of the $8.0 million capital contribution that has not then
been distributed to CHI in such special distributions. See Distributions of Cash Upon Liquidation below. If the sharing arrangement in respect of the specified wells in the Robinsons Bend Field (the Trust Wells)
is terminated during a quarter, the special distribution to CHI as the holder of our Class D interests will be prorated for that quarter based on the ratio of the number of days in such quarter prior to the effective date of such termination to 90.
If we and any of the Trust, the trustee of the Trust, or any subsequent holder of the NPI become involved in a dispute or proceeding in which such person asserts that prior to December 31, 2012 the sharing arrangement ceased to be applicable in
calculating amounts payable in respect of production from the Trust Wells, special cash distributions in respect of the Class D interests for periods commencing at the inception of such dispute will be suspended, and such suspended amounts will only
be paid to the holder of the Class D interests to the extent it is finally determined that the sharing arrangement remained applicable during some or all of the suspension period.
In connection with litigation related to the Torch NPI, we have suspended all quarterly cash distributions with respect to our Class D
interests. This suspension, approved by our board of managers, includes the $0.3 million quarterly cash distribution for the three months ended September 30, 2010 and $3.3 million which represents the distributions that were suspended for the
quarterly periods ended June 30, 2010, March 31, 2010, and December 31, September 30, June 30, and March 31, 2009, and December 31, September 30, June 30, and March 31, 2008. Including the suspended
distributions, the remaining undistributed amount of the Class D interests is $6.7 million.
Distributions of Cash Upon Liquidation
General
If we dissolve in accordance with our limited liability company agreement, we will sell or otherwise dispose of our assets in a process called liquidation. We will first apply the proceeds of liquidation
to the payment of our creditors. We will distribute any remaining proceeds to the unitholders, to CHI, the entity that contributed $8.0 million to us in exchange for the Class D interests, CEPH and CEPM in accordance with their capital account
balances, as adjusted to reflect any gain or loss upon the sale or other disposition of our assets in liquidation.
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Manner of Adjustments for Gain
The manner of the adjustment for gain is set forth in our limited liability company agreement, and requires that we will allocate any gain
to the unitholders and holders of the Class A units in the following manner:
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first
, to the holders of common units who have negative balances in their capital accounts to the extent of and in proportion to those negative
balances;
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second
, 2% to the holder of our Class A units and 98% to the common unitholders, pro rata, until the capital account for each common unit
is equal to the sum of:
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(1)
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the unrecovered initial common unit price; and
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(2)
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the amount of the IQD for the quarter during which our liquidation occurs; and
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third
, 100% to the holder of our Class D interests, until the capital account of the Class D interests equals, in the aggregate, the excess, if
any, of (i) the $8.0 million capital contribution made to us by CHI at the closing of our initial public offering for all of our Class D interests over (ii) the cumulative amount distributed as a special distribution to the holder of the
Class D interests in accordance with the description under Quarterly Cash Distributions On Our Class D interests above;
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fourth
, 2% to the holder of our Class A units and 98% to the common unitholders, pro rata, until the capital account for each common unit
is equal to the sum of:
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(1)
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the amount described above under the second bullet point of this paragraph; and
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(2)
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the excess of (I) over (II), where
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(I)
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equals the sum of the excess of the Target Distribution per common unit over the IQD for each quarter of our existence; and
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(II)
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equals the cumulative amount per common unit of any distributions of available cash from operating surplus in excess of the IQD per common unit that we distributed 98%
to our common unitholders, pro rata, for each quarter of our existence; and
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thereafter
, 2% to the holder of our Class A units, 83% to all common unitholders, pro rata, and 15% to the holder of our management
incentive interests.
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Manner of Adjustments for Losses
Upon our liquidation, we will generally allocate any loss 2% to the holder of the Class A units and 98% to the holders of the
outstanding common units, pro rata.
Adjustments to Capital Accounts
We will make adjustments to capital accounts upon the issuance of additional common units. In doing so, we will allocate any unrealized
and, for tax purposes, unrecognized gain or loss resulting from the adjustments to the holder of the Class A units, the common unitholders, the holders of Class D interests and the holders of the management incentive interests in the same
manner as we allocate gain or loss upon
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liquidation. In the event that we make positive adjustments to the capital accounts upon the issuance of
additional common units, we will allocate any later negative adjustments to the capital accounts resulting from the issuance of additional common units or upon our liquidation in a manner which results, to the extent possible, in the capital account
balances of the holders of the management incentive interests equaling the amount which they would have been if no earlier positive adjustments to the capital accounts had been made.
CONFLICTS OF INTEREST AND FIDUCIARY DUTIES
Conflicts of Interest
Affiliates of
Constellation own all of our Class A units, 5,918,894 common units, our management incentive interests and our Class D interests. Conflicts of interest exist and may arise in the future as a result of the relationships between us and our
unaffiliated unitholders and our board of managers and executive officers and Constellation and its affiliates, including CEPM and CEPH. These potential conflicts may relate to the divergent interests of these parties.
Whenever a conflict arises between Constellation and its affiliates, on the one hand, and us or any other unitholder, on the other hand,
our board of managers will resolve that conflict. Our limited liability company agreement limits the remedies available to unitholders in the event a unitholder has a claim relating to conflicts of interest.
No breach of obligation will occur under our limited liability company agreement in respect of any conflict of interest if the resolution
of the conflict is:
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approved by the conflicts committee of our board of managers, although our board of managers is not obligated to seek such approval;
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approved by the vote of a majority of the outstanding units, excluding any common or Class A units owned by CEPM, CEPH or any of their affiliates,
although our board of managers is not obligated to seek such approval;
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on terms no less favorable to us than those generally provided to or available from unaffiliated third parties; or
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fair and reasonable to us, taking into account the totality of the relationships between the parties involved, including other transactions that may be
particularly favorable or advantageous to us.
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We anticipate that our board of managers will submit for
review and approval by our conflicts committee any acquisitions of properties or other assets that we propose to acquire from Constellation or any of its affiliates.
If our board of managers does not seek approval from the conflicts committee of our board of managers and our board determines that the resolution or course of action taken with respect to the conflict of
interest satisfies either of the standards set forth in the third and fourth bullet points above, then it will be presumed that, in making its decision, the board of managers, including board members affected by the conflict of interest, acted in
good faith, and in any proceeding brought by or on behalf of any member or the company, the person bringing or prosecuting such proceeding will have the burden of overcoming such presumption. Unless the resolution of a conflict is specifically
provided for in our limited liability company agreement, our board of managers or its conflicts committee may consider any factors in good faith when resolving a conflict. When our limited liability company agreement requires someone to act in good
faith, it requires that person to reasonably believe that he is acting in our best interests, unless the context otherwise requires.
16
Conflicts of interest could arise in the situations described below, among others.
Constellation and its affiliates may compete with us and have no obligations to offer us the opportunity to purchase or
own interests in any assets.
None of Constellation or any of its affiliates is restricted from competing with us.
Constellation and its affiliates may acquire, invest in or dispose of exploration and production or other assets, including those that might be in direct competition with us. In addition, neither Constellation nor its affiliates has any obligation
to offer us the opportunity to purchase or own interests in any assets.
Affiliates of Constellation not only have the
exclusive right to elect two members of our board of managers but also may influence the election of the other three members of our board of managers.
CEPM, as the holder of our Class A units will have the exclusive right to elect two members of our board of managers, and CEPH, as the largest holder of our common units, may be able to influence any
vote of common unitholders, including the election of the three members of our board of managers that are elected by the common unitholders. In turn, our board of managers shall have the power to appoint our officers. Situations in which the
interests of our management and Constellation and its affiliates may differ from interests of our unaffiliated unitholders include the following situations:
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our limited liability company agreement gives our board of managers broad discretion in establishing cash reserves for the proper conduct of our
business, which will affect the amount of cash available for distribution. For example, our management will use its reasonable discretion to establish and maintain cash reserves sufficient to fund our drilling program;
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our management team determines the timing and extent of our drilling program and related capital expenditures, asset purchases and sales, borrowings,
issuances of additional membership interests and reserve adjustments, all of which will affect the amount of cash that we distribute to our unitholders;
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our board of managers may cause us to borrow funds in order to permit us to pay cash distributions to our unitholders, even if the purpose or effect of
the borrowing is to make management incentive distributions; and
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our board of managers is allowed to take into account the interest of parties other than us, such as Constellation and its affiliates, in resolving
conflicts of interest, which has the effect of limiting the fiduciary duty to our unaffiliated unitholders.
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Our Class A managers may also serve as managers, directors, officers, employees or contractors of Constellation or its other
affiliates as a result of which conflicts of interest may exist and may arise in the future.
Our Class A managers
may also be managers, directors, officers, employees or contractors of Constellation or its affiliates (other than us). In making decisions in such persons capacity as a manager, director, officer, employee or contractor of Constellation or
such affiliate, such person may make a decision that favors the interests of Constellation or such affiliate over your interests and may be to our detriment, notwithstanding that in making decisions in such persons capacity as our manager such
person is required to act in good faith and in accordance with the standards set forth in our limited liability company agreement. If in resolving a conflict of interest any of our Class A managers satisfies the applicable standards set forth
in our limited liability company agreement for resolving a conflict of interest, you will not be able to assert that such resolution constituted a breach of fiduciary duty owed to us or to you by such Class A manager.
17
We may compete for the time and effort of our managers who are also managers,
directors, officers employees or contractors of Constellation and its affiliates.
Constellation and its affiliates
conduct business and activities of their own in which we have no economic interest. Certain of our managers may serve as managers, directors, officers, employees or contractors of Constellation and its affiliates. Our managers are not required to
work full time on our business and affairs and may devote significant time to the affairs of Constellation and its affiliates. There could be material competition for the time and effort of our managers who provide services to Constellation and its
affiliates.
Unitholders will have no right to enforce obligations of Constellation and its affiliates under agreements
with us.
Any agreements between us, on the one hand, and Constellation and its affiliates, on the other hand, will not
grant to our unitholders any right to enforce the obligations of Constellation and its affiliates in our favor.
Contracts between us, on the one hand, and Constellation and its affiliates, on the other, will not be the result of
arms-length negotiations.
Neither our limited liability company agreement nor any of the other contracts or
arrangements, between us and Constellation and its affiliates are or will be the result of arms-length negotiations.
Fiduciary Duties
Our limited liability company agreement provides that our business and affairs shall be managed under
the direction of our board of managers, which shall have the power to appoint our officers. Our limited liability company agreement further provides that the authority and function of our board of managers and officers shall be identical to the
authority and functions of a board of directors and officers of a corporation organized under the Delaware General Corporation Law (DGCL). However, our managers and officers do not owe us the same duties that the directors and officers
of a corporation organized under the DGCL would owe to that corporation. Rather, our limited liability company agreement provides that the fiduciary duties and obligations owed to us and to our members by our managers and officers is generally to
act in good faith in the performance of their duties on our behalf. Our limited liability company agreement permits affiliates of our managers to invest or engage in other businesses or activities that compete with us. In addition, if our conflicts
committee approves a transaction involving potential conflicts, or if a transaction is on terms generally available from unaffiliated third parties or an action is taken that is fair and reasonable to the company, unitholders will not be able to
assert that such approval constituted a breach of fiduciary duties owed to them by our managers and officers.
DESCRIPTION OF THE COMMON UNITS
The Common Units
The common units represent limited liability company interests in us. The holders of common units are entitled to participate in
distributions and exercise the rights or privileges provided under our limited liability company agreement. For a description of the relative rights and preferences of holders of common units in and to distributions, please read this section and
How We Make Cash Distributions. For a description of the rights and privileges of holders of common units under our limited liability company agreement, including voting rights, please read The Limited Liability Company
Agreement.
18
Transfer Agent and Registrar
Computershare Trust Company, N.A. serves as registrar and transfer agent for the common units. We pay all fees charged by the transfer
agent for transfers of common units, except the following fees that will be paid by holders of common units:
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surety bond premiums to replace lost or stolen certificates, taxes and other governmental charges;
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special charges for services requested by a holder of a common unit; and
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other similar fees or charges.
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There is no charge to unitholders for disbursements of our cash distributions. We will indemnify the transfer agent, its agents and each of their shareholders, managers, officers and employees against all
claims and losses that may arise out of acts performed or omitted in that capacity, except for any liability due to any gross negligence or intentional misconduct of the indemnified person or entity.
The transfer agent may at any time resign, by notice to us, or be removed by us. The resignation or removal of the transfer agent will
become effective upon our appointment of a successor transfer agent and registrar and its acceptance of the appointment. If no successor has been appointed and has accepted the appointment within 30 days after notice of the resignation or removal,
we are authorized to act as the transfer agent and registrar until a successor is appointed.
Transfer of Common
Units
By transfer of common units in accordance with our limited liability company agreement, each transferee of common
units shall be admitted as a unitholder of our company with respect to the common units transferred when such transfer and admission is reflected on our books and records. Additionally, each transferee of common units:
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becomes the record holder of the common units;
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automatically agrees to be bound by the terms and conditions of, and is deemed to have executed our limited liability company agreement;
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represents that the transferee has the capacity, power and authority to enter into the limited liability company agreement;
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grants powers of attorney to our officers and any liquidator of our company as specified in the limited liability company agreement; and
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makes the consents and waivers contained in our limited liability company agreement.
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A transferee will become a unitholder of our company for the transferred common units upon the recording of the name of the transferee on
our books and records.
Until a common unit has been transferred on our books, we and the transfer agent, notwithstanding any
notice to the contrary, may treat the record holder of the common unit as the absolute owner for all purposes, except as otherwise required by law or stock exchange regulations.
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DESCRIPTION OF DEBT SECURITIES
Any debt securities that we offer under a prospectus supplement will be direct, unsecured general obligations. The debt securities will
be either senior debt securities or subordinated debt securities. The debt securities will be issued under one or more separate indentures between us and The Bank of Nova Scotia Trust Company of New York, as trustee. Senior debt securities will be
issued under a senior indenture, and subordinated debt securities will be issued under a subordinated indenture. Together, the senior indenture and the subordinated indenture are called the indentures. The indentures will be supplemented
by supplemental indentures, the material provisions of which will be described in a prospectus supplement.
As used in this
description, the words CEP, we, us and our refer to Constellation Energy Partners LLC, and not to any of its subsidiaries or affiliates.
We have summarized some of the material provisions of the indentures below. This summary does not restate those agreements in their
entirety. A form of senior indenture and a form of subordinated indenture have been filed as exhibits to the registration statement of which this prospectus is a part. We urge you to read each of the indentures because each one, and not this
description, defines the rights of holders of debt securities.
Capitalized terms defined in the indentures have the same
meanings when used in this prospectus.
General
The debt securities issued under the indentures will be our direct, unsecured general obligations. The senior debt securities will rank
equally with all of our other senior and unsubordinated debt. The subordinated debt securities will have a junior position to all of our senior debt.
The following description sets forth the general terms and provisions that could apply to debt securities that we may offer to sell. A prospectus supplement relating to any series of debt securities being
offered will include specific terms relating to the offering. These terms will include some or all of the following:
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the title and type of the debt securities;
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the total principal amount of the debt securities;
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the percentage of the principal amount at which the debt securities will be issued and any payments due if the maturity of the debt securities is
accelerated;
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the dates on which the principal of the debt securities will be payable;
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the interest rate which the debt securities will bear and the interest payment dates for the debt securities;
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any conversion or exchange features;
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any optional redemption periods;
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any sinking fund or other provisions that would obligate us to repurchase or otherwise redeem some or all of the debt securities;
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any provisions granting special rights to holders when a specified event occurs;
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any changes to or additional events of default or covenants;
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any special tax implications of the debt securities, including provisions for original issue discount securities, if offered; and
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any other terms of the debt securities.
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None of the indentures will limit the amount of debt securities that may be issued. Each indenture will allow debt securities to be issued up to the principal amount that may be authorized by us and may
be in any currency or currency unit designated by us.
Debt securities of a series may be issued in registered or global form.
Covenants
Under the indentures, we:
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will pay the principal of, interest and any premium on, the debt securities when due;
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will maintain a place of payment;
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will deliver a certificate to the trustee at the end of each fiscal year reviewing our obligations under the indentures;
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will preserve our limited liability company existence; and
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will deposit sufficient funds with any paying agent on or before the due date for any principal, interest or premium.
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Mergers and Sale of Assets
Each of the indentures will provide that we may not consolidate with or merge into any other Person or sell, convey, transfer or lease all or substantially all of our properties and assets (on a
consolidated basis) to another Person, unless:
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either: (a) CEP is the surviving Person; or (b) the Person formed by or surviving any such consolidation, amalgamation or merger or resulting
from such conversion (if other than CEP) or to which such sale, assignment, transfer, conveyance or other disposition has been made is a corporation, limited liability company or limited partnership organized or existing under the laws of the United
States, any state of the United States or the District of Columbia;
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the Person formed by or surviving any such conversion, consolidation, amalgamation or merger (if other than CEP) or the Person to which such sale,
assignment, transfer, conveyance or other disposition has been made assumes all of the obligations of CEP under such indenture and the debt securities governed thereby pursuant to agreements reasonably satisfactory to the trustee;
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we or the successor will not immediately be in default under such indenture; and
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we deliver an officers certificate and opinion of counsel to the trustee stating that such consolidation, amalgamation, merger, sale, transfer or
lease and any supplemental indenture complies with Article Eight of the indenture and that all conditions precedent set forth in such indenture relating to such transaction have been complied with.
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Upon the assumption of our obligations under each indenture by a successor, we will be
discharged from all obligations under such indenture, except in the case of a lease.
As used in the indenture and in this
description, the word Person means any individual, corporation, company, limited liability company, partnership, limited partnership, joint venture, association, joint-stock company, trust, other entity, unincorporated organization or
government or any agency or political subdivision thereof.
Events of Default
Event of default, when used in the indentures, with respect to debt securities of any series, will mean any of the following:
(1) default in the payment of any interest upon any debt security of that series when it becomes due and payable, and
continuance of such default for a period of 30 days;
(2) default in the payment of the principal of (or premium, if any,
on) any debt security of that series at its maturity;
(3) default in the performance, or breach, of any covenant set
forth in Article Ten of the applicable indenture (other than a covenant a default in whose performance or whose breach is elsewhere specifically dealt with as an event of default or which has expressly been included in such indenture solely for the
benefit of one or more series of debt securities other than that series), and continuance of such default or breach for a period of 90 days after there has been given, by registered or certified mail, to CEP by the trustee or to CEP and the trustee
by the holders of at least 25% in principal amount of the then-outstanding debt securities of that series a written notice specifying such default or breach and requiring it to be remedied and stating that such notice is a Notice of
Default thereunder;
(4) default in the performance, or breach, of any covenant in the applicable indenture (other
than a covenant set forth in Article Ten of such indenture or any other covenant a default in whose performance or whose breach is elsewhere specifically dealt with as an event of default or which has expressly been included in such indenture solely
for the benefit of one or more series of debt securities other than that series), and continuance of such default or breach for a period of 180 days after there has been given, by registered or certified mail, to CEP by the trustee or to CEP and the
trustee by the holders of at least 25% in principal amount of the then-outstanding debt securities of that series a written notice specifying such default or breach and requiring it to be remedied and stating that such notice is a Notice of
Default thereunder;
(5) CEP, pursuant to or within the meaning of any bankruptcy law, (i) commences a
voluntary case, (ii) consents to the entry of any order for relief against it in an involuntary case, (iii) consents to the appointment of a custodian of it or for all or substantially all of its property, or (iv) makes a general
assignment for the benefit of its creditors;
(6) a court of competent jurisdiction enters an order or decree under any
bankruptcy law that (i) is for relief against CEP in an involuntary case, (ii) appoints a custodian of CEP or for all or substantially all of its property, or (iii) orders the liquidation of CEP ; and the order or decree remains
unstayed and in effect for 60 consecutive days;
(7) default in the deposit of any sinking fund payment when due; or
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(8) any other event of default provided with respect to debt securities of that series
in accordance with provisions of the indenture related to the issuance of such debt securities.
An event of default for a
particular series of debt securities does not necessarily constitute an event of default for any other series of debt securities issued under an indenture. The trustee may withhold notice to the holders of debt securities of any default (except in
the payment of principal, interest or any premium) if it considers the withholding of notice to be in the interests of the holders.
If an event of default for any series of debt securities occurs and continues, the trustee or the holders of 25% in aggregate principal amount of the debt securities of the series may declare the entire
principal of all of the debt securities of that series to be due and payable immediately. If this happens, subject to certain conditions, the holders of a majority of the aggregate principal amount of the debt securities of that series can void the
declaration.
Other than its duties in case of a default, a trustee is not obligated to exercise any of its rights or powers
under any indenture at the request, order or direction of any holders, unless the holders offer the trustee indemnity reasonably satisfactory to the trustee. If they provide this indemnification, and subject to the conditions set forth in the
indenture, the holders of a majority in principal amount outstanding of any series of debt securities may direct the time, method and place of conducting any proceeding or any remedy available to the trustee, or exercising any power conferred upon
the trustee, for any series of debt securities.
Amendments and Waivers
Subject to certain exceptions, the indentures and the debt securities issued thereunder may be amended or supplemented with the consent of
the holders of a majority in aggregate principal amount of the then-outstanding debt securities of each series affected by such amendment or supplemental indenture, with each such series voting as a separate class (including, without limitation,
consents obtained in connection with a purchase of, or tender offer or exchange offer for, debt securities) and, subject to certain exceptions, any past default or compliance with any provisions may be waived with respect to each series of debt
securities with the consent of the holders of a majority in principal amount of the then-outstanding debt securities of such series voting as a separate class (including consents obtained in connection with a purchase of, or tender offer or exchange
offer for, debt securities).
Without the consent of each holder of the outstanding debt securities affected, an amendment,
supplement or waiver may not, among other things:
(1) change the stated maturity of the principal of, or any installment
of principal of or interest on, any debt security, or reduce the principal amount thereof or the rate of interest thereon or any premium payable upon the redemption thereof, or reduce the amount of the principal of an original issue discount
security that would be due and payable upon a declaration of acceleration of the maturity thereof pursuant to the applicable indenture, or the coin or currency in which any debt security or any premium or the interest thereon is payable, or impair
the right to institute suit for the enforcement of any such payment on or after the stated maturity thereof (or, in the case of redemption, on or after the redemption date therefor);
(2) reduce the percentage in principal amount of the then-outstanding debt securities of any series, the consent of whose holders is
required for any such amendment, supplemental indenture, or the consent of whose holders is required for any waiver of compliance with certain provisions of the applicable indenture or certain defaults thereunder and their consequences provided for
in the applicable indenture;
(3) modify any of the provisions set forth in (i) the provisions of the applicable
indenture related to the holders unconditional right to receive principal, premium, if any, and interest on the debt securities or (ii) the provisions of the applicable indenture related to the waiver of past defaults under such
indenture;
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(4) waive a redemption payment with respect to any debt security;
provided
,
however
, that any purchase or repurchase of debt securities shall not be deemed a redemption of the debt securities;
(5) release any guarantor from any of its obligations under its guarantee or the applicable indenture, except in accordance with the
terms of such indenture (as amended or supplemented by any supplemental indenture); or
(6) make any change in the
foregoing amendment and waiver provisions, except to increase any percentage provided for therein or to provide that certain other provisions of the applicable indenture cannot be modified or waived without the consent of the holder of the
outstanding debt security affected thereby.
Notwithstanding the foregoing, without the consent of any holder of debt
securities, CEP, the guarantors, if any, and the trustee may amend each of the indentures or the debt securities issued thereunder to:
(1) cure any ambiguity or defect or to correct or supplement any provision therein that may be inconsistent with any other provision therein;
(2) evidence the succession of another Person to CEP and the assumption by any such successor of the covenants of CEP therein and,
to the extent applicable, of the debt securities;
(3) provide for uncertificated debt securities in addition to or in
place of certificated debt securities;
provided
that the uncertificated debt securities are issued in registered form for purposes of Section 163(f) of the Internal Revenue Code of 1986, as amended (the Code), or in the
manner such that the uncertificated debt securities are described in Section 163(f)(2)(B) of the Code;
(4) add a
guarantee and cause any Person to become a guarantor, and/or to evidence the succession of another Person to a guarantor and the assumption by any such successor of the guarantee of such guarantor therein and, to the extent applicable, endorsed upon
any debt securities of any series;
(5) secure the debt securities of any series;
(6) add to the covenants of CEP such further covenants, restrictions, conditions or provisions as CEP shall consider to be
appropriate for the benefit of the holders of all or any series of debt securities (and if such covenants, restrictions, conditions or provisions are to be for the benefit of less than all series of debt securities, stating that such covenants are
expressly being included solely for the benefit of such series), and to make the occurrence, or the occurrence and continuance, of a default in any such additional covenants, restrictions, conditions or provisions an event of default permitting the
enforcement of all or any of the several remedies provided in the applicable indenture as set forth therein, or to surrender any right or power therein conferred upon CEP;
provided
, that in respect of any such additional covenant,
restriction, condition or provision, such amendment or supplemental indenture may provide for a particular period of grace after default (which period may be shorter or longer than that allowed in the case of other defaults) or may provide for an
immediate enforcement upon such an event of default or may limit the remedies available to the trustee upon such an event of default or may limit the right of the holders of a majority in aggregate principal amount of the debt securities of such
series to waive such an event of default;
(7) make any change to any provision of the applicable indenture that does not
adversely affect the rights or interests of any holder of debt securities issued thereunder;
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(8) provide for the issuance of additional debt securities in accordance with the
provisions set forth in the applicable indenture on the date of such indenture;
(9) add any additional defaults or
events of default in respect of all or any series of debt securities;
(10) add to, change or eliminate any of the
provisions of the applicable indenture to such extent as shall be necessary to permit or facilitate the issuance of debt securities in bearer form, registrable or not registrable as to principal, and with or without interest coupons;
(11) change or eliminate any of the provisions of the applicable indenture; provided that any such change or elimination shall
become effective only when there is no debt security outstanding of any series created prior to the execution of such amendment or supplemental indenture that is entitled to the benefit of such provision;
(12) establish the form or terms of debt securities of any series as permitted thereunder, including to reopen any series of any
debt securities as permitted thereunder;
(13) evidence and provide for the acceptance of appointment thereunder by a
successor trustee with respect to the debt securities of one or more series and to add to or change any of the provisions of the applicable indenture as shall be necessary to provide for or facilitate the administration of the trusts thereunder by
more than one trustee, pursuant to the requirements of such indenture;
(14) conform the text of the applicable indenture
(and/or any supplemental indenture) or any debt securities issued thereunder to any provision of a description of such debt securities appearing in a prospectus or prospectus supplement or an offering memorandum or offering circular to the extent
that such provision appears on its face to have been intended to be a verbatim recitation of a provision of such indenture (and/or any supplemental indenture) or any debt securities issued thereunder; or
(15) modify, eliminate or add to the provisions of the applicable indenture to such extent as shall be necessary to effect the
qualification of such indenture under the Trust Indenture Act of 1939, as amended (the Trust Indenture Act), or under any similar federal statute subsequently enacted, and to add to such indenture such other provisions as may be
expressly required under the Trust Indenture Act.
The consent of the holders is not necessary under either indenture to
approve the particular form of any proposed amendment. It is sufficient if such consent approves the substance of the proposed amendment. After an amendment under an indenture becomes effective, CEP is required to mail to the holders of debt
securities thereunder a notice briefly describing such amendment. However, the failure to give such notice to all such holders, or any defect therein, will not impair or affect the validity of the amendment.
Legal Defeasance and Covenant Defeasance
Each indenture provides that CEP may, at its option and at any time, elect to have all of its obligations discharged with respect to the debt securities outstanding thereunder and all obligators of any
guarantors of such debt securities discharged with respect to their guarantees (Legal Defeasance), except for:
(1) the rights of holders of outstanding debt securities to receive payments in respect of the principal of, or interest or premium,
if any, on such debt securities when such payments are due from the trust referred to below;
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(2) CEPs obligations with respect to the debt securities concerning temporary
debt securities, registration of debt securities, mutilated, destroyed, lost or stolen debt securities, the maintenance of an office or agency for payment and money for security payments held in trust;
(3) the rights, powers, trusts, duties and immunities of the trustee, and CEPs and each guarantors obligations in
connection therewith; and
(4) the Legal Defeasance and Covenant Defeasance (as defined below) provisions of the
applicable indenture.
In addition, CEP may, at its option and at any time, elect to have the obligations of CEP released with
respect to certain provisions of each indenture, including certain provisions described in any prospectus supplement (such release and termination being referred to as Covenant Defeasance), and thereafter any failure to comply with such
obligations or provisions will not constitute a default or event of default. In addition, in the event Covenant Defeasance occurs in accordance with the applicable indenture, any defeasible events of default will no longer constitute an event of
default.
In order to exercise either Legal Defeasance or Covenant Defeasance:
(1) CEP must irrevocably deposit with the trustee, in trust, for the benefit of the holders of the debt securities, cash in U.S.
dollars,
non-callable
government securities, or a combination of cash in U.S. dollars and
non-callable
U.S. government securities, in amounts as will be sufficient, in
the opinion of a nationally recognized investment bank, appraisal firm or firm of independent public accountants, to pay the principal of, and interest and premium, if any, on the outstanding debt securities on the stated date for payment thereof or
on the applicable redemption date, as the case may be, and CEP must specify whether the debt securities are being defeased to such stated date for payment or to a particular redemption date;
(2) in the case of Legal Defeasance, CEP must deliver to the trustee an opinion of counsel to the trustee confirming that
(a) CEP has received from, or there has been published by, the Internal Revenue Service a ruling or (b) since the issue date of the debt securities, there has been a change in the applicable federal income tax law, in either case to the
effect that, and based thereon such opinion of counsel will confirm that, the holders of the outstanding debt securities will not recognize income, gain or loss for federal income tax purposes as a result of such Legal Defeasance and will be subject
to federal income tax on the same amounts, in the same manner and at the same time as would have been the case if such Legal Defeasance had not occurred;
(3) in the case of Covenant Defeasance, CEP must deliver to the trustee an opinion of counsel to the trustee confirming that the holders of the outstanding debt securities will not recognize income,
gain or loss for federal income tax purposes as a result of such Covenant Defeasance and will be subject to federal income tax on the same amounts, in the same manner and at the same times as would have been the case if such Covenant Defeasance had
not occurred;
(4) no default or event of default shall have occurred and be continuing on the date of such deposit
(other than a default or event of default resulting from the borrowing of funds to be applied to such deposit);
(5) the
deposit must not result in a breach or violation of, or constitute a default under, any other instrument to which CEP or any guarantor is a party or by which CEP is bound;
(6) such Legal Defeasance or Covenant Defeasance must not result in a breach or violation of, or constitute a default under, any material agreement or instrument (other than the applicable indenture)
to which CEP or any of its subsidiaries is a party or by which CEP or any of its subsidiaries is bound;
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(7) CEP must deliver to the trustee an officers certificate stating that the
deposit was not made by CEP with the intent of preferring the holders of debt securities over the other creditors of CEP with the intent of defeating, hindering, delaying or defrauding creditors of CEP or the creditors of others;
(8) CEP must deliver to the trustee an officers certificate, stating that all conditions precedent set forth in clauses
(1) through (6) of this paragraph have been complied with; and
(9) CEP must deliver to the trustee an opinion
of counsel (which opinion of counsel may be subject to customary assumptions, qualifications, and exclusions) stating that all conditions precedent set forth in clauses (2), (3) and (6) of this paragraph have been complied with.
Satisfaction and Discharge
Each of the indentures will be discharged and will cease to be of further effect (except as to surviving rights of registration of transfer or exchange of debt securities and certain rights of the
trustee, as expressly provided for in such indenture) as to all outstanding debt securities and guarantees issued thereunder when:
(1) either (a) all of the debt securities theretofore authenticated and delivered under such indenture (except lost, stolen or destroyed debt securities that have been replaced or paid and debt
securities for whose payment money has theretofore been deposited in trust or segregated and held in trust by CEP and thereafter repaid to CEP or discharged from such trust) have been delivered to the trustee for cancellation or (b) all debt
securities not theretofore delivered to the trustee for cancellation have become due and payable or will become due and payable at their stated maturity within one year, or are to be called for redemption within one year under arrangements
satisfactory to the trustee for the giving of notice of redemption by the trustee in the name, and at the expense, of CEP, and CEP or the guarantors, if any, have irrevocably deposited or caused to be deposited with the trustee funds in an amount
sufficient to pay and discharge the entire indebtedness on the debt securities not theretofore delivered to the trustee for cancellation, for principal of and premium, if any, and interest on the debt securities to the date of deposit (in the case
of debt securities that have become due and payable) or to the stated maturity or redemption date, as the case may be, together with instructions from CEP irrevocably directing the trustee to apply such funds to the payment thereof at maturity or
redemption, as the case may be;
(2) CEP has paid all other sums then due and payable under such indenture by CEP; and
(3) CEP has delivered to the trustee an officers certificate and an opinion of counsel, which state that all
conditions precedent under such indenture relating to the satisfaction and discharge of such indenture have been complied with.
No Personal Liability of Directors, Managers, Officers, Employees, Partners, Members and Unitholders
No director,
manager, officer, employee, incorporator, partner, member or unitholder of CEP or its subsidiaries, as such, shall have any liability for any obligations of CEP under the debt securities, the indentures, the guarantees or for any claim based on, in
respect of, or by reason of, such obligations or their creation. Each holder of debt securities, upon CEPs issuance of the debt securities and execution of the indentures, waives and releases all such liability. The waiver and release are part
of the consideration for issuance of the debt securities. Such waiver may not be effective to waive liabilities under the federal securities laws and it is the view of the SEC that such a waiver is against public policy.
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Denominations
Unless stated otherwise in the prospectus supplement for each issuance of debt securities, the debt securities will be issued in
denominations of $1,000 each or integral multiples of $1,000.
Paying Agent and Registrar
The trustee will initially act as paying agent and registrar for the debt securities. CEP may change the paying agent or registrar without
prior notice to the holders of the debt securities, and CEP may act as paying agent or registrar.
Transfer and
Exchange
A holder may transfer or exchange debt securities in accordance with the applicable indenture. The registrar and
the trustee may require a holder, among other things, to furnish appropriate endorsements and transfer documents, and CEP may require a holder to pay any taxes and fees required by law or permitted by the applicable indenture. CEP is not required to
transfer or exchange any debt security selected for redemption. In addition, CEP is not required to transfer or exchange any debt security for a period of 15 days before a selection of debt securities to be redeemed.
Subordination
The payment of the principal of, any premium on and interest on, subordinated debt securities and any other payment obligations of CEP in respect of subordinated debt securities (including any obligation
to repurchase subordinated debt securities) is subordinated in certain circumstances in right of payment, as set forth in the subordinated indenture, to the prior payment in full in cash of all senior debt.
CEP also may not make any payment, whether by redemption, purchase, retirement, defeasance or otherwise, upon or in respect of
subordinated debt securities, except from the trust described under Legal Defeasance and Covenant Defeasance, if
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a default in the payment of all or any portion of the obligations on any senior debt (payment default) occurs that has not been cured or
waived, or
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any other default occurs and is continuing with respect to designated senior debt pursuant to which the maturity thereof may be accelerated
(non-payment default) and, solely with respect to this clause, the trustee for the subordinated debt securities receives a notice of the default (a Payment Blockage Notice) from the trustee or other representative for the
holders of such designated senior debt.
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Cash payments on subordinated debt securities will be resumed
(a) in the case of a payment default, upon the date on which such default is cured or waived and (b) in case of a nonpayment default, the earliest of the date on which such nonpayment default is cured or waived, the termination of the
payment blockage period by written notice to the trustee for the subordinated debt securities from the trustee or other representative for the holders of such designated senior debt, the payment in full of such designated senior debt or 179 days
after the date on which the applicable Payment Blockage Notice is received. No new payment blockage period may be commenced unless and until 360 days have elapsed since the date of commencement of the payment blockage period resulting from the
immediately prior Payment Blockage Notice. No nonpayment default in respect of designated senior debt that existed or was continuing on the date of delivery of any Payment Blockage Notice to the trustee for the subordinated debt securities will be,
or be made, the basis for a subsequent Payment Blockage Notice unless such default shall have been cured or waived for a period of no less than 90 consecutive days.
Upon any payment or distribution of assets or securities of CEP (other than with the money, securities or proceeds held under any defeasance trust established in accordance with the subordinated
indenture), in connection with any dissolution or winding up or total or partial liquidation or reorganization of CEP,
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whether voluntary or involuntary, or in bankruptcy, insolvency, receivership or other proceedings or other marshalling of assets for the benefit of creditors, all amounts due or to become due
upon all senior debt shall first be paid in full, in cash or cash equivalents, before the holders of the subordinated debt securities or the trustee on their behalf shall be entitled to receive any payment by or on behalf of CEP on account of the
subordinated debt securities, or any payment to acquire any of the subordinated debt securities for cash, property or securities, or any distribution with respect to the subordinated debt securities of any cash, property or securities. Before any
payment may be made by, or on behalf of, CEP on any subordinated debt security (other than with the money, securities or proceeds held under any defeasance trust established in accordance with the subordinated indenture) in connection with any such
dissolution, winding up, liquidation or reorganization, any payment or distribution of assets or securities for CEP, to which the holders of subordinated debt securities or the trustee on their behalf would be entitled, shall be made by CEP or by
any receiver, trustee in bankruptcy, liquidating trustee, agent or other similar Person making such payment or distribution, or by the holders or the trustee if received by them or it, directly to the holders of senior debt or their representatives
or to any trustee or trustees under any indenture pursuant to which any such senior debt may have been issued, as their respective interests appear, to the extent necessary to pay all such senior debt in full, in cash or cash equivalents, after
giving effect to any concurrent payment, distribution or provision therefor to or for the holders of such senior debt.
As a
result of these subordination provisions, in the event of the liquidation, bankruptcy, reorganization, insolvency, receivership or similar proceeding or an assignment for the benefit of the creditors of CEP or a marshalling of assets or liabilities
of CEP, holders of subordinated debt securities may receive ratably less than other creditors.
Payment and
Transfer
Principal, interest and any premium on fully registered debt securities will be paid at designated places.
Payment will be made by check mailed to the persons in whose names the debt securities are registered on days specified in the indentures or any prospectus supplement. Debt securities payments in other forms will be paid at a place designated by us
and specified in a prospectus supplement.
Fully registered debt securities may be transferred or exchanged at the office of
the trustee or at any other office or agency maintained by us for such purposes, without the payment of any service charge except for any tax or governmental charge.
Global Securities
The debt securities of a
series may be issued in whole or in part in the form of one or more global certificates that we will deposit with a depositary identified in the applicable prospectus supplement. Unless and until it is exchanged in whole or in part for the
individual debt securities that it represents, a global security may not be transferred except as a whole:
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by the applicable depositary to a nominee of the depositary;
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by any nominee to the depositary itself or another nominee; or
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by the depositary or any nominee to a successor depositary or any nominee of the successor.
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We will describe the specific terms of the depositary arrangement with respect to a series of debt securities in the applicable
prospectus supplement. We anticipate that the following provisions will generally apply to depositary arrangements.
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When we issue a global security in registered form, the depositary for the global security
or its nominee will credit, on its book-entry registration and transfer system, the respective principal amounts of the individual debt securities represented by that global security to the accounts of persons that have accounts with the depositary
(participants). Those accounts will be designated by the dealers, underwriters or agents with respect to the underlying debt securities or by us if those debt securities are offered and sold directly by us. Ownership of beneficial
interests in a global security will be limited to participants or persons that may hold interests through participants. For interests of participants, ownership of beneficial interests in the global security will be shown on records maintained by
the applicable depositary or its nominee. For interests of persons other than participants, that ownership information will be shown on the records of participants. Transfer of that ownership will be effected only through those records. The laws of
some states require that certain purchasers of securities take physical delivery of securities in definitive form. These limits and laws may impair our ability to transfer beneficial interests in a global security.
As long as the depositary for a global security, or its nominee, is the registered owner of that global security, the depositary or
nominee will be considered the sole owner or holder of the debt securities represented by the global security for all purposes under the applicable indenture. Except as provided below, owners of beneficial interests in a global security:
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will not be entitled to have any of the underlying debt securities registered in their names;
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will not receive or be entitled to receive physical delivery of any of the underlying debt securities in definitive form; and
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will not be considered the owners or holders under the indenture relating to those debt securities.
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Payments of the principal of, any premium on and any interest on individual debt securities represented by a global security registered
in the name of a depositary or its nominee will be made to the depositary or its nominee as the registered owner of the global security representing such debt securities. Neither we, the trustee for the debt securities, any paying agent nor the
registrar for the debt securities will be responsible for any aspect of the records relating to or payments made by the depositary or any participants on account of beneficial interests in the global security.
We expect that the depositary or its nominee, upon receipt of any payment of principal, any premium or interest relating to a global
security representing any series of debt securities, immediately will credit participants accounts with the payments. Those payments will be credited in amounts proportional to the respective beneficial interests of the participants in the
principal amount of the global security as shown on the records of the depositary or its nominee. We also expect that payments by participants to owners of beneficial interests in the global security held through those participants will be governed
by standing instructions and customary practices. This is now the case with securities held for the accounts of customers registered in street name. Those payments will be the sole responsibility of those participants.
If the depositary for a series of debt securities is at any time unwilling, unable or ineligible to continue as depositary and we do not
appoint a successor depositary within 90 days, we will issue individual debt securities of that series in exchange for the global security or securities representing that series. In addition, we may at any time in our sole discretion determine not
to have any debt securities of a series represented by one or more global securities. In that event, we will issue individual debt securities of that series in exchange for the global security or securities. The foregoing is subject to any
limitations described in the applicable prospectus supplement. In any such instance, the owner of the beneficial interest will be entitled to physical delivery of individual debt securities equal in principal amount to the beneficial interest and to
have the debt securities registered in its name. Those individual debt securities will be issued in any authorized denominations.
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Governing Law
Each indenture and the debt securities will be governed by and construed in accordance with the laws of the State of New York.
Information Concerning the Trustee
The Bank of Nova Scotia Trust Company of New York will be the trustee under the indentures. A successor trustee may be appointed in accordance with the terms of the indentures.
The indentures and the provisions of the Trust Indenture Act incorporated by reference therein, will contain certain limitations on the
rights of the trustee, should it become a creditor of us, to obtain payment of claims in certain cases, or to realize on certain property received in respect of any such claim as security or otherwise. The trustee will be permitted to engage in
other transactions; however, if it acquires any conflicting interest (within the meaning of the Trust Indenture Act), it must eliminate such conflicting interest or resign.
A single banking or financial institution may act as trustee with respect to both the subordinated indenture and the senior indenture. If this occurs, and should a default occur with respect to either the
subordinated debt securities or the senior debt securities, such banking or financial institution would be required to resign as trustee under one of the indentures within 90 days of such default, pursuant to the Trust Indenture Act, unless such
default were cured, duly waived or otherwise eliminated.
THE LIMITED LIABILITY COMPANY AGREEMENT
The following is a summary of the material provisions of our limited liability company agreement. Our limited liability
company agreement is incorporated by reference as an exhibit to the registration statement of which this prospectus constitutes a part. We will provide prospective investors with a copy of the form of this agreement upon request at no charge.
We summarize the following provisions of our limited liability company agreement elsewhere in this prospectus:
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with regard to distributions of available cash, please read How We Make Cash Distributions.
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with regard to the transfer of common units, please read Description of the Common UnitsTransfer of Common Units; and
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with regard to allocations of taxable income and taxable loss, please read Material Tax Consequences.
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Organization
Our company was formed in February 2005 and will remain in existence until dissolved in accordance with our limited liability company agreement.
Purpose
Under our limited liability company
agreement, we are permitted to engage, directly or indirectly, in any activity that our board of managers approves and that a limited liability company organized under Delaware law lawfully may conduct; provided, that our board of managers shall not
cause us to engage, directly or indirectly, in any business activities that it determines would cause us to be treated as an association taxable as a corporation or otherwise taxable as an entity for federal income tax purposes.
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Although our board of managers has the ability to cause us and our operating subsidiaries to
engage in activities other than the acquisition, development and exploitation of oil and natural gas properties and related midstream assets, our board of managers has no current plans to do so. Our board of managers is authorized in general to
perform all acts it deems to be necessary or appropriate to carry out our purposes and to conduct our business.
Fiduciary Duties
Our limited liability company agreement provides that the fiduciary duties and obligations owed to us and to our members by our managers and officers is generally limited to their acting in good faith in
the performance of their duties on our behalf. For a description of fiduciary duties, please read Conflicts of Interest and Fiduciary Duties.
Agreement to be Bound by Limited Liability Company Agreement; Power of Attorney
By purchasing a common unit in us, you will be admitted as a member of our company and will be deemed to have agreed to be bound by the terms of our limited liability company agreement. Pursuant to this
agreement, each holder of common units and each person who acquires a common unit from a holder of common units grants to our board of managers (and, if appointed, a liquidator) a power of attorney to, among other things, execute and file documents
required for our qualification, continuance or dissolution. The power of attorney also grants our board of managers the authority to make certain amendments to, and to make consents and waivers under and in accordance with, our limited liability
company agreement.
Capital Contributions
Unitholders (including holders of common units) are not obligated to make additional capital contributions, except as described below
under Limited Liability.
Limited Liability
Unlawful Distributions
The Delaware Limited Liability Company Act (the Delaware Act) provides that any unitholder who receives a distribution and knew at the time of the distribution that the distribution was in
violation of the Delaware Act shall be liable to the company for the amount of the distribution for three years. Under the Delaware Act, a limited liability company may not make a distribution to any unitholder if, after the distribution, all
liabilities of the company, other than liabilities to unitholders on account of their limited liability company interests and liabilities for which the recourse of creditors is limited to specific property of the company, would exceed the fair value
of the assets of the company. For the purpose of determining the fair value of the assets of a company, the Delaware Act provides that the fair value of property subject to liability for which recourse of creditors is limited shall be included in
the assets of the company only to the extent that the fair value of that property exceeds the nonrecourse liability. Under the Delaware Act, an assignee who becomes a substituted unitholder of a company is liable for the obligations of his assignor
to make contributions to the company, except the assignee is not obligated for liabilities unknown to him at the time he became a unitholder and that could not be ascertained from the limited liability company agreement.
Failure to Comply with the Limited Liability Provisions of Jurisdictions in Which We Do Business
Our subsidiaries may be deemed to conduct business in Alabama, Kansas, Nebraska, Oklahoma and Texas. We may decide to conduct business in
other states, and maintenance of limited liability for us, as a member of our operating subsidiaries, may require compliance with legal requirements in the jurisdictions in which the operating subsidiaries conduct business, including qualifying our
subsidiaries to do business there. Limitations on the liability of unitholders for the obligations of a limited liability company have not been clearly established in many jurisdictions. We will operate in a manner that our board of managers
considers reasonable and necessary or appropriate to preserve the limited liability of our unitholders.
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Voting Rights
Holders of our common units and our Class A units have voting rights on most matters. The following matters require the unitholder
vote specified below:
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Election of members of the board of managers
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Our board of managers consists of five members, as required by our limited liability company agreement. Except as set forth below, at each annual meeting of our unitholders, Class A
unitholders, voting as a single class, will elect two managers and the holders of our common units, voting together as a single class, will elect the remaining three managers. Please read Election of Members of Our Board of
Managers, Removal of Members of Our Board of Managers and Elimination of Special Voting Rights of Class A Units.
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Issuance of additional securities including common units
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No approval right.
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Amendment of the limited liability company agreement
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Certain amendments may be made by our board of managers without unitholder approval. Other amendments generally require the approval of both a common unit majority and Class A unit
majority. Please read Amendment of Our Limited Liability Company Agreement.
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Merger of our company or the sale of all or substantially all of our assets
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Common unit majority and Class A unit majority. Please read
Merger, Sale or Other Disposition of Assets.
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Dissolution of our company
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Common unit majority and Class A unit majority. Please read
Termination and Dissolution.
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Matters requiring the approval of a common unit majority require the approval of at least a
majority of the outstanding common units voting together as a single class. In addition, matters requiring the approval of a Class A unit majority require the approval of at least a majority of the outstanding Class A units voting
together as a single class.
Issuance of Additional Securities
Our limited liability company agreement authorizes us to issue an unlimited number of additional securities and authorizes us to buy
securities for the consideration and on the terms and conditions determined by our board of managers without the approval of our unitholders.
It is possible that we will fund acquisitions through the issuance of additional common units or other equity securities. Holders of any additional common units we issue will be entitled to share equally
with the then-existing holders of common units, Class A units and management incentive interests in our distributions of available cash. Also, the issuance of additional common units or other equity securities may dilute the value of the
interests of the then-existing holders of common units in our net assets.
In accordance with Delaware law and the provisions
of our limited liability company agreement, we may also issue additional securities that, as determined by our board of managers, may have special voting or other rights to which the common and Class A units are not entitled.
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The holders of common and Class A units will not have preemptive or preferential rights to
acquire additional units or other securities.
Election of Members of Our Board of Managers
At our first annual meeting of the holders of our Class A units and our common unitholders following our initial public offering:
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two members of our board of managers were elected by CEPM, as the holder of all of our Class A units; and
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three members of our board of managers were elected by our common unitholders.
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The board of managers will be subject to
re-election
on an annual basis in this manner at our annual meeting of
the holders of our Class A units and our common unitholders.
Removal of Members of Our Board of Managers
Any manager elected by the holder of our Class A units may be removed, with or without cause, by the holders of
66 2/3% of the outstanding Class A units then entitled to vote at an election of managers. Any manager elected by the holders of our common units may be removed, with or without cause, by the holders of at least a majority of the outstanding
common units then entitled to vote at an election of managers.
Increase in the Size of Our Board of Managers
The size of our board of managers may increase only with the approval of the holders of 66 2/3% outstanding
Class A units. If the size of our board of managers is so increased, the vacancy created thereby shall be filled by a person appointed by our board of managers or a nominee approved by a majority vote of our common unitholders, unless such
vacancy is specified by an amendment to our limited liability company agreement as a vacancy to be filled by our Class A unitholders, in which case such vacancy shall be filled by a person approved by our Class A unitholders.
Elimination of Special Voting Rights of Class A Units
The holders of our Class A units have the right, voting as a separate class, to elect two of the five members of our board of
managers and any replacement of either of such members, subject to the matters described under Election of Members of Our Board of ManagersIncrease in the Size of Our Board of Managers above. This right can be eliminated only
upon a proposal submitted by or with the consent of our board of managers and the vote of the holders of not less than 66 2/3% of our outstanding common units. If such elimination is so approved and Constellation and its affiliates do not vote their
common units in favor of such elimination, the Class A units will be converted into common units on a
one-for-one
basis and CEPM will have the right to convert its
management incentive interests into common units based on the then-fair market value of such interests.
Amendment of Our Limited Liability Company Agreement
General
Amendments to our limited liability company agreement may be proposed only by or with the consent of our board of managers. To adopt a proposed amendment, other than the amendments discussed below, our
board of managers is required to seek written approval of the holders of the number of units required to approve the amendment or call a meeting of our unitholders to consider and vote upon the proposed amendment. Except as described below, an
amendment must be approved by a common unit majority and a Class A unit majority.
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Prohibited Amendments
No amendment may be made that would:
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enlarge the obligations of any unitholder without its consent, unless approved by at least a majority of the type or class of member interests so
affected;
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provide that we are not dissolved upon an election to dissolve our company by our board of managers that is approved by a common unit majority and a
Class A unit majority;
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entitle members holding common units and/or Class A units to more or less than one vote per unit;
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prohibit the holders of Class A units from acting without a meeting;
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change the procedures for notice to members of business to be brought before a meeting and nominations to board of managers;
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require some percentage other than a majority of votes cast affirmatively or negatively by members holding units for approval of matters submitted for
a member vote;
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allow the calling of a special meeting by other than a majority of the board of managers;
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change the term of existence of our company;
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give any person the right to dissolve our company other than our board of managers right to dissolve our company with the approval of a common
unit majority and a Class A unit majority; or
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enlarge the size of our board of managers without the approval of the holders of 66 2/3% of our Class A units.
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The provision of our limited liability company agreement preventing the amendments having the effects described in any of the clauses
above can be amended upon the approval of the holders of at least 75% of the outstanding common units, voting together as a single class, and 75% of the outstanding Class A units, voting together as a single class.
No Unitholder Approval
Our board of managers may generally make amendments to our limited liability company agreement without unitholder approval to reflect:
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a change in our name, the location of our principal place of our business, our registered agent or our registered office;
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the admission, substitution, withdrawal or removal of members in accordance with our limited liability company agreement;
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a change that our board of managers determines to be necessary or appropriate for us to qualify or continue our qualification as a company in which our
members have limited liability under the laws of any state or to ensure that neither we, our operating subsidiaries nor any of its subsidiaries will be treated as an association taxable as a corporation or otherwise taxed as an entity for federal
income tax purposes;
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the merger of our company or any of its subsidiaries into, or the conveyance of all of our assets to, a newly formed entity if the sole purpose of that
merger or conveyance is to effect a mere change in our legal form into another limited liability entity;
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an amendment that is necessary, in the opinion of our counsel, to prevent us, members of our board, or our officers, agents or trustees from in any
manner being subjected to the provisions of the Investment Company Act of 1940, the Investment Advisors Act of 1940, or plan asset regulations adopted under the Employee Retirement Income Security Act of 1974 (ERISA) whether
or not substantially similar to plan asset regulations currently applied or proposed;
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an amendment that our board of managers determines to be necessary or appropriate for the authorization of additional securities or rights to acquire
securities;
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any amendment expressly permitted in our limited liability company agreement to be made by our board of managers acting alone;
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an amendment effected, necessitated or contemplated by a merger agreement that has been approved under the terms of our limited liability company
agreement;
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any amendment that our board of managers determines to be necessary or appropriate for the formation by us of, or our investment in, any corporation,
partnership or other entity, as otherwise permitted by our limited liability company agreement;
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a change in our fiscal year or taxable year and related changes;
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a merger, conversion or conveyance effected in accordance with the limited liability company agreement; and
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any other amendments substantially similar to any of the matters described in the clauses above.
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In addition, our board of managers may make amendments to our limited liability company agreement without unitholder approval if our
board of managers determines that those amendments:
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do not adversely affect the unitholders (including any particular class of unitholders as compared to other classes of unitholders) in any material
respect;
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are necessary or appropriate to satisfy any requirements, conditions or guidelines contained in any opinion, directive, order, ruling or regulation of
any federal or state agency or judicial authority or contained in any federal or state statute;
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are necessary or appropriate to facilitate the trading of common units or to comply with any rule, regulation, guideline or requirement of any
securities exchange on which the common units are or will be listed for trading, compliance with any of which our board of managers deems to be in the best interests of us and our common unitholders;
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are necessary or appropriate for any action taken by our board of managers relating to splits or combinations of units under the provisions of our
limited liability company agreement; or
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are required to effect the intent expressed in this prospectus or the intent of the provisions of our limited liability company agreement or are
otherwise contemplated by our limited liability company agreement.
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Opinion of Counsel and Unitholder
Approval
Our board of managers will not be required to obtain an opinion of counsel that an amendment will not result
in a loss of limited liability to our unitholders or result in our being treated as an entity for federal income tax purposes if one of the amendments described above under No Unitholder Approval should occur. No other amendments
to our limited liability company agreement will become effective without the approval of holders of at least 90% of the common units and Class A units unless we obtain an opinion of counsel to the effect that the amendment will not affect the
limited liability under applicable law of any unitholder of our company.
Any amendment that would have a material adverse
effect on the rights or preferences of any type or class of outstanding units in relation to other classes of units will require the approval of at least a majority of the type or class of units so affected. Any amendment that reduces the voting
percentage required to take any action is required to be approved by the affirmative vote of unitholders whose aggregate outstanding units constitute not less than the voting requirement sought to be reduced.
Merger, Sale or Other Disposition of Assets; Conversion
Our board of managers is generally prohibited, without the prior approval of a common unit majority and a Class A unit majority from
causing us to, among other things, sell, exchange or otherwise dispose of all or substantially all of our assets in a single transaction or a series of related transactions, including by way of merger, consolidation or other combination, or
approving on our behalf the sale, exchange or other disposition of all or substantially all of the assets of our subsidiaries, provided that our board of managers may mortgage, pledge, hypothecate or grant a security interest in all or substantially
all of our assets without that approval. Our board of managers may also sell all or substantially all of our assets under a foreclosure or other realization upon the encumbrances above without that approval.
If the conditions specified in the limited liability company agreement are satisfied, our board of managers may merge our company or any
of its subsidiaries into, or convey all of our assets to, a newly formed entity if the sole purpose of that merger or conveyance is to effect a mere change in our legal form into another limited liability entity. Additionally, the Company may
convert into any other entity as defined in the Delaware Limited Liability Company Act, whether such entity is formed under the laws of the State of Delaware or any other state in the United States of America. Our unitholders are not
entitled to dissenters rights of appraisal under the limited liability company agreement or applicable Delaware law in the event of a merger or consolidation, a sale of all or substantially all of our assets or any other transaction or event.
Termination and Dissolution
We will continue as a company until terminated under our limited liability company agreement. We will dissolve upon: (1) the election of our board of managers to dissolve us, if approved by a common
unit majority and a Class A unit majority; (2) the sale, exchange or other disposition of all or substantially all of the assets and properties of our company and our subsidiaries; or (3) the entry of a decree of judicial dissolution
of our company.
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Liquidation and Distribution of Proceeds
Upon our dissolution, the liquidator authorized to wind up our affairs will, acting with all of the powers of our board of managers that
the liquidator deems necessary or desirable in its judgment, liquidate our assets and apply the proceeds of the liquidation as provided in How We Make Cash DistributionsDistributions of Cash Upon Liquidation. The liquidator may
defer liquidation or distribution of our assets for a reasonable period of time or distribute assets to unitholders in kind if it determines that a sale would be impractical or would cause undue loss to our unitholders.
Anti-Takeover Provisions
Our limited liability company agreement contains specific provisions that are intended to discourage a person or group from attempting to take control of our company without the approval of our board of
managers. Specifically, our limited liability company agreement provides that we will elect to have Section 203 of the DGCL apply to transactions in which an interested common unitholder (as described below) seeks to enter into a merger or
business combination with us. Under this provision, such a holder will not be permitted to enter into a merger or business combination with us unless:
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prior to such time, our board of managers approved either the business combination or the transaction that resulted in the common unitholders
becoming an interested common unitholder;
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upon consummation of the transaction that resulted in the common unitholder becoming an interested common unitholder, the interested common unitholder
owned at least 85% of our outstanding common units at the time the transaction commenced, excluding for purposes of determining the number of common units outstanding those common units owned:
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by persons who are managers and also officers; and
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by employee common unit plans in which employee participants do not have the right to determine confidentially whether common units held subject to the
plan will be tendered in a tender or exchange offer; or
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at or subsequent to such time the business combination is approved by our board of managers and authorized at an annual or special meeting of our
common unitholders, and not by written consent, by the affirmative vote of the holders of at least 66 2/3% of our outstanding voting common units that are not owned by the interested common unitholder.
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Section 203 of the DGCL defines business combination to include:
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any merger or consolidation involving the company and the interested common unitholder;
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any sale, transfer, pledge or other disposition of 10% or more of the assets of the company involving the interested common unitholder;
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subject to certain exceptions, any transaction that results in the issuance or transfer by the company of any common units of the company to the
interested common unitholder;
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any transaction involving the company that has the effect of increasing the proportionate share of the units of any class or series of the company
beneficially owned by the interested common unitholder; or
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the receipt by the interested common unitholder of the benefit of any loans, advances, guarantees, pledges or other financial benefits provided by or
through the company.
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In general, by reference to Section 203, an interested common unitholder is
any person or entity, other than Constellation, CEPM, their affiliates or transferees, that beneficially owns (or within three years did own) 15% or more of the outstanding common units of the company and any entity or person affiliated with or
controlling or controlled by such entity or person.
The existence of this provision would be expected to have an
anti-takeover effect with respect to transactions not approved in advance by our board of managers, including discouraging attempts that might result in a premium over the market price for common units held by common unitholders.
Our limited liability agreement also restricts the voting rights of common unitholders by providing that any units held by a person that
owns 20% or more of any class of units then outstanding, other than Constellation, CEPM, their affiliates or transferees and persons who acquire such units with the prior approval of the board of managers, cannot vote on any matter.
Limited Call Right
If at any time any person owns more than 80% of the then-issued and outstanding common units, it will have the right, which it may assign in whole or in part to any of its affiliates or to us, to acquire
all, but not less than all, of the remaining common units held by unaffiliated persons as of a record date to be selected by our board of managers, on at least 10 days but not more than 60 days notice. The common unitholders are not entitled to
dissenters rights of appraisal under the limited liability company agreement or applicable Delaware law if this limited call right is exercised. The purchase price in the event of this purchase is the greater of:
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the highest cash price paid by such person for any common units purchased within the 90 days preceding the date on which such person first mails notice
of its election to purchase the remaining common units; and
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the closing market price of the common units as of the date three days before the date the notice is mailed.
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As a result of this limited call right, a holder of common units may have his limited liability company interests purchased at an
undesirable time or price. The tax consequences to a common unitholder of the exercise of this call right are the same as a sale by that common unitholder of his common units in the market. Please read Material Tax
ConsequencesDisposition of Units.
Meetings; Voting
All notices of meetings of unitholders shall be sent or otherwise given in accordance with Sections 11.4 and 14.1 of our limited liability
company agreement not less than 10 days nor more than 60 days before the date of the meeting. The notice shall specify the place, date and hour of the meeting and (i) in the case of a special meeting, the general nature of the business to be
transacted (no business other than that specified in the notice may be transacted) or (ii) in the case of the annual meeting, those matters which the board of managers, at the time of giving the notice, intends to present for action by the
unitholders (but any proper matter may be presented at the meeting for such action). The notice of any meeting at which managers are to be elected shall include the name of any nominee or nominees who, at the time of the notice, the board of
managers intends to present for election. Any previously scheduled meeting of the unitholders may be postponed, and any special meeting of the unitholders may be cancelled, by resolution of the board of managers upon public notice given prior to the
date previously scheduled for such meeting of unitholders.
Units that are owned by an assignee who is a record holder, but
who has not yet been admitted as a member, shall be voted at the written direction of the record holder by a proxy designated by our board of managers. Absent direction of this kind, the units will not be voted, except that units held by us on
behalf of
non-citizen
assignees shall be voted in the same ratios as the votes of unitholders on other units are cast.
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Any action required or permitted to be taken by our common unitholders must be effected at a
duly called annual or special meeting of unitholders and may not be effected by any consent in writing by such common unitholders.
Special meetings of the unitholders may only be called by a majority of our board of managers. Unitholders may vote either in person or by proxy at meetings. The holders of a majority of the outstanding
units for which a meeting has been called represented in person or by proxy shall constitute a quorum unless any action by the unitholders requires approval by holders of a greater percentage of the units, in which case the quorum shall be the
greater percentage.
Each record holder of a unit has a vote according to his percentage interest in us, although additional
units having special voting rights could be issued. Please read Issuance of Additional Securities. Units held in nominee or street name accounts will be voted by the broker or other nominee in accordance with the instruction of the
beneficial owner unless the arrangement between the beneficial owner and its nominee provides otherwise.
Any notice, demand,
request, report or proxy material required or permitted to be given or made to record holders of units under our limited liability company agreement will be delivered to the record holder by us or by the transfer agent.
Our limited liability agreement also restricts the voting rights of common unitholders by providing that any units held by a person that
owns 20% or more of any class of units then outstanding, other than Constellation, CEPM, their affiliates or transferees and persons who acquire such units with the prior approval of the board of managers, cannot vote on any matter.
Non-Citizen
Assignees; Redemption
If we or any of our subsidiaries are or become subject to federal, state or local laws or regulations that, in the reasonable
determination of our board of managers, create a substantial risk of cancellation or forfeiture of any property that we have an interest in because of the nationality, citizenship or other related status of any unitholder or assignee, we may redeem,
upon 30 days advance notice, the units held by the unitholder or assignee at their current market price. To avoid any cancellation or forfeiture, our board of managers may require each unitholder or assignee to furnish information about his
nationality, citizenship or related status. If a unitholder or assignee fails to furnish information about his nationality, citizenship or other related status within 30 days after a request for the information or our board of managers determines
after receipt of the information that the unitholder or assignee is not an eligible citizen, the unitholder or assignee may be treated as a
non-citizen
assignee. In addition to other limitations on the rights
of an assignee who is not a substituted unitholder, a
non-citizen
assignee does not have the right to direct the voting of his units and may not receive distributions in kind upon our liquidation.
Indemnification
Under our limited liability company agreement and subject to specified limitations, we will indemnify to the fullest extent permitted by law from and against all losses, claims, damages or similar events
any person who is or was our manager or officer, or while serving as our manager or officer, is or was serving as a tax matters member or, at our request, as a manager, officer, tax matters member, employee, partner, fiduciary or trustee of us or
any of our subsidiaries. Additionally, we shall indemnify to the fullest extent permitted by law and authorized by our board of managers, from and against all losses, claims, damages or similar events, any person who is or was an employee or agent
(other than an officer) of our company.
Any indemnification under our limited liability company agreement will only be out of
our assets. We are authorized to purchase insurance against liabilities asserted against and expenses incurred by persons for our activities, regardless of whether we would have the power to indemnify the person against liabilities under our limited
liability company agreement.
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Books and Reports
We are required to keep appropriate books of our business at our principal offices. The books will be maintained for both tax and
financial reporting purposes on an accrual basis. For tax and fiscal reporting purposes, our fiscal year is the calendar year.
We will furnish or make available to record holders of units, within 120 days after the close of each fiscal year, an annual report
containing audited financial statements and a report on those financial statements by our independent public accountants. Except for our fourth quarter, we will also furnish or make available summary financial information within 90 days after the
close of each quarter.
We will furnish each record holder of a unit with information reasonably required for tax reporting
purposes within 90 days after the close of each calendar year. This information is expected to be furnished in summary form so that some complex calculations normally required of unitholders can be avoided. Our ability to furnish this summary
information to unitholders will depend on the cooperation of unitholders in supplying us with specific information. Every unitholder will receive information to assist him in determining his federal and state tax liability and filing his federal and
state income tax returns, regardless of whether he supplies us with information.
Right To Inspect Our Books and
Records
Our limited liability company agreement provides that a unitholder can, for a purpose reasonably related to his
interest as a unitholder, upon reasonable demand and at his own expense, have furnished to him:
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a current list of the name and last known address of each unitholder;
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a copy of our tax returns;
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information as to the amount of cash, and a description and statement of the agreed value of any other property or services, contributed or to be
contributed by each unitholder and the date on which each became a unitholder;
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copies of our limited liability company agreement, the certificate of formation of the company, related amendments and powers of attorney under which
they have been executed;
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information regarding the status of our business and financial condition; and
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any other information regarding our affairs as is just and reasonable.
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Our board of managers may, and intends to, keep confidential from our unitholders information that it believes to be in the nature of
trade secrets or other information, the disclosure of which our board of managers believes in good faith is not in our best interests, information that could damage our company or our business, or information that we are required by law or by
agreements with a third-party to keep confidential.
Registration Rights
We have agreed to register for sale under the Securities Act and applicable state securities laws any common units or other of our
securities held by CEPM, CEPH or any of their affiliates if an exemption from the registration requirements is not otherwise available. These registration rights continue for two
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years following any termination of the special voting rights of the holders of our Class A units. We have also agreed to include any of our securities held by CEPM, CEPH or their affiliates
in any registration statement that we file to offer our securities for cash, except an offering relating solely to an employee benefit plan, for the same period. We are obligated to pay all expenses incidental to the registration, excluding
underwriting discounts and commissions.
DESCRIPTION OF WARRANTS
We may issue warrants to purchase common units, debt securities or rights. We may issue warrants independently or together with other
securities that may be attached to or separate from the warrants. If we issue warrants, we may do so under one or more warrant agreements between us and a warrant agent that we will name in the prospectus supplement.
The prospectus supplement relating to any warrants being offered will include specific terms relating to the offering. These terms will
include some or all of the following:
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the title of the warrants;
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the securities purchasable upon the exercise of such warrants;
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the aggregate number of warrants to be issued;
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the principal amount of securities purchasable upon exercise of each warrant;
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the price or prices at which each warrant will be issued;
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the procedures for exercising the warrants;
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the date upon which the exercise of warrants will commence;
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the expiration date, and any other material terms of the warrants; and
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any other terms of such warrants, including the terms, procedures and limitations relating to the exchange and exercise of such warrants.
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The warrants do not confer upon the holders thereof any voting or other rights of unitholders.
DESCRIPTION OF RIGHTS
We may issue rights to purchase our common units, debt securities or warrants. The rights may be issued independently or together with any other security offered hereby and may or may not be transferable
by the persons purchasing or receiving the rights in such offering. In connection with any offering of such rights, we may enter into a standby underwriting or other arrangement with one or more underwriters or other purchasers pursuant to which
such underwriters or other purchasers may be required to purchase any offered securities remaining unsubscribed for after such rights offering.
Each series of rights will be issued under a separate rights agreement that we will enter into with one or more banks, trust companies or other financial institutions, as rights agent, all of which will
be set forth in the applicable prospectus supplement. The rights agent will act solely as our agent in connection with the certificates relating to the rights and will not assume any obligation or relationship of agency or trust for or with any
holders of rights certificates or beneficial owners of rights.
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The applicable prospectus supplement relating to any rights that we offer will include
specific terms of any offering of rights for which this prospectus is being delivered, including the following:
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the price, if any, per right;
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the exercise price payable for each common unit, debt security or warrant upon the exercise of the rights;
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the number of rights issued or to be issued to each unitholder;
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the number and terms of the common units, debt securities or warrants that may be purchased per each right;
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the extent to which the rights are transferable;
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any other terms of the rights, including the terms, procedures and limitations relating to the exchange and exercise of the rights;
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the respective dates on which the holders ability to exercise the rights will commence and will expire;
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the extent to which the rights may include an over-subscription privilege with respect to unsubscribed securities; and
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if applicable, the material terms of any standby underwriting or purchase arrangement entered into by us in connection with the offering of such
rights.
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The description in the applicable prospectus supplement of any rights that we may offer will not
necessarily be complete and will be qualified in its entirety by reference to the applicable rights certificate, which will be filed with the SEC.
MATERIAL TAX CONSEQUENCES
This section is a
discussion of the material U.S. federal tax consequences that may be relevant to prospective common unitholders who are individual citizens or residents of the United States and, unless otherwise noted in the following discussion, is the opinion of
Andrews Kurth LLP, counsel to us, insofar as it relates to matters of U.S. federal income tax law and legal conclusions with respect to those matters. This section is based on current provisions of the Internal Revenue Code of 1986, as amended,
existing and proposed regulations and current administrative rulings and court decisions, all of which are subject to change. Later changes in these authorities may cause the tax consequences to vary substantially from the consequences described
below. Unless the context otherwise requires, references in this section to us or we are references to Constellation Energy Partners LLC and our limited liability company operating subsidiaries.
This section does not address all U.S. federal income tax matters that affect us or common unitholders. Furthermore, this section focuses
on common unitholders who are individual citizens or residents of the United States whose functional currency is the U.S. dollar and who hold units as a capital asset (generally, property that is held as an investment) and has no application to
corporations, partnerships (and entities treated as partnerships for U.S. federal income tax purposes), estates, trusts,
non-resident
aliens or other common unitholders subject to specialized tax treatment,
such as
tax-exempt
institutions, foreign persons, individual retirement accounts (IRAs), employee benefit plans, real estate investment trusts (REITs) or mutual funds. Accordingly, we urge each prospective
common unitholder to consult with his own tax advisor in analyzing the U.S. federal, state, local and foreign tax consequences particular to him of the ownership or disposition of our units.
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No ruling has been or will be requested from the IRS regarding any matter that affects us or
prospective common unitholders. Instead, we rely on opinions and advice of Andrews Kurth LLP. Unlike a ruling, an opinion of counsel represents only that counsels best legal judgment and does not bind the IRS or the courts. Accordingly, the
opinions and statements made in this discussion may not be sustained by a court if contested by the IRS. Any contest of this sort with the IRS may materially and adversely impact the market for our units and the prices at which our units trade. In
addition, the costs of any contest with the IRS, principally legal, accounting and related fees, will result in a reduction in cash available for distribution to our common unitholders and thus will be borne directly by our common unitholders.
Furthermore, the tax treatment of us, or of an investment in us, may be significantly modified by future legislative or administrative changes or court decisions. Any modifications may or may not be retroactively applied.
All statements regarding matters of law and legal conclusions set forth below, unless otherwise noted, are the opinion of Andrews Kurth
LLP and are based on the accuracy of the representations made by us. Statements of fact do not represent opinions of Andrews Kurth LLP.
For the reasons described below, Andrews Kurth LLP has not rendered an opinion with respect to the following specific U.S. federal income tax issues:
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the treatment of a common unitholder whose units are loaned to a short seller to cover a short sale of units (please read Tax Consequences
of Unit OwnershipTreatment of Short Sales);
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whether our monthly convention for allocating taxable income and losses is permitted by existing Treasury Regulations (please read
Disposition of UnitsAllocations Between Transferors and Transferees); and
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whether our method for depreciating Section 743 adjustments is sustainable in certain cases (please read Tax Consequences of Unit
OwnershipSection 754 Election and Uniformity of Units).
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Partnership Status
Except as discussed in the following paragraph, a limited liability company that has more than one member and that has not elected to be treated as a corporation is treated as a partnership for U.S.
federal income tax purposes and, therefore, is not a taxable entity and incurs no U.S. federal income tax liability. Instead, each partner is required to take into account his respective share of items of our income, gain, loss and deduction of the
partnership in computing his U.S. federal income tax liability, even if no cash distributions are made to him. Distributions by a partnership to a partner are generally not taxable to the partner unless the amount of cash distributed to him is in
excess of his adjusted basis in his partnership interest.
Section 7704 of the Internal Revenue Code provides that
publicly traded partnerships will, as a general rule, be taxed as corporations. However, an exception, referred to in this discussion as the Qualifying Income Exception, exists with respect to publicly traded partnerships for which 90%
or more of the gross income for every taxable year consists of qualifying income. Qualifying income includes income and gains derived from the exploration, development, mining or production, processing, transportation and marketing of
natural resources, including oil, natural gas, and products thereof. Other types of qualifying income include interest (other than from a financial business), dividends, gains from the sale of real property and gains from the sale or other
disposition of capital assets held for the production of income that otherwise constitutes qualifying income. We estimate that less than 3% of our current gross income does not constitute qualifying income; however, this estimate could change from
time to time. Based on and
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subject to this estimate, the factual representations made by us, and a review of the applicable legal authorities, Andrews Kurth LLP is of the opinion that more than 90% of our current gross
income constitutes qualifying income. The portion of our income that is qualifying income can change from time to time.
No
ruling has been or will be sought from the IRS, and the IRS has made no determination as to our status or the status of our operating subsidiaries for U.S. federal income tax purposes or whether our operations generate qualifying income
under Section 7704 of the Internal Revenue Code. Instead, we will rely on the opinion of Andrews Kurth LLP. Andrews Kurth LLP is of the opinion, based upon the Internal Revenue Code, its regulations, published revenue rulings, court decisions
and factual representations made by us, that we are and will continue to be classified as a partnership, and each of our operating subsidiaries will be disregarded as an entity separate from us, for U.S. federal income tax purposes.
In rendering its opinion, Andrews Kurth LLP has relied on factual representations made by us. The representations made by us upon which
Andrews Kurth LLP has relied include, without limitation:
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Neither we nor any of our limited liability company subsidiaries have elected or will elect to be treated as a corporation; and
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For each taxable year, more than 90% of our gross income has been and will be income that Andrews Kurth LLP has opined or will opine is
qualifying income within the meaning of Section 7704(d) of the Internal Revenue Code.
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If
we fail to meet the Qualifying Income Exception, other than a failure that is determined by the IRS to be inadvertent and that is cured within a reasonable time after discovery, we will be treated as if we had transferred all of our assets, subject
to liabilities, to a newly formed corporation, on the first day of the year in which we fail to meet the Qualifying Income Exception, in return for stock in that corporation and then distributed that stock to common unitholders in liquidation of
their interests in us. This deemed contribution and liquidation would be
tax-free
to common unitholders and us so long as we, at that time, do not have liabilities in excess of the tax basis of our assets.
Thereafter, we would be treated as a corporation for U.S. federal income tax purposes.
If we were taxable as a corporation
for U.S. federal income tax purposes in any taxable year, either as a result of a failure to meet the Qualifying Income Exception or otherwise, our items of income, gain, loss and deduction would be reflected only on our tax return rather than being
passed through to common unitholders, and our net income would be taxed to us at corporate rates. In addition, any distribution made to a common unitholder would be treated as taxable dividend income to the extent of our current or accumulated
earnings and profits, or, in the absence of earnings and profits, a nontaxable return of capital to the extent of the common unitholders tax basis in his units, or taxable capital gain, after the common unitholders tax basis in his units
is reduced to zero. Accordingly, taxation as a corporation would result in a material reduction in a common unitholders cash flow and
after-tax
return and thus would likely result in a substantial
reduction of the value of the units.
The remainder of this section assumes that we are and will continue to be classified as
a partnership for U.S. federal income tax purposes.
Common Unitholder Status
Common unitholders who become members of CEP will be treated as partners of CEP for U.S. federal income tax purposes. Also, common
unitholders whose units are held in street name or by a nominee and who have the right to direct the nominee in the exercise of all substantive rights attendant to the ownership of their units will be treated as partners of CEP for U.S. federal
income tax purposes. A beneficial owner of units whose units have been transferred to a short seller to complete a short sale would appear to lose his
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status as a partner with respect to those units for U.S. federal income tax purposes. Please read Tax Consequences of Unit OwnershipTreatment of Short Sales. As there is
no direct or indirect controlling authority addressing assignees of common units who are entitled to execute and deliver transfer applications and thereby become entitled to direct the exercise of attendant rights, but who fail to execute and
deliver transfer applications, Andrews Kurth LLPs opinion does not extend to these persons. Furthermore, a purchaser or other transferee of common units who does not execute and deliver a transfer application may not receive some U.S. federal
income tax information or reports furnished to record holders of common units unless the common units are held in a nominee or street name account and the nominee or broker has executed and delivered a transfer application for those common units.
Items of our income, gain, loss, or deduction are not reportable by a common unitholder who is not a partner for U.S. federal
income tax purposes, and any cash distributions received by a common unitholder who is not a partner for U.S. federal income tax purposes would therefore be fully taxable as ordinary income. These common unitholders are urged to consult their own
tax advisors with respect to their status as partners in us for U.S. federal income tax purposes.
The references to
common unitholders in the discussion that follows are to persons who are treated as partners in CEP for U.S. federal income tax purposes.
Tax Consequences of Unit Ownership
Flow-Through of Taxable Income
Subject to the discussion below under Entity-Level Collections, neither we nor our subsidiaries pay any U.S. federal income tax. Instead, each common unitholder is be required to report
on his income tax return his share of our income, gains, losses and deductions without regard to whether corresponding cash distributions are received by him. Consequently, we may allocate income to a common unitholder even if he has not received a
cash distribution. Each common unitholder is required to include in income his share of our income, gain, loss and deduction for our taxable year or years ending with or within his taxable year. Our taxable year ends on December 31.
Treatment of Distributions
Distributions made by us to a common unitholder generally are not be taxable to the common unitholder for U.S. federal income tax purposes to the extent of his tax basis in his units immediately before
the distribution. Cash distributions made by us to a common unitholder in an amount in excess of his tax basis in his units generally are considered to be gain from the sale or exchange of those units, taxable in accordance with the rules described
under Disposition of Units below. To the extent that cash distributions made by us cause a common unitholders at risk amount to be less than zero at the end of any taxable year, the common unitholder must
recapture any losses deducted in previous years. Please read Limitations on Deductibility of Losses.
Any
reduction in a common unitholders share of our liabilities for which no partner bears the economic risk of loss, known as nonrecourse liabilities, will be treated as a distribution of cash to that common unitholder.
A decrease in a common unitholders percentage interest in us because of our issuance of additional common units will decrease his
share of our nonrecourse liabilities and thus will result in a corresponding deemed distribution of cash, which may constitute a
non-pro
rata distribution. A
non-pro
rata distribution of money or property may result in ordinary income to a common unitholder, regardless of his tax basis in his units, if the distribution reduces the common unitholders share of our unrealized receivables,
including recapture of intangible drilling and development costs, depletion and depreciation recapture, and/or substantially appreciated inventory items, both as defined in Section 751 of the Internal Revenue Code, and collectively,
Section 751 Assets. To that extent, he will be treated as having received his proportionate share of the Section 751
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Assets and having exchanged those assets with us in return for the
non-pro
rata portion of the actual distribution made to him. This latter deemed exchange
will generally result in the common unitholders realization of ordinary income. That income will equal the excess of (1) the
non-pro
rata portion of that distribution over (2) the common
unitholders tax basis (generally zero) for the share of Section 751 Assets deemed relinquished in the exchange.
Basis of Units
A common unitholders initial tax basis in his units will be the amount he paid for the units plus his share of our nonrecourse liabilities. That basis will be increased by his share of our income
and by any increases in his share of our nonrecourse liabilities. That basis generally will be decreased, but not below zero, by distributions to him from us, by his share of our losses, by depletion deductions taken by him to the extent such
deductions do not exceed his proportionate share of the adjusted tax basis of the underlying producing properties, by any decreases in his share of our nonrecourse liabilities and by his share of our expenditures that are not deductible in computing
taxable income and are not required to be capitalized. A common unitholders share of our nonrecourse liabilities will generally be based on his share of our profits. Please read Disposition of UnitsRecognition of Gain or
Loss.
Limitations on Deductibility of Losses
The deduction by a common unitholder of his share of our losses is limited to his tax basis in his units and, in the case of an
individual, estate, trust or corporate common unitholder (if more than 50% of the value of its stock is owned directly or indirectly by or for five or fewer individuals or some
tax-exempt
organizations) to the
amount for which the common unitholder is considered to be at risk with respect to our activities, if that amount is less than his tax basis. A common unitholder subject to these limitations must recapture losses deducted in previous
years to the extent that distributions cause his at risk amount to be less than zero at the end of any taxable year. Losses disallowed to a common unitholder or recaptured as a result of these limitations will carry forward and will be allowable as
a deduction in a later year to the extent that his tax basis or at risk amount, whichever is the limiting factor, is subsequently increased. Upon the taxable disposition of a unit, any gain recognized by a common unitholder can be offset by losses
that were previously suspended by the at risk limitation but may not be offset by losses suspended by the basis limitation. Any loss previously suspended by the at risk limitation in excess of that gain is no longer utilizable.
In general, a common unitholder will be at risk to the extent of his tax basis in his units, excluding any portion of that basis
attributable to his share of our nonrecourse liabilities, reduced by (i) any portion of that basis representing amounts otherwise protected against loss because of a guarantee, stop loss agreement, or other similar arrangement and (ii) any
amount of money the common unitholder borrows to acquire or hold his units, if the lender of those borrowed funds owns an interest in us, is related to another common unitholder or can look only to the units for repayment. A common unitholders
at risk amount will increase or decrease as the tax basis of another common unitholders common units increases or decreases, other than tax basis increases or decreases attributable to increases or decreases in his share of our nonrecourse
liabilities.
The at risk limitation applies on an
activity-by-activity
basis, and in the case of oil and natural gas properties, each property is treated as a separate activity. Thus, a taxpayers interest in each
oil or gas property is generally required to be treated separately so that a loss from any one property would be limited to the at risk amount for that property and not the at risk amount for all the taxpayers oil and natural gas properties.
It is uncertain how this rule is implemented in the case of multiple oil and natural gas properties owned by a single entity treated as a partnership for U.S. federal income tax purposes. However, for taxable years ending on or before the date on
which further guidance is published, the IRS will permit aggregation of oil or gas properties we own in computing a common unitholders at risk limitation with respect to us. If a common unitholder must compute his at risk amount separately
with respect to each oil or gas property we own, he may not be allowed to utilize his share of losses or deductions attributable to a particular property even though he has a positive at risk amount with respect to his units as a whole.
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The passive loss limitation generally provides that individuals, estates, trusts and some
closely held corporations and personal service corporations are permitted to deduct losses from passive activities, which are generally defined as trade or business activities in which the taxpayer does not materially participate, only to the extent
of the taxpayers income from those passive activities. The passive loss limitation is applied separately with respect to each publicly traded partnership. Consequently, any passive losses we generate will be available to offset only our
passive income generated in the future and will not be available to offset income from other passive activities or investments, including our investments, a common unitholders investments in other publicly traded partnerships, or a common
unitholders salary or active business income. Passive losses that are not deductible because they exceed a common unitholders share of income we generate may only be deducted by the common unitholder in full when he disposes of his
entire investment in us in a fully taxable transaction with an unrelated party. The passive activity loss limitations are applied after certain other applicable limitations on deductions, including the at risk rules and the tax basis limitation.
A common unitholders share of our net income may be offset by any of our suspended passive losses, but it may not be
offset by any other current or carryover losses from other passive activities, including those attributable to other publicly traded partnerships.
Limitation on Interest Deductions
The deductibility of a
non-corporate
taxpayers investment interest expense is generally limited to the amount of that taxpayers net investment income. Investment interest expense includes:
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interest on indebtedness properly allocable to property held for investment;
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our interest expense attributable to portfolio income; and
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the portion of interest expense incurred to purchase or carry an interest in a passive activity to the extent attributable to portfolio income.
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The computation of a common unitholders investment interest expense will take into account interest
on any margin account borrowing or other loan incurred to purchase or carry a common unit.
Net investment income includes
gross income from property held for investment and amounts treated as portfolio income under the passive loss limitations, less deductible expenses, other than interest, directly connected with the production of investment income, but generally does
not include gains attributable to the disposition of property held for investment. The IRS has indicated that net passive income earned by a publicly traded partnership will be treated as investment income to its common unitholders for purposes of
the investment interest expense limitations. In addition, the common unitholders share of our portfolio income will be treated as investment income.
Entity-Level Collections
If we are required or elect under
applicable law to pay any federal, state or local income tax on behalf of any common unitholder or any former common unitholder, we are authorized to pay those taxes from our funds. That payment, if made, will be treated as a distribution of cash to
the common unitholder on whose behalf the payment was made. If the payment is made on behalf of a common unitholder whose identity cannot be determined, we are authorized to treat the payment as a distribution to all current common unitholders. We
are authorized to amend our limited liability company agreement in the manner necessary to maintain uniformity of intrinsic tax characteristics of units and to adjust later distributions, so that after giving effect to these distributions, the
priority and characterization of distributions otherwise applicable under our limited liability company agreement is maintained as nearly as is practicable. Payments by us as described above could give rise to an overpayment of tax on behalf of a
common unitholder in which event the common unitholder would be required to file a claim in order to obtain a credit or refund.
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Allocation of Income, Gain, Loss and Deduction
In general, if we have a net profit, our items of income, gain, loss and deduction will be allocated among the common unitholders in
accordance with their percentage interests in us. If we have a net loss for an entire year, the loss will be allocated to our common unitholders according to their percentage interests in us to the extent of their positive capital account balances.
Specified items of our income, gain, loss and deduction will be allocated under Section 704(c) of the Internal Revenue
Code to account for the difference between the tax basis and fair market value of our assets at the time we issue common units in an offering, which assets are referred to in this discussion as Contributed Property. These allocations are
required to eliminate the difference between a partners book capital account, credited with the fair market value of Contributed Property, and the tax capital account, credited with the tax basis of Contributed
Property, referred to in this discussion as the
book-tax
disparity. The effect of these allocations to a common unitholder who purchases common units in such an offering will be essentially the
same as if the tax basis of our assets were equal to their fair market value at the time of the offering. In the event we issue additional common units or engage in certain other transactions in the future, Section 704(c) allocations will be
made to all holders of common units to account for the difference between the book basis for purposes of maintaining capital accounts and the fair market value of all property held by us at the time of the future transaction. In
addition, items of recapture income will be allocated to the extent possible to the common unitholder who was allocated the deduction giving rise to the treatment of that gain as recapture income in order to minimize the recognition of ordinary
income by other common unitholders. Finally, although we do not expect that our operations will result in the creation of negative capital accounts, if negative capital accounts nevertheless result, items of our income and gain will be allocated in
an amount and manner sufficient to eliminate the negative balance as quickly as possible.
An allocation of items of our
income, gain, loss or deduction, other than an allocation required by Section 704(c), will generally be given effect for U.S. federal income tax purposes in determining a common unitholders share of an item of income, gain, loss or
deduction only if the allocation has substantial economic effect. In any other case, a common unitholders share of an item will be determined on the basis of his interest in us, which will be determined by taking into account all the facts and
circumstances, including:
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his relative contributions to us;
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the interests of all the common unitholders in profits and losses;
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the interest of all the common unitholders in cash flow; and
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the rights of all the common unitholders to distributions of capital upon liquidation.
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Treatment of Short Sales
A common unitholder whose units are loaned to a short seller to cover a short sale of units may be considered as having disposed of those units. If so, he would no longer be a partner for tax
purposes with respect to those units during the period of the loan and may recognize gain or loss from the disposition. As a result, during this period:
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none of our income, gain, loss or deduction with respect to those units would be reportable by the common unitholder;
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any cash distributions received by the common unitholder with respect to those units would be fully taxable; and
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all of these distributions would appear to be ordinary income.
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Andrews Kurth LLP has not rendered an opinion regarding the treatment of a common unitholder whose common units are loaned to a short
seller. Therefore, common unitholders desiring to assure their status as partners and avoid the risk of gain recognition are urged to modify any applicable brokerage account agreements to prohibit their brokers from borrowing and loaning their
common units. The IRS has announced that it is studying issues relating to the tax treatment of short sales of partnership interests. Please also read Disposition of UnitsRecognition of Gain or Loss.
Alternative Minimum Tax
Each common unitholder is required to take into account his distributive share of any items of our income, gain, loss or deduction for purposes of the alternative minimum tax. The current minimum tax rate
for
non-corporate
taxpayers is 26% on the first $175,000 of alternative minimum taxable income in excess of the exemption amount and 28% on any additional alternative minimum taxable income. Prospective common
unitholders are urged to consult their tax advisors with respect to the impact of an investment in our common units on their liability for the alternative minimum tax.
Tax Rates
Under current law, the highest effective U.S. federal
income tax rate for individuals currently is 35% and the maximum U.S. federal income tax rate for net long-term capital gains (generally, gains from the sale of certain investment assets held for more than one year) of an individual currently is
15%. Both rates are scheduled to remain at their current respective rate for years 2010 through 2012, but may increase beginning January 1, 2013.
The recently enacted Health Care and Education Reconciliation Act of 2010 and the Patient Protection and Affordable Care Act of 2010 is scheduled to impose a 3.8% Medicare tax on certain investment income
earned by individuals, estates, and trusts for taxable years beginning after December 31, 2012. For these purposes, investment income generally includes a common unitholders allocable share of our income and gain realized by a common
unitholder from a sale of common units. In the case of an individual, the tax will be imposed on the lesser of (i) the common unitholders net investment income from all investments, or (ii) the amount by which the common
unitholders modified adjusted gross income exceeds $250,000 (if the common unitholder is married and filing jointly or a surviving spouse) or $200,000 (if the common unitholder is unmarried). In the case of an estate or trust, the tax will be
imposed on the lesser of (i) undistributed net investment income, or (ii) the excess adjusted gross income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.
Section 754 Election
We have made the election permitted by Section 754 of the Internal Revenue Code. That election is irrevocable without the consent of the IRS. That election will generally permit us to adjust a unit
purchasers tax basis in our assets (inside basis) under Section 743(b) of the Internal Revenue Code to reflect his purchase price. The Section 743(b) adjustment applies to a person who purchases common units in an
offering from the selling unitholder, but does not apply to a person who purchases common units directly from us, and it belongs only to the purchaser and not to other common unitholders. Please also read, however, Allocation of Income,
Gain, Loss and Deduction above. For purposes of this discussion, a common unitholders inside basis in our assets has two components: (1) his share of our tax basis in our assets (common basis) and (2) his
Section 743(b) adjustment to that basis.
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The timing and calculation of deductions attributable to Section 743(b) adjustments to
our common basis will depend upon a number of factors, including the nature of the assets to which the adjustment is allocable, the extent to which the adjustment offsets any Internal Revenue Code Section 704(c) type gain or loss with respect
to an asset and certain elections we make as to the manner in which we apply Internal Revenue Code Section 704(c) principles with respect to an asset to which the adjustment is applicable. Please read Allocation of Income, Gain,
Loss and Deduction.
The timing of these deductions may affect the uniformity of our common units. Under our limited
liability company agreement, our board is authorized to take a position to preserve the uniformity of common units even if that position is not consistent with these and any other Treasury Regulations or if the position would result in lower annual
depreciation or amortization deductions than would otherwise be allowable to some common unitholders. Please read Uniformity of Units. Andrews Kurth LLP is unable to opine as to the validity of any such alternate tax positions
because there is no clear applicable authority. A common unitholders basis in a common unit is reduced by his share of our deductions (whether or not such deductions were claimed on an individual income tax return) so that any position that we
take that understates deductions will overstate the common unitholders basis in his common units and may cause the common unitholder to understate gain or overstate loss on any sale of such common units. Please read Uniformity of
Units.
A Section 754 election is advantageous if the transferees tax basis in his common units is higher
than the units share of the aggregate tax basis of our assets immediately prior to the transfer. In that case, as a result of the election, the transferee would have, among other items, a greater amount of depletion and depreciation deductions
and the transferees share of any gain or loss on a sale of our assets would be less. Conversely, a Section 754 election is disadvantageous if the transferees tax basis in his common units is lower than those units share of the
aggregate tax basis of our assets immediately prior to the transfer. Thus, the fair market value of the common units may be affected either favorably or unfavorably by the election. A basis adjustment is required regardless of whether a
Section 754 election is made in the case of a transfer of an interest in us if we have a substantial
built-in
loss immediately after the transfer, or if we distribute property and have a substantial basis
reduction. Generally a
built-in
loss or a basis reduction is substantial if it exceeds $250,000.
The calculations involved in the Section 754 election are complex and will be made on the basis of assumptions as to the fair market value of our assets and other matters. For example, the allocation
of the Section 743(b) adjustment among our assets must be made in accordance with the Internal Revenue Code. The IRS could seek to reallocate some or all of any Section 743(b) adjustment we allocated to our tangible assets to goodwill
instead. Goodwill, as an intangible asset, is generally either
non-amortizable
or amortizable over a longer period of time or under a less accelerated method than our tangible assets. We cannot assure you that
the determinations we make will not be successfully challenged by the IRS or that the resulting deductions will not be reduced or disallowed altogether. Should the IRS require a different basis adjustment to be made, and should, in our opinion, the
expense of compliance exceeds the benefit of the election, we may seek permission from the IRS to revoke our Section 754 election. If permission is granted, a subsequent purchaser of common units may be allocated more income than such purchaser
would have been allocated had the election not been revoked.
Tax Treatment of Operations
Accounting Method and Taxable Year
We use the year ending December 31 as our taxable year and the accrual method of accounting for U.S. federal income tax purposes. Each common unitholder is required to include in income his share of
our income, gain, loss and deduction for our taxable year ending within or with his taxable year. In addition, a common unitholder who has a taxable year ending on a date other than December 31 and who disposes of all of his common units
following the close of our taxable year but before the close of his
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taxable year must include his share of our income, gain, loss and deduction in income for his taxable year, with the result that he will be required to include in income for his taxable year his
share of more than twelve months of our income, gain, loss and deduction. Please read Disposition of UnitsAllocations Between Transferors and Transferees.
Depletion Deductions
Subject to the limitations on deductibility of losses discussed above, common unitholders are entitled to deductions for the greater of either cost depletion or (if otherwise allowable) percentage
depletion with respect to our oil and natural gas interests. Although the Internal Revenue Code requires each common unitholder to compute his own depletion allowance and maintain records of his share of the adjusted tax basis of the underlying
property for depletion and other purposes, we intend to furnish each of our common unitholders with information relating to this computation for U.S. federal income tax purposes. Each common unitholder, however, remains responsible for calculating
his own depletion allowance and maintaining records of his share of the adjusted tax basis of the underlying property for depletion and other purposes.
Percentage depletion is generally available with respect to common unitholders who qualify under the independent producer exemption contained in Section 613A(c) of the Internal Revenue Code. For this
purpose, an independent producer is a person not directly or indirectly involved in the retail sale of oil, natural gas, or derivative products or the operation of a major refinery. Percentage depletion is calculated as an amount generally equal to
15% (and, in the case of marginal production, potentially a higher percentage) of the common unitholders gross income from the depletable property for the taxable year. The percentage depletion deduction with respect to any property is limited
to 100% of the taxable income of the common unitholder from the property for each taxable year, computed without the depletion allowance. A common unitholder that qualifies as an independent producer may deduct percentage depletion only to the
extent the common unitholders average net daily production of domestic crude oil, or the natural gas equivalent, does not exceed 1,000 barrels. This depletable amount may be allocated between oil and natural gas production, with 6,000 cubic
feet of domestic natural gas production regarded as equivalent to one barrel of crude oil. The 1,000 barrel limitation must be allocated among the independent producer and controlled or related persons and family members in proportion to the
respective production by such persons during the period in question.
In addition to the foregoing limitations, the percentage
depletion deduction otherwise available is limited to 65% of a common unitholders total taxable income from all sources for the year, computed without the depletion allowance, net operating loss carrybacks, or capital loss carrybacks. Any
percentage depletion deduction disallowed because of the 65% limitation may be deducted in the following taxable year if the percentage depletion deduction for such year plus the deduction carryover does not exceed 65% of the common
unitholders total taxable income for that year. The carryover period resulting from the 65% net income limitation is unlimited.
Common unitholders that do not qualify under the independent producer exemption are generally restricted to depletion deductions based on cost depletion. Cost depletion deductions are calculated by
(i) dividing the common unitholders share of the adjusted tax basis in the underlying mineral property by the number of mineral units (barrels of oil and thousand cubic feet, or Mcf, of natural gas) remaining as of the beginning of the
taxable year and (ii) multiplying the result by the number of mineral units sold within the taxable year. The total amount of deductions based on cost depletion cannot exceed the common unitholders share of the total adjusted tax basis in
the property.
All or a portion of any gain recognized by a common unitholder as a result of either the disposition by us of
some or all of our oil and natural gas interests or the disposition by the common unitholder of some or all of his common units may be taxed as ordinary income to the extent of recapture of depletion deductions, except for percentage depletion
deductions in excess of the basis of the property. The amount of the recapture is generally limited to the amount of gain recognized on the disposition.
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The foregoing discussion of depletion deductions does not purport to be a complete analysis
of the complex legislation and Treasury Regulations relating to the availability and calculation of depletion deductions by the common unitholders. Further, because depletion is required to be computed separately by each common unitholder and not by
us, no assurance can be given, and Andrews Kurth LLP is unable to express any opinion, with respect to the availability or extent of percentage depletion deductions to the common unitholders for any taxable year. Moreover, the availability of
percentage depletion may be reduced or eliminated if recently proposed (or similar) tax legislation is enacted. For a discussion of such legislative proposals, please read Recent Legislative Developments. We encourage each
prospective common unitholder to consult his tax advisor to determine whether percentage depletion would be available to him.
Deductions for Intangible Drilling and Development Costs
We elect to currently deduct intangible drilling and development costs (IDCs). IDCs generally include our expenses for wages,
fuel, repairs, hauling, supplies and other items that are incidental to, and necessary for, the drilling and preparation of wells for the production of oil, natural gas or geothermal energy. The option to currently deduct IDCs applies only to those
items that do not have a salvage value.
Although we elect to currently deduct IDCs, each common unitholder will have the
option of either currently deducting IDCs or capitalizing all or part of the IDCs and amortizing them on a straight-line basis over a
60-month
period, beginning with the taxable month in which the expenditure
is made. If a common unitholder makes the election to amortize the IDCs over a
60-month
period, no IDC preference amount in respect of those IDCs will result for alternative minimum tax purposes.
Integrated oil companies must capitalize 30% of all their IDCs (other than IDCs paid or incurred with respect to oil and natural gas
wells located outside of the United States) and amortize these IDCs over 60 months beginning in the month in which those costs are paid or incurred. If the taxpayer ceases to be an integrated oil company, it must continue to amortize those costs as
long as it continues to own the property to which the IDCs relate. An integrated oil company is a taxpayer that has economic interests in oil and natural gas properties and also carries on substantial retailing or refining operations. An
oil or gas producer is deemed to be a substantial retailer or refiner if it is subject to the rules disqualifying retailers and refiners from taking percentage depletion. In order to qualify as an independent producer that is not subject
to these IDC deduction limits, a common unitholder, either directly or indirectly through certain related parties, may not be involved in the refining of more than 75,000 barrels of oil (or the equivalent amount of natural gas) on average for any
day during the taxable year or in the retail marketing of oil and natural gas products exceeding $5 million per year in the aggregate.
IDCs previously deducted that are allocable to property (directly or through ownership of an interest in a partnership) and that would have been included in the adjusted basis of the property had the IDC
deduction not been taken are recaptured to the extent of any gain realized upon the disposition of the property or upon the disposition by a common unitholder of interests in us. Recapture is generally determined at the common unitholder level.
Where only a portion of the recapture property is sold, any IDCs related to the entire property are recaptured to the extent of the gain realized on the portion of the property sold. In the case of a disposition of an undivided interest in a
property, a proportionate amount of the IDCs with respect to the property is treated as allocable to the transferred undivided interest to the extent of any gain recognized. Please read Disposition of UnitsRecognition of Gain or
Loss.
Deduction for United States Production Activities
Subject to the limitations on the deductibility of losses discussed above and the limitation discussed below, common unitholders will be
entitled to a deduction, herein referred to as the Section 199 deduction, equal to 6% of our qualified production activities income that is allocated to such common unitholder but not to exceed 50% of such common unitholders actual or
deemed IRS Form
W-2
wages for the taxable year allocable to domestic production gross receipts.
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Qualified production activities income is generally equal to gross receipts from domestic
production activities reduced by cost of goods sold allocable to those receipts, other expenses directly associated with those receipts, and a share of other deductions, expenses and losses that are not directly allocable to those receipts or
another class of income. The products produced must be manufactured, produced, grown or extracted in whole or in significant part by the taxpayer in the United States.
For a partnership, the Section 199 deduction is determined at the partner level. To determine his Section 199 deduction, each common unitholder will aggregate his share of the qualified
production activities income allocated to him from us with the common unitholders qualified production activities income from other sources. Each common unitholder must take into account his distributive share of the expenses allocated to him
from our qualified production activities regardless of whether we otherwise have taxable income. However, our expenses that otherwise would be taken into account for purposes of computing the Section 199 deduction are only taken into account
only if and to the extent the common unitholders share of losses and deductions from all of our activities is not disallowed by the basis rules, the
at-risk
rules or the passive activity loss rules.
Please read Tax Consequences of Unit OwnershipLimitations on Deductibility of Losses.
The amount of a
common unitholders Section 199 deduction for each year is limited to 50% of the IRS Form
W-2
wages actually or deemed paid by the common unitholder during the calendar year that are deducted in
arriving at qualified production activities income. Each common unitholder is treated as having been allocated IRS Form
W-2
wages from us equal to the common unitholders allocable share of our wages that
are deducted in arriving at our qualified production activities income for that taxable year. It is not anticipated that we or our subsidiaries will pay material wages that will be allocated to our common unitholders, and thus a common
unitholders ability to claim the Section 199 deduction may be limited.
This discussion of the Section 199
deduction does not purport to be a complete analysis of the complex legislation and Treasury authority relating to the calculation of domestic production gross receipts, qualified production activities income, or IRS Form
W-2
Wages, or how such items are allocated by us to common unitholders. Further, because the Section 199 deduction is required to be computed separately by each common unitholder, no assurance can be given, and
Andrews Kurth LLP is unable to express any opinion, as to the availability or extent of the Section 199 deduction to the common unitholders. Moreover, the availability of Section 199 deductions may be reduced or eliminated if recently
proposed (or similar) tax legislation is enacted. For a discussion of such legislative proposals, please read Recent Legislative Developments. Each prospective common unitholder is encouraged to consult his tax advisor to determine
whether the Section 199 deduction would be available to him.
Lease Acquisition Costs
The cost of acquiring oil and natural gas leaseholder or similar property interests is a capital expenditure that must be recovered
through depletion deductions if the lease is productive. If a lease is proved worthless and abandoned, the cost of acquisition less any depletion claimed may be deducted as an ordinary loss in the year the lease becomes worthless. Please read
Depletion Deductions.
Geophysical Costs
Geophysical costs paid or incurred in connection with the exploration for, or development of, oil or gas within the United States are
allowed as a deduction ratably over the
24-month
period beginning on the date that such expense was paid or incurred.
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Operating and Administrative Costs
Amounts paid for operating a producing well are deductible as ordinary business expenses, as are administrative costs to the extent they
constitute ordinary and necessary business expenses which are reasonable in amount.
Recent Legislative Developments
In early 2010, the White House released President Obamas budget proposal for the Fiscal Year 2011 (the
Budget Proposal). Among the changes recommended in the Budget Proposal was the elimination of certain key U.S. federal income tax preferences relating to oil and natural gas exploration and development. Changes in the Budget
Proposal included, but were not limited to, (i) the repeal of the percentage depletion allowance for oil and natural gas properties, (ii) the elimination of current deductions for intangible drilling and development costs, (iii) the
elimination of the deduction for certain domestic production activities, and (iv) an extension of the amortization period for certain geological and geophysical expenditures. Each of these changes was proposed to be effective for taxable years
beginning, or in the case of costs described in (ii) and (iv), costs paid or incurred, after December 31, 2010. No such changes have been enacted. It is unclear whether these or similar changes will be proposed or enacted and, if enacted,
how soon any such changes could become effective. The passage of any legislation as a result of these proposals or any other similar changes in U.S. federal income tax laws could eliminate or postpone certain tax deductions that are currently
available with respect to oil and natural gas exploration and development, and any such change could increase the taxable income allocable to our common unitholders and negatively impact the value of an investment in our common units.
Tax Basis, Depreciation and Amortization
The tax basis of our assets, such as casing, tubing, tanks, pumping units and other similar property, will be used for purposes of computing depreciation and cost recovery deductions and, ultimately, gain
or loss on the disposition of these assets. The U.S. federal income tax burden associated with the difference between the fair market value of our assets and their tax basis immediately prior to (i) this offering will be borne by our existing
common unitholders, and (ii) any other offering will be borne by our common unitholders as of that time. Please read Tax Consequences of Unit OwnershipAllocation of Income, Gain, Loss and Deduction.
To the extent allowable, we may elect to use the depreciation and cost recovery methods that will result in the largest deductions being
taken in the early years after assets are placed in service. Property we subsequently acquire or construct may be depreciated using accelerated methods permitted by the Internal Revenue Code.
If we dispose of depreciable property by sale, foreclosure, or otherwise, all or a portion of any gain, determined by reference to the
amount of depreciation previously deducted and the nature of the property, may be subject to the recapture rules and taxed as ordinary income rather than capital gain. Similarly, a common unitholder who has taken cost recovery or depreciation
deductions with respect to property we own will likely be required to recapture some or all of those deductions as ordinary income upon a sale of his interest in us. Please read Tax Consequences of Unit OwnershipAllocation of
Income, Gain, Loss and Deduction and Disposition of UnitsRecognition of Gain or Loss.
The costs
incurred in selling our units (called syndication expenses) must be capitalized and cannot be deducted currently, ratably or upon our termination. There are uncertainties regarding the classification of costs as organization expenses,
which we may be able to amortize, and as syndication expenses, which we may not amortize. The underwriting discounts and commissions we incur will be treated as syndication expenses.
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Valuation and Tax Basis of Our Properties
The U.S. federal income tax consequences of the ownership and disposition of common units will depend in part on our estimates of the
relative fair market values and the tax bases of our assets. Although we may from time to time consult with professional appraisers regarding valuation matters, we will make many of the relative fair market value estimates ourselves. These estimates
and determinations of basis are subject to challenge and will not be binding on the IRS or the courts. If the estimates of fair market value or basis are later found to be incorrect, the character and amount of items of income, gain, loss or
deduction previously reported by common unitholders might change, and common unitholders might be required to adjust their tax liability for prior years and incur interest and penalties with respect to those adjustments.
Disposition of Units
Recognition of Gain or Loss
Gain or loss will be recognized on a
sale of common units equal to the difference between the common unitholders amount realized and the common unitholders tax basis for the common units sold. A common unitholders amount realized will equal the sum of the cash or the
fair market value of other property he receives plus his share of our nonrecourse liabilities. Because the amount realized includes a common unitholders share of our nonrecourse liabilities, the gain recognized on the sale of common units
could result in a tax liability in excess of any cash received from the sale.
Prior distributions from us in excess of
cumulative net taxable income for a common unit that decreased a common unitholders tax basis in that unit will, in effect, become taxable income if the common unit is sold at a price greater than the common unitholders tax basis in that
unit, even if the price received is less than his original cost.
Except as noted below, gain or loss recognized by a common
unitholder, other than a dealer in units, on the sale or exchange of a common unit held for more than one year will generally be taxable as capital gain or loss. A portion of this gain or loss, which will likely be substantial, however,
will be separately computed and taxed as ordinary income or loss under Section 751 of the Internal Revenue Code to the extent attributable to assets giving rise to unrealized receivables or inventory items that we own.
The term unrealized receivables includes potential recapture items, including depreciation, depletion, and IDC recapture. Ordinary income attributable to unrealized receivables and inventory items may exceed net taxable gain realized on
the sale of a common unit and may be recognized even if there is a net taxable loss realized on the sale of a common unit. Thus, a common unitholder may recognize both ordinary income and a capital loss upon a sale of common units. Net capital loss
may offset capital gains and no more than $3,000 of ordinary income, in the case of individuals, and may only be used to offset capital gain in the case of corporations.
The IRS has ruled that a partner who acquires interests in a partnership in separate transactions must combine those interests and maintain a single adjusted tax basis for all those interests. Upon a sale
or other disposition of less than all of those interests, a portion of that tax basis must be allocated to the interests sold using an equitable apportionment method. Treasury Regulations under Section 1223 of the Internal Revenue
Code allow a selling common unitholder who can identify common units transferred with an ascertainable holding period to elect to use the actual holding period of the common units transferred. Thus, according to the ruling, a common unitholder will
be unable to select high or low basis common units to sell as would be the case with corporate stock, but, according to the regulations, may designate specific common units sold for purposes of determining the holding period of common units
transferred. A common unitholder electing to use the actual holding period of common units transferred must consistently use that identification method for all subsequent sales or exchanges of common units. A common unitholder considering the
purchase of additional common units or a sale of common units purchased in separate transactions is urged to consult his tax advisor as to the possible consequences of this ruling and application of the Treasury Regulations.
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Specific provisions of the Internal Revenue Code affect the taxation of some financial
products and securities, including partnership interests, by treating a taxpayer as having sold an appreciated partnership interest, one in which gain would be recognized if it were sold, assigned or terminated at its fair market value,
if the taxpayer or related persons enter(s) into:
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an offsetting notional principal contract; or
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a futures or forward contract with respect to the partnership interest or substantially identical property.
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Moreover, if a taxpayer has previously entered into a short sale, an offsetting notional principal contract or a futures or forward
contract with respect to the partnership interest, the taxpayer will be treated as having sold that position if the taxpayer or a related person then acquires the partnership interest or substantially identical property. The Secretary of the
Treasury is also authorized to issue regulations that treat a taxpayer who enters into transactions or positions that have substantially the same effect as the preceding transactions as having constructively sold the financial position.
Allocations Between Transferors and Transferees
In general, our taxable income or loss will be determined annually, will be prorated on a monthly basis and will be subsequently apportioned among the common unitholders in proportion to the number of
units owned by each of them as of the opening of the applicable exchange on the first business day of the month (the Allocation Date). However, gain or loss realized on a sale or other disposition of our assets other than in the ordinary
course of business will be allocated among the common unitholders on the Allocation Date in the month in which that gain or loss is recognized. As a result, a common unitholder transferring common units may be allocated income, gain, loss and
deduction realized after the date of transfer.
Although simplifying conventions are contemplated by the Code and most
publicly traded partnerships use similar simplifying conventions, the use of this method may not be permitted under existing Treasury Regulations. Recently, however, the Department of the Treasury and the IRS issued proposed Treasury Regulations
that provide a safe harbor pursuant to which a publicly-traded partnership may use a similar monthly simplifying convention to allocate tax items among transferor and transferee unitholders, although such tax items must be prorated on a daily basis.
Nonetheless, the proposed regulations do not specifically authorize the use of the proration method we have adopted. Existing publicly-traded partnerships are entitled to rely on those proposed Treasury Regulations; however, they are not binding on
the IRS and are subject to change until the final Treasury Regulations are issued. Accordingly, Andrews Kurth LLP is unable to opine on the validity of this method of allocating income and deductions between common unitholders. If this method is not
allowed under the Treasury Regulations, or only applies to transfers of less than all of the common unitholders interest, our taxable income or losses might be reallocated among the common unitholders. We are authorized to revise our method of
allocation between common unitholders, as well as among common unitholders whose interests vary during a taxable year, to conform to a method permitted under future Treasury Regulations.
A common unitholder who owns units at any time during a quarter and who disposes of them prior to the record date set for a cash
distribution for that quarter will be allocated items of our income, gain, loss and deductions attributable to that quarter but will not be entitled to receive that cash distribution.
Notification Requirements
A common unitholder who sells any of his common units, other than through a broker, generally is required to notify us in writing of that sale within 30 days after the sale (or, if earlier,
January 15 of the year following the sale). A purchaser of common units who purchases units from another common unitholder is
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also generally required to notify us in writing of that purchase within 30 days after the purchase. Upon receiving such notifications, we are required to notify the IRS of that transaction
and to furnish specified information to the transferor and transferee. Failure to notify us of a transfer of common units may, in some cases, lead to the imposition of penalties. However, these reporting requirements do not apply to a sale by an
individual who is a citizen of the United States and who effects the sale or exchange through a broker who will satisfy such requirements.
Constructive Termination
We will be considered to have
constructively terminated for federal income tax purposes if there is a sale or exchange of 50% or more of the total interests in our capital and profits within a twelve-month period. A constructive termination results in the closing of our taxable
year for all common unitholders. In the case of a common unitholder reporting on a taxable year other than a fiscal year ending December 31, the closing of our taxable year may result in more than 12 months of our taxable income or loss being
includable in his taxable income for the year of termination. A constructive termination occurring on a date other than December 31 will result in us filing two tax returns for one calendar year and the cost of the preparation of these returns
will be borne by all common unitholders. However, pursuant to an IRS relief procedure for publicly traded partnerships that have technically terminated, the IRS may allow, among other things, that we provide a single Schedule
K-1
for the tax year in which a termination occurs. We would be required to make new tax elections after a constructive termination, including a new election under Section 754 of the Internal Revenue Code, and
a constructive termination would result in a deferral of our deductions for depreciation. A constructive termination could also result in penalties if we were unable to determine that the constructive termination had occurred. Moreover, a
constructive termination might either accelerate the application of, or subject us to, any tax legislation enacted before the constructive termination.
Uniformity of Units
Because we cannot match
transferors and transferees of common units, we must maintain uniformity of the economic and tax characteristics of the units to a purchaser of these units. In the absence of uniformity, we may be unable to completely comply with a number of U.S.
federal income tax requirements, both statutory and regulatory. A lack of uniformity can result from a literal application of Treasury Regulation Section 1.167(c)-1(a)(6) and Treasury Regulation Section 1.197-2(g)(3), neither of which is
anticipated to apply to a material portion of our assets. Any
non-uniformity
could have a negative impact on the value of the common units. Please read Tax Consequences of Unit
OwnershipSection 754 Election.
Our limited liability company agreement permits us to take positions in filing our
tax returns that preserve the uniformity of our common units even under circumstances like those described above. These positions may include reducing for some common unitholders the depreciation, amortization or loss deductions to which they would
otherwise be entitled or reporting a slower amortization of Section 743(b) adjustments for some common unitholders than that to which they would otherwise be entitled. Andrews Kurth LLP is unable to opine as to validity of such filing
positions. A common unitholders basis in common units is reduced by his share of our deductions (whether or not such deductions were claimed on an individual income tax return) so that any position that we take that understates deductions will
overstate the common unitholders basis in his common units, and may cause the common unitholder to understate gain or overstate loss on any sale of such common units. Please read Disposition of Units Recognition of Gain
or Loss and Tax Consequences of Unit Ownership Section 754 Election. The IRS may challenge one or more of any positions we take to preserve the uniformity of common units. If such a challenge were sustained,
the uniformity of common units might be affected, and, under some circumstances, the gain from the sale of common units might be increased without the benefit of additional deductions.
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Tax-Exempt
Organizations and Other
Investors
Ownership of units by employee benefit plans, other
tax-exempt
organizations,
non-resident
aliens, foreign corporations and other foreign persons raises issues unique to those investors and, as described below, may have substantially adverse tax consequences to them.
Prospective common unitholders who are
tax-exempt
entities or
non-U.S.
persons should consult their tax advisor before investing in our common units.
Employee benefit plans and most other organizations exempt from U.S. federal income tax, including individual retirement accounts and
other retirement plans, are subject to U.S. federal income tax on unrelated business taxable income. Virtually all of our income allocated to a common unitholder that is a
tax-exempt
organization will be
unrelated business taxable income and will be taxable to them.
Non-resident
aliens
and foreign corporations, trusts or estates that own units will be considered to be engaged in business in the United States because of the ownership of units. As a consequence they will be required to file federal tax returns to report their share
of our income, gain, loss or deduction and pay U.S. federal income tax at regular rates on their share of our net income or gain. Under rules applicable to publicly traded partnerships, we will withhold tax, at the highest effective applicable rate,
from cash distributions made quarterly to foreign common unitholders. Each foreign common unitholder must obtain a taxpayer identification number from the IRS and submit that number to our transfer agent on a Form
W-8
BEN or applicable substitute form in order to obtain credit for these withholding taxes. A change in applicable law may require us to change these procedures.
In addition, because a foreign corporation that owns units will be treated as engaged in a United States trade or business, that
corporation may be subject to the United States branch profits tax at a rate of 30%, in addition to regular U.S. federal income tax, on its share of our income and gain, as adjusted for changes in the foreign corporations U.S. net
equity, which is effectively connected with the conduct of a United States trade or business. That tax may be reduced or eliminated by an income tax treaty between the United States and the country in which the foreign corporate common
unitholder is a qualified resident. In addition, this type of common unitholder is subject to special information reporting requirements under Section 6038C of the Internal Revenue Code.
A foreign common unitholder who sells or otherwise disposes of a common unit will be subject to U.S. federal income tax on gain realized
on the sale or disposition of that unit to the extent the gain is effectively connected with a United States trade or business of the foreign common unitholder. Under a ruling published by the IRS interpreting the scope of effectively
connected income, a foreign unitholder would be considered to be engaged in business in the United States by virtue of the ownership of common units, and part or all of that common unitholders gain would be effectively connected with
that unitholders indirect U.S. trade or business. Moreover, under the Foreign Investment in Real Property Tax Act, a foreign common unitholder generally will be subject to U.S. federal income tax upon the sale or disposition of a
unit if (i) he owned (directly or constructively applying certain attribution rules) more than 5% of our units at any time during the five-year period ending on the date of such disposition and (ii) 50% or more of the fair market value of
all of our assets consisted of U.S. real property interests at any time during the shorter of the period during which such common unitholder held the units or the
5-year
period ending on the date of
disposition. Currently, more than 50% of our assets consist of U.S. real property interests and we do not expect that to change in the foreseeable future. Therefore, foreign common unitholders may be subject to U.S. federal income tax on gain
from the sale or disposition of their common units.
Administrative Matters
Information Returns and Audit Procedures
We intend to furnish to each common unitholder, within 90 days after the close of each calendar year, specific tax information, including a Schedule
K-1,
which
describes his share of our income, gain, loss and deduction for our preceding taxable year. In preparing this information, which will not be reviewed by counsel, we will take various accounting and reporting positions, some of which have been
mentioned earlier, to determine each common unitholders share of income, gain, loss and deduction.
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We cannot assure you that those positions will yield a result that conforms to the
requirements of the Internal Revenue Code, Treasury Regulations or administrative interpretations of the IRS. Neither we nor Andrews Kurth LLP can assure prospective common unitholders that the IRS will not successfully contend in court that those
positions are impermissible. Any challenge by the IRS could negatively affect the value of the units.
The IRS may audit our
U.S. federal income tax information returns. Adjustments resulting from an IRS audit may require each common unitholder to adjust a prior years tax liability and possibly may result in an audit of his own return. Any audit of a common
unitholders return could result in adjustments not related to our returns as well as those related to our returns.
Partnerships generally are treated as separate entities for purposes of federal tax audits, judicial review of administrative adjustments
by the IRS and tax settlement proceedings. The tax treatment of partnership items of income, gain, loss and deduction are determined in a partnership proceeding rather than in separate proceedings with the partners. The Internal Revenue Code
requires that one partner be designated as the Tax Matters Partner for these purposes. The limited liability company agreement appoints CEPM as our Tax Matters Partner, subject to redetermination by our board of managers from time to
time.
The Tax Matters Partner will make some elections on our behalf and on behalf of common unitholders. In addition, the
Tax Matters Partner can extend the statute of limitations for assessment of tax deficiencies against common unitholders for items in our returns. The Tax Matters Partner may bind a common unitholder with less than a 1% profits interest in us to a
settlement with the IRS unless that common unitholder elects, by filing a statement with the IRS, not to give that authority to the Tax Matters Partner. The Tax Matters Partner may seek judicial review, by which all the common unitholders are bound,
of a final partnership administrative adjustment and, if the Tax Matters Partner fails to seek judicial review, judicial review may be sought by any common unitholder having at least a 1% interest in profits or by any group of common unitholders
having in the aggregate at least a 5% interest in profits. However, only one action for judicial review will go forward, and each common unitholder with an interest in the outcome may participate in that action.
A common unitholder must file a statement with the IRS identifying the treatment of any item on his U.S. federal income tax return that
is not consistent with the treatment of the item on our return. Intentional or negligent disregard of this consistency requirement may subject a common unitholder to substantial penalties.
Nominee Reporting
Persons who hold an interest in us as a nominee for another person are required to furnish to us:
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the name, address and taxpayer identification number of the beneficial owner and the nominee;
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a statement regarding whether the beneficial owner is:
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a person that is not a United States person,
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a foreign government, an international organization or any wholly-owned agency or instrumentality of either of the foregoing, or
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the amount and description of units held, acquired or transferred for the beneficial owner; and
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specific information including the dates of acquisitions and transfers, means of acquisitions and transfers, and acquisition cost for purchases, as
well as the amount of net proceeds from sales.
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Brokers and financial institutions are required to furnish
additional information, including whether they are United States persons and specific information on units they acquire, hold or transfer for their own account. A penalty of $50 per failure, up to a maximum of $100,000 per calendar year, is imposed
by the Internal Revenue Code for failure to report that information to us. The nominee is required to supply the beneficial owner of the units with the information furnished to us.
Accuracy-related Penalties
An additional tax equal to 20% of the amount of any portion of an underpayment of tax that is attributable to one or more specified causes, including negligence or disregard of rules or regulations,
substantial understatements of income tax and substantial valuation misstatements, is imposed by the Internal Revenue Code. No penalty will be imposed, however, for any portion of an underpayment if it is shown that there was a reasonable cause for
the underpayment of that portion and that the taxpayer acted in good faith regarding the underpayment of that portion.
For
individuals, substantial understatement of income tax in any taxable year exists if the amount of the understatement exceeds the greater of 10% of the tax required to be shown on the return for the taxable year or $5,000. The amount of any
understatement subject to penalty generally is reduced if any portion is attributable to a position adopted on the return:
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for which there is, or was, substantial authority, or
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as to which there is a reasonable basis and the relevant facts of that position are disclosed on the return.
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If any item of income, gain, loss or deduction included in the distributive shares of common unitholders could result in that kind of an
understatement of income for which no substantial authority exists, we must disclose the pertinent facts on our return. In addition, we will make a reasonable effort to furnish sufficient information for common unitholders to
make adequate disclosure on their returns to avoid liability for this penalty. More stringent rules would apply to an understatement of tax resulting from ownership of units if we were classified as a tax shelter, which we do not believe
includes us, or any of our investments, plans or arrangements.
A substantial valuation misstatement exists if (a) the
value of any property, or the tax basis of any property, claimed on a tax return is 150% or more of the amount determined to be the correct amount of the valuation or tax basis, (b) the price for any property or services (or for the use of
property) claimed on any such return with respect to any transaction between persons described in Section 482 of the Internal Revenue Code is 200% or more (or 50% or less) of the amount determined under Section 482 to be the correct amount
of such price, or (c) the net Section 482 transfer price adjustment for the taxable year exceeds the lesser of $5 million or 10% of the taxpayers gross receipts. No penalty is imposed unless the portion of the underpayment
attributable to a substantial valuation misstatement exceeds $5,000 ($10,000 for a corporation other than an S Corporation or a personal holding company). The penalty is increased to 40% in the event of a gross valuation misstatement. We do not
anticipate making any valuation misstatements.
61
Reportable Transactions
If we were to engage in a reportable transaction, we (and possibly you and others) would be required to make a detailed
disclosure of the transaction to the IRS. A transaction may be a reportable transaction based upon any of several factors, including the fact that it is a type of transaction publicly identified by the IRS as a listed transaction or that
it produces certain kinds of losses for partnerships, individuals, S corporations, and trusts in excess of $2 million in any single taxable year, or $4 million in any combination of six successive tax years. Our participation in a reportable
transaction could increase the likelihood that our U.S. federal income tax information return (and possibly a common unitholders tax return) is audited by the IRS. Please read Information Returns and Audit Procedures above.
Moreover, if we were to participate in a reportable transaction with a significant purpose to avoid or evade tax or a listed
transaction, our common unitholders could be subject to the following provisions of the American Jobs Creation Act of 2004:
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accuracy-related penalties with a broader scope, significantly narrower exceptions, and potentially greater amounts than described above at
Accuracy-related Penalties,
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for those persons otherwise entitled to deduct interest on federal tax deficiencies,
non-deductibility
of
interest on any resulting tax liability, and
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in the case of a listed transaction, an extended statute of limitations.
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We do not expect to engage in any reportable transactions.
State, Local and Other Tax Considerations
In
addition to U.S. federal income taxes, you will be subject to other taxes, including state and local income taxes, unincorporated business taxes, and estate, inheritance or intangible taxes that may be imposed by the various jurisdictions in which
we do business or own property or in which you are a resident. We currently do business and own property in Nebraska, Kansas, Oklahoma and Alabama. We are registered to do business in Texas. We may also own property or do business in other states in
the future. Although an analysis of those various taxes is not presented here, each prospective common unitholder should consider their potential impact on his investment in us. You may not be required to file a return and pay taxes in some states
because your income from that state falls below the filing and payment requirement. You will be required, however, to file state income tax returns and to pay state income taxes in many of the states in which we may do business or own property, and
you may be subject to penalties for failure to comply with those requirements. In some states, tax losses may not produce a tax benefit in the year incurred and also may not be available to offset income in subsequent taxable years. Some of the
states may require us, or we may elect, to withhold a percentage of income from amounts to be distributed to a common unitholder who is not a resident of the state. Withholding, the amount of which may be greater or less than a particular common
unitholders income tax liability to the state, generally does not relieve a nonresident common unitholder from the obligation to file an income tax return. Amounts withheld may be treated as if distributed to common unitholders for purposes of
determining the amounts distributed by us. Please read Tax Consequences of Unit OwnershipEntity-Level Collections. Based on current law and our estimate of our future operations, we anticipate that any amounts required to be
withheld will not be material.
It is the responsibility of each common unitholder to investigate the legal and tax
consequences, under the laws of pertinent states and localities, of his investment in us. Andrews Kurth LLP has not rendered an opinion on the state local, or foreign tax consequences of an investment in us. We strongly recommend that each
prospective common unitholder consult, and depend on, his own tax counsel or other advisor with regard to those matters. It is the responsibility of each common unitholder to file all tax returns, that may be required of him.
62
Tax Consequences of Ownership of Debt Securities
Because the terms and corresponding tax consequences of various debt issuances may differ significantly, descriptions of the material U.S.
federal income tax consequences of the acquisition, ownership and disposition of debt securities will be set forth in the prospectus supplement relating to the offering of any such debt securities.
INVESTMENT IN OUR COMPANY BY EMPLOYEE BENEFIT PLANS
An investment in us by an employee benefit plan is subject to additional considerations because the investments of these plans are
subject to the fiduciary responsibility and prohibited transaction provisions of ERISA and restrictions imposed by Section 4975 of the Internal Revenue Code. For these purposes, the term employee benefit plan includes, but is not
limited to, qualified pension, profit-sharing and stock bonus plans, Keogh plans, simplified employee pension plans and tax deferred annuities or IRAs established or maintained by an employer or employee organization. Among other things, the person
with investment discretion with respect to the assets of an employee benefit plan, often called a fiduciary, should consider:
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whether the investment is prudent under Section 404(a)(1)(B) of ERISA;
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whether in making the investment, that plan will satisfy the diversification requirements of Section 404(a)(l)(C) of ERISA; and
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whether the investment will result in recognition of unrelated business taxable income by the plan and, if so, the potential
after-tax
investment return.
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A plan fiduciary should determine whether an
investment in us is authorized by the appropriate governing instrument and is a proper investment for the plan.
Section 406 of ERISA and Section 4975 of the Internal Revenue Code prohibits employee benefit plans, and IRAs that are not
considered part of an employee benefit plan, from engaging in specified transactions involving plan assets with parties that are parties in interest under ERISA or disqualified persons under the Internal Revenue
Code with respect to the plan.
In addition to considering whether the purchase of common units is a prohibited transaction, a
fiduciary of an employee benefit plan should consider whether the plan will, by investing in us, be deemed to own an undivided interest in our assets, with the result that CEPM also would be a fiduciary of the plan and our operations would be
subject to the regulatory restrictions of ERISA, including its prohibited transaction rules, as well as the prohibited transaction rules of the Internal Revenue Code.
The Department of Labor regulations and Section 3(42) of ERISA provide guidance with respect to whether the assets of an entity in which employee benefit plans acquire equity interests would be
deemed plan assets under some circumstances. Under these rules, an entitys assets would not be considered to be plan assets if, among other things:
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the equity interests acquired by employee benefit plans are publicly offered securitiesi.e., the equity interests are widely held by 100 or more
investors independent of the issuer and each other, freely transferable and registered under some provisions of the federal securities laws;
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the entity is an operating company,i.e., it is primarily engaged in the production or sale of a product or service other than the
investment of capital either directly or through a majority owned subsidiary or subsidiaries; or
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there is no significant investment by benefit plan investors, which is defined to mean that less than 25% of the value of each class of equity
interest, disregarding some interests held by CEPM, its affiliates, and some other persons, is held by employee benefit plans subject to Part 4 of Title I of ERISA, IRAs and other plans subject to Section 4975 of the Code and any entity whose
underlying assets include plan assets by reason of such plans investment in such entity.
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Our assets
should not be considered plan assets under these regulations because it is expected that the investment will satisfy the requirements in the first bullet above.
Plan fiduciaries contemplating a purchase of our common units should consult with their own counsel regarding the consequences under ERISA and the Internal Revenue Code in light of the serious penalties
imposed on persons who engage in prohibited transactions or other violations.
PLAN OF
DISTRIBUTION
We may sell the securities being offered hereby directly to purchasers, through agents, through underwriters
or through dealers.
We, or agents designated by us, may directly solicit, from time to time, offers to purchase the
securities. Any such agent may be deemed to be an underwriter as that term is defined in the Securities Act of 1933. We will name the agents involved in the offer or sale of the securities and describe any commissions payable by us to these agents
in the prospectus supplement. Unless otherwise indicated in the prospectus supplement, these agents will be acting on a best efforts basis for the period of their appointment. The agents may be entitled under agreements they may enter into with us
to indemnification by us against specified civil liabilities, including liabilities under the Securities Act of 1933. The agents may also be our customers or may engage in transactions with or perform services for us in the ordinary course of
business.
If we use any underwriters in the sale of the securities in respect of which this prospectus is delivered, we will
enter into an underwriting agreement with those underwriters at the time of sale to them. We will set forth the names of the underwriters and the terms of the transaction in a prospectus supplement, which will be used by the underwriters to make
resales of the securities in respect of which this prospectus is delivered to the public. We may indemnify the underwriters under the underwriting agreement against specified liabilities, including liabilities under the Securities Act of 1933. The
underwriters may also be our customers or may engage in transactions with or perform services for us in the ordinary course of business.
Agents could makes sales in privately negotiated transactions and/or any other method permitted by law, including sales deemed to be an at the market offering as defined in Rule 415
promulgated under the Securities Act, which includes sales made directly on or through NYSE Arca, the existing trading market for our common units, or sales made to or through a market maker other than on an exchange.
If we use a dealer in the sale of the securities in respect of which this prospectus is delivered, we will sell those securities to the
dealer, as principal. The dealer may then resell those securities to the public at varying prices to be determined by the dealer at the time of resale. We may indemnify the dealers against specified liabilities, including liabilities under the
Securities Act of 1933. The dealers may also be our customers or may engage in transactions with, or perform services for us in the ordinary course of business.
We also may sell common units and debt securities directly. In this case, no underwriters or agents would be involved. We may use electronic media, including the Internet, to sell offered securities
directly.
Because the Financial Industry Regulatory Authority (FINRA) views our common units as interests in a
direct participation program, any offering of common units under the registration statement of which this prospectus forms a part will be made in compliance with Rule 2310 of the FINRA Conduct Rules.
64
To the extent required, this prospectus may be amended or supplemented from time to time to
describe a particular plan of distribution. The place and time of delivery for the securities in respect of which this prospectus is delivered will be set forth in the accompanying prospectus supplement.
In connection with offerings of securities under the registration statement of which this prospectus forms a part and in compliance with
applicable law, underwriters, brokers or dealers may engage in transactions that stabilize or maintain the market price of the securities at levels above those that might otherwise prevail in the open market. Specifically, underwriters, brokers or
dealers may over-allot in connection with offerings, creating a short position in the securities for their own accounts. For the purpose of covering a syndicate short position or stabilizing the price of the securities, the underwriters, brokers or
dealers may place bids for the securities or effect purchases of the securities in the open market. Finally, the underwriters may impose a penalty whereby selling concessions allowed to syndicate members or other brokers or dealers for distribution
of the securities in offerings may be reclaimed by the syndicate if the syndicate repurchases previously distributed securities in transactions to cover short positions, in stabilization transactions or otherwise. These activities may stabilize,
maintain or otherwise affect the market price of the securities, which may be higher than the price that might otherwise prevail in the open market, and, if commenced, may be discontinued at any time.
In compliance with FINRA guidelines, the maximum consideration or discount to be received by any FINRA member or independent broker
dealer may not exceed 8% of the aggregate amount of the securities offered pursuant to this prospectus and any applicable prospectus supplement.
LEGAL MATTERS
Certain legal matters in
connection with the securities will be passed upon for us by Andrews Kurth LLP, Houston, Texas. If certain legal matters in connection with an offering of the securities made by this prospectus and a related prospectus supplement are passed on by
counsel for the underwriters of such offering, that counsel will be named in the applicable prospectus supplement related to that offering.
EXPERTS
The financial statements and
managements assessment of the effectiveness of internal control over financial reporting (which is included in Managements Report on Internal Control over Financial Reporting) incorporated in this prospectus by reference to the Annual
Report on Form
10-K
for the year ended December 31, 2009 have been so incorporated in reliance on the reports of PricewaterhouseCoopers LLP, an independent registered public accounting firm, given on the
authority of said firm as experts in auditing and accounting.
Certain information included or incorporated by reference in
this prospectus regarding our estimated quantities of natural gas reserves was prepared by Netherland, Sewell & Associates, Inc.
WHERE YOU CAN FIND MORE INFORMATION
We have
filed a registration statement with the SEC under the Securities Act of 1933, as amended, that registers the offer and sale of the securities covered by this prospectus. The registration statement, including the attached exhibits, contains
additional relevant information about us. In addition, we file annual, quarterly and other reports and other information with the SEC. You may read and copy any document we file with the SEC at the SECs Public Reference Room at 100 F Street,
N.E., Room 1580, Washington, D.C. 20549. Please call the SEC at
1-800-SEC-0330
for further information on the operation of the
SECs Public Reference Room. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Our SEC filings are available on the
SECs web site at http://www.sec.gov. You also can obtain information about us at the offices of the New York Stock Exchange, 20 Broad Street, New York, New York 10005.
65
The SEC allows us to incorporate by reference the information we have filed with
the SEC. This means that we can disclose important information to you without actually including the specific information in this prospectus by referring you to other documents filed separately with the SEC. The information incorporated by reference
is an important part of this prospectus. Information that we later provide to the SEC, and which is deemed to be filed with the SEC, will automatically update information previously filed with the SEC, and may replace information in this
prospectus and information previously filed with the SEC.
We incorporate by reference in this prospectus the following
documents that we have previously filed with the SEC:
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Annual Report on Form
10-K
(File No.
1-33147)
for the year ended
December 31, 2009 filed on February 25, 2010;
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Quarterly Reports on Form
10-Q
(File
No. 1-33147)
for the quarter
ended March 31, 2010 filed on May 7, 2010, for the quarter ended June 30, 2010 filed on August 6, 2010 and for the quarter ended September 30, 2010 filed on November 5, 2010;
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Current Reports on Form
8-K
(File
No. 1-33147)
filed on
December 22, 2010 (except for the information under Item 7.01 and the related exhibit), December 7, 2010 (except for the information under Item 7.01 and the related exhibit), October 28, 2010, July 30, 2010, and
March 3, 2010; and
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The description of our common units contained in our registration statement on Form
8-A
(File
No. 1-33147)
filed on November 13, 2006.
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All documents that we
file pursuant to Section 13(a), 13(c), 14 or 15(d) of the Securities Exchange Act of 1934, as amended, after the date of this prospectus and until our offerings hereunder are completed will be deemed to be incorporated by reference into this
prospectus and will be a part of this prospectus from the date of filing of the document. Nothing in this prospectus shall be deemed to incorporate information furnished to, but not filed with, the SEC pursuant to Item 2.02 or Item 7.01 of
Form
8-K
(or corresponding information furnished under Item 9.01 or included as an exhibit).
We make available free of charge on or through our Internet website,
http://www.constellationenergypartners.com
, our Annual Report on Form
10-K,
Quarterly
Reports on Form
10-Q,
Current Reports on Form
8-K
and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon
as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Information contained on our Internet website is not part of this prospectus.
You may obtain any of the documents incorporated by reference in this prospectus from the SEC through the SECs website at the
address provided above. You also may request a copy of any document incorporated by reference in this prospectus (excluding any exhibits to those documents, unless the exhibit is specifically incorporated by reference in this document), at no cost,
by visiting our Internet website at
http://www.constellationenergypartners.com
, or by writing or calling us at the following address:
Investor Relations
Constellation Energy Partners LLC
1801 Main Street, Suite 1300
Houston, TX 77002
Telephone: (877) 847-0009
You should rely only on the information incorporated by reference or provided in this prospectus. We have not authorized anyone else to
provide you with any information. You should not assume that the information incorporated by reference or provided in this prospectus is accurate as of any date other than the date on the front of each document.
66
APPENDIX A
GLOSSARY OF TERMS
Adjusted Operating Surplus
for any period means:
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(a)
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Operating Surplus generated with respect to that period;
less
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(b)
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any net increase in working capital borrowings with respect to that period (excluding any such borrowings to the extent the proceeds are distributed to the record
holder of the Class D interests);
less
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(c)
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any net reduction in cash reserves for operating expenditures with respect to that period not relating to an operating expenditure made with respect to that period;
plus
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(d)
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any net decrease in working capital borrowings with respect to that period;
plus
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(e)
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any net increase in cash reserves for operating expenditures made with respect to that period required by any debt instrument for the repayment of principal, interest
or premium.
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Available Cash
means, for any quarter ending prior to liquidation:
(i) all cash and cash equivalents of Constellation Energy Partners LLC and its subsidiaries (or the Companys
proportionate share of cash and cash equivalents in the case of subsidiaries that are not wholly-owned) on hand at the end of that quarter; and
(ii) all additional cash and cash equivalents of Constellation Energy Partners LLC and its subsidiaries (or the Companys proportionate share of cash and cash equivalents in the case of
subsidiaries that are not wholly-owned) on hand on the date of determination of available cash for that quarter resulting from working capital borrowings made subsequent to the end of such quarter,
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(b)
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less the amount of any cash reserves established by the board of managers (or the Companys proportionate share of cash reserves in the case of subsidiaries that
are not wholly-owned) to
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(i) provide for the proper conduct of the business of
Constellation Energy Partners LLC and its subsidiaries (including reserves for future capital expenditures including drilling and acquisitions and for anticipated future credit needs) subsequent to such quarter,
(ii) comply with applicable law or any loan agreement, security agreement, mortgage, debt instrument or other
agreement or obligation to which Constellation Energy Partners LLC or any of its subsidiaries is a party or by which it is bound or its assets are subject; or
A-1
(iii) provide funds for distributions (1) to our unitholders or
(2) in respect of our Class D interests or management incentive interests with respect to any one or more of the next four quarters;
provided, however
, that the board of managers may not establish cash reserves pursuant to (iii) above if the effect of such reserves would be
that the Company is unable to distribute the Initial Quarterly Distribution on all Common Units and Class A Units with respect to such Quarter; and
provided
further
, that disbursements made by us or any of our subsidiaries or cash
reserves established, increased or reduced after the end of that quarter but on or before the date of determination of available cash for that quarter shall be deemed to have been made, established, increased or reduced, for purposes of determining
available cash, within that quarter if our board of managers so determines.
Capital Surplus
is generated by:
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(a)
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borrowings other than working capital borrowings;
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(b)
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sales of debt and equity securities; and
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(c)
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sales or other disposition of assets for cash, other than inventory, accounts receivable and other current assets sold in the ordinary course of business or as a part
of normal retirements or replacements of assets.
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Operating expenditures
means all expenditures of
Constellation Energy Partners LLC and its subsidiaries (or Constellation Energy Partners LLCs proportionate share in the case of subsidiaries that are not wholly-owned), including taxes, payments made in the ordinary course of business under
commodity hedge contracts (other than payments in connection with termination of same prior to its termination date), provided that with respect to amounts paid in connection with the initial purchase or placing of a commodity hedge contract, such
amounts shall be amortized over the life of the applicable commodity hedge contract and upon its termination, if earlier, manager and officer compensation, compensation paid to our board of managers, repayment of working capital borrowings, debt
service payments, and estimated maintenance capital expenditures, provided that operating expenditures will not include:
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repayment of working capital borrowings deducted from operating surplus pursuant to subparagraph (h) of the definition of operating surplus when
such repayment actually occurs;
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payments (including prepayments) of principal of and premium on indebtedness, other than working capital borrowings;
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capital expenditures made for acquisitions or for capital improvements, or expansion capital expenditures;
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actual maintenance capital expenditures;
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investment capital expenditures;
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payment of transaction expenses relating to interim capital transactions; or
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distributions to members (including distributions in respect of our Class D interests and management incentive interests).
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A-2
Where capital expenditures are made in part for acquisitions or for capital improvements and
in part for other purposes, our board of managers, with the concurrence of the conflicts committee, shall determine the allocation between the amounts paid for each.
Operating surplus
for any period means:
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$20.0 million (if we choose to distribute as operating surplus up to $20.0 million of cash we receive in the future from
non-operating
sources such as asset sales, issuances of securities and long-term borrowings); plus
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(b)
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all of our cash receipts, excluding cash from (1) borrowings that are not working capital borrowings, (2) sales of equity and debt securities and
(3) sales or other dispositions of assets outside the ordinary course of business; plus
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(c)
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working capital borrowings made after the end of a quarter but before the date of determination of operating surplus for the quarter; plus
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(d)
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cash distributions paid on equity issued to finance all or a portion of the construction, replacement or improvement of a capital asset (such as equipment or reserves)
during the period beginning on the date that the group member enters into a binding obligation to commence the construction, acquisition or improvement of a capital improvement or replacement of a capital asset and ending on the earlier to occur of
the date the capital improvement or capital asset commences commercial service or the date that it is abandoned or disposed of; plus
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(e)
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if the right to receive distributions (other than distributions in liquidation) on the Class D interests terminates before December 31, 2012, the excess of the
amount of the original $8.0 million contribution by CHI for the Class D interests over the cumulative cash distributions paid on the Class D interests before such termination shall be included in operating surplus, such inclusion to occur over a
series of quarters with the amount included in each quarter to be equal to the amount of the payment a group member makes to the Trust in respect of the NPI for such quarter that would not have been paid but for termination of the sharing
arrangement; less
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(f)
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our operating expenditures; less
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(g)
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the amount of cash reserves established by our board of managers to provide funds for future operating expenditures; less
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(h)
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all working capital borrowings not repaid within twelve months after having been incurred.
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Working capital borrowings
. Borrowings used solely for working capital purposes or to pay distributions to members made pursuant
to a credit facility, commercial paper facility or other similar financing arrangement, provided that when it is incurred it is the intent of the borrower to repay such borrowings within 12 months from other than Working Capital Borrowings.
A-3
PROSPECTUS
5,918,894
Common Units Representing Class B Limited Liability Company Interests
This prospectus
relates to 5,918,894 common units representing Class B limited liability company interests in us that may be offered and sold by the selling unitholder named in this prospectus. The selling unitholder acquired the common units in connection with our
initial public offering occurring in November 2006. We are not selling any common units under this prospectus and will not receive any proceeds from the sale of common units by the selling unitholder. The common units to which this prospectus
relates may be offered and sold from time to time directly from the selling unitholder or alternatively through underwriters or broker-dealers or agents. The selling unitholder may sell the common units in one or more transactions, at fixed prices,
at prevailing market prices at the time of sale or at negotiated prices. Because all of the common units being offered under this prospectus are being offered by the selling unitholder, we cannot currently determine the price or prices at which our
common units may be sold under this prospectus.
Our common units are traded on the NYSE Arca, Inc. under the trading symbol
CEP.
Each time the selling unitholder offers to sell securities under the prospectus, the selling unitholder will
provide a prospectus supplement that will contain specific information about the terms of that offering. The prospectus supplement also may add, update or change information contained in this prospectus. This prospectus may be used to offer and sell
common units only if accompanied by a prospectus supplement. You should read this prospectus and any prospectus supplement carefully before you invest. You should also read the documents we refer to in the Where You Can Find More
Information section of this prospectus for information on us and our financial statements.
Investing in
our securities involves risks. See
Risk Factors
beginning on page 2.
Neither
the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.
The date of this prospectus is February 14, 2011
TABLE OF CONTENTS
i
You should rely only on the information contained in this prospectus. We have not authorized anyone to
provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. You should assume that the information appearing in this prospectus is accurate as of the date on the front cover
of this prospectus only. Our business, financial condition, results of operations and prospects may have changed since that date.
ii
ABOUT THIS PROSPECTUS
This prospectus is part of a registration statement on Form
S-3
that we have filed with the
Securities and Exchange Commission, or SEC, using a shelf registration process. Under this shelf registration process, the selling unitholder named in this prospectus or in any supplement to this prospectus may sell the common units
described in this prospectus in one or more offerings. This prospectus provides you with a general description of us and the common units the selling unitholder may offer under this prospectus.
Each time the selling unitholder sells common units under this prospectus, the selling unitholder will provide a prospectus supplement
that will contain specific information about the terms of that offering. The prospectus supplement also may add to, update, or change information in this prospectus. If there is any inconsistency between the information in this prospectus and any
prospectus supplement, you should rely on the information in the prospectus supplement. You should read carefully this prospectus, any prospectus supplement and the additional information described below under the heading Where You Can Find
More Information. We include a glossary of some of the terms used in this prospectus in Appendix A.
References in this
prospectus to Constellation Energy Partners, we, our, us, CEP or like terms refer to Constellation Energy Partners LLC and its subsidiaries. References in this prospectus to
CEPM are to Constellation Energy Partners Management, LLC, a Delaware limited liability company. References in this prospectus to CCG are to Constellation Energy Commodities Group, Inc., a Delaware corporation. References in
this prospectus to CEPH are to Constellation Energy Partners Holdings, LLC, a Delaware limited liability company. References to CHI are to Constellation Holdings, Inc., a Delaware corporation. References in this prospectus to
Constellation are to Constellation Energy Group, Inc., a Maryland corporation. We refer to our Class A limited liability company interests as the Class A units, our Class B limited liability company interests as the common
units, our Class C limited liability company interests as the management incentive interests and our Class D limited liability company interests as the Class D interests.
1
ABOUT CONSTELLATION ENERGY PARTNERS LLC
We are a limited liability company that was formed by Constellation in 2005 to acquire oil and natural gas reserves. We are focused on
the acquisition, development and production of oil and natural gas properties as well as related midstream assets. Our primary business objective is to create long-term value and to generate stable cash flows allowing us to resume making quarterly
cash distributions to our unitholders and over time to increase the amount of our future quarterly distributions. Our proved reserves are located in the Black Warrior Basin in Alabama, the Cherokee Basin in Kansas and Oklahoma, the Woodford Shale in
the Arkoma Basin in Oklahoma, and the Central Kansas Uplift in Kansas and Nebraska.
Our principal executive offices are
located at 1801 Main Street, Suite 1300, Houston, TX 77002, and our telephone number is
(832) 308-3700.
Our website is located at
http://www.constellationenergypartners.com
. We make our periodic
reports and other information filed with or furnished to the SEC available, free of charge, through our website, as soon as reasonably practicable after those reports and other information are electronically filed with or furnished to the SEC.
Information on our website or any other website is not incorporated by reference into this prospectus and does not constitute a part of this prospectus.
RISK FACTORS
Limited liability company
interests are inherently different from capital stock of a corporation, although many of the business risks to which we are subject are similar to those that would be faced by a corporation engaged in a similar business. You should carefully
consider the risk factors discussed in our Annual Report on Form
10-K
for the year ended December 31, 2009 and our quarterly reports on Form
10-Q
for the quarters
ended March 31, 2010, June 30, 2010 and September 30, 2010, together with all of the other information included in this prospectus, any prospectus supplement and the documents we have incorporated by reference into this
prospectus in evaluating an investment in our common units. The described risks could materially and adversely affect our business, financial condition or results of operation. If any of the described risks actually were to occur, we may not be able
to resume or pay quarterly distributions on our common units, the trading price of our common units could decline and you could lose part or all of your investment in our company.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
Some information contained in this prospectus, any prospectus supplement and the documents we incorporate by reference herein and therein
may contain forward-looking statements that are subject to a number of risks and uncertainties, many of which are beyond our control, which may include statements about:
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the volatility of realized oil and natural gas prices;
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the conditions of the capital markets, inflation, interest rates, availability of credit facilities to support business requirements, liquidity, and
general economic conditions;
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the discovery, estimation, development and replacement of oil and natural gas reserves;
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our business, financial, and operational strategy;
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our drilling locations;
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our cash flow, liquidity and financial position;
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the ability to extend or refinance our reserve-based credit facility;
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the level of our borrowing base under our reserve-based credit facility;
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the resumption, timing or amount of our cash distribution;
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2
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the impact from any termination of the NPI sharing arrangement or any change in the calculation of the NPI;
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our hedging program and our derivative positions;
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our production volumes;
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our lease operating expenses, general and administrative costs, depletion rates and finding and development costs;
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the availability of drilling and production equipment, labor and other services;
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our future operating results;
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our prospect development and property acquisitions;
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the marketing of oil and natural gas;
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competition in the oil and natural gas industry;
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the impact of the current global credit and economic environment;
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the impact of weather and the occurrence of natural disasters such as fires, floods, hurricanes, tornados, earthquakes, snow and ice storms and other
catastrophic events and natural disasters;
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governmental regulation, including environmental regulation, and taxation of the oil and natural gas industry;
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developments in
oil-producing
and natural gas producing countries;
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support from our former sponsor or a change in any sponsor; and
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our strategic plans, objectives, expectations, forecasts, budgets, estimates and intentions for future operations.
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All of these types of statements, other than statements of historical fact, are forward-looking statements. In some cases,
forward-looking statements can be identified by terminology such as may, could, should, expect, plan, project, intend, anticipate, believe,
estimate, predict, potential, pursue, target, continue, the negative of such terms or other comparable terminology.
The forward-looking statements are largely based on our expectations, which reflect estimates and assumptions made by our management.
These estimates and assumptions reflect our best judgment based on currently known market conditions and other factors. Although we believe such estimates and assumptions to be reasonable, they are inherently uncertain and involve a number of risks
and uncertainties that are beyond our control. In addition, managements assumptions about future events may prove to be inaccurate. Management cautions all readers that forward-looking statements are not guarantees of future performance, and
we cannot assure any reader that such statements will be realized or the forward-looking events and circumstances will occur. Actual results may differ materially from those anticipated or implied in the forward-looking statements due to factors
listed in the Risk Factors section and elsewhere in this prospectus, any prospectus supplement and the documents incorporated herein and therein by reference. All forward-looking statements speak only as of the date of this prospectus
or, in any document that we incorporate by reference, the date of that document. We do not intend to publicly update or revise any forward-looking statements as a result of new information, future events or otherwise, other than as required under
the securities laws. These cautionary statements qualify all forward-looking statements attributable to us or persons acting on our behalf.
USE OF PROCEEDS
We will not receive any
proceeds from the sale of common units offered under this prospectus. Any proceeds from the sale of common units offered under this prospectus will be received by the selling unitholder.
3
HOW WE MAKE CASH DISTRIBUTIONS
Initial Quarterly Distributions
The amount of distributions paid under our cash distribution policy and the decision to make any distribution will be determined by our board of managers, taking into consideration the terms of our
limited liability company agreement. At our initial public offering in November 2006, we set our initial quarterly distribution (IQD) at $0.4625 per each common and Class A unit, or $1.85 per year, subject to having sufficient available
cash after we establish appropriate reserves and pay fees and expenses. We have suspended our $0.13 per unit quarterly distributions to unitholders since the quarter ended June 30, 2009, as we have had no available cash (taking into account the
cash reserves set by our board of managers for the proper conduct of our business). We have used any excess operating cash flows to reduce our outstanding indebtedness. Given our current focus on debt reduction, we anticipate that our distribution
will remain suspended through the fourth quarter of 2011. Our quarterly distribution is intended to reflect the level of cash that we expect to be available for distribution per common unit and Class A unit each quarter from our productive
assets. There is no guarantee we will pay a quarterly distribution in any quarter and we will be prohibited from making any distributions to unitholders if it would cause an event of default or an event of default is existing under our reserve-based
credit facility. Our board of managers has adopted a policy that it will resume our quarterly cash distribution only when it believes that (i) we have sufficient reserves and liquidity for the proper conduct of our business, including the
maintenance of our asset base, (ii) we can maintain such an increased distribution level for a sustained period, and (iii) we are compliant with the terms and conditions specified in our reserve-based credit facility and our operating
agreement. While this is our current policy, our board of managers may alter such policy in the future when and if it determines such alteration to be appropriate.
Distributions of Available Cash
Overview
Our limited liability company agreement requires that, within 45 days after the end of each quarter, we distribute all of our available
cash to unitholders of record on the applicable record date.
Definition of Available Cash
We define available cash in the glossary, and it generally means, for each fiscal quarter, all cash on hand at the end of the quarter:
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less the amount of cash reserves established by our board of managers to:
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provide for the proper conduct of our business (including reserves for future capital expenditures and credit needs);
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comply with applicable law, any of our debt instruments, or other agreements; or
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provide funds for distributions (1) to our unitholders for any one or more of the next four quarters or (2) in respect of our Class D
interests or management incentive interests;
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plus all cash on hand on the date of determination of available cash for the quarter resulting from working capital borrowings made after the end of
the quarter. Working capital borrowings are generally borrowings that are made under our reserve-based credit facility or another arrangement and in all cases are used solely for working capital purposes or to pay distributions to unitholders.
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4
Operating Surplus and Capital Surplus
General
All cash distributed to unitholders will be characterized as either operating surplus or capital surplus. Our limited liability company agreement requires that we distribute
available cash from operating surplus differently than available cash from capital surplus.
Definition of Operating
Surplus
We define operating surplus in the glossary, and for any period, it generally means:
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$20.0 million (as described below);
plus
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all of our cash receipts after the closing of our initial public offering, excluding cash from (1) borrowings that are not working capital
borrowings, (2) sales of equity and debt securities, and (3) sales or other dispositions of assets outside the ordinary course of business;
plus
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working capital borrowings made after the end of a quarter but before the date of determination of operating surplus for the quarter;
plus
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cash distributions paid on equity issued to finance all or a portion of the construction, replacement or improvement of a capital asset (such as
equipment or reserves) during the period beginning on the date that we enter into a binding obligation to commence the construction, acquisition or improvement of a capital improvement or replacement of a capital asset and ending on the earlier to
occur of the date the capital improvement or capital asset is placed into service or the date that it is abandoned or disposed of;
plus
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if the right to receive distributions (other than distributions in liquidation) on the Class D interests terminates before December 31, 2012, the
excess of the amount of the $8.0 million contribution by CHI for the Class D interests over the cumulative cash distributions paid on the Class D interests before such termination shall be included in operating surplus, such inclusion to occur over
a series of quarters with the amount included in each quarter to be equal to the amount of the payment we make to the Torch Energy Royalty Trust (the Trust) in respect of the NPI for such quarter that would not have been paid but for
termination of the sharing arrangement;
less
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our operating expenditures (as defined below);
less
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the amount of cash reserves established by our board of managers to provide funds for future operating expenditures;
less
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all working capital borrowings not repaid within twelve months after having been incurred.
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As described above, operating surplus does not reflect actual cash on hand that is available for distribution to our unitholders. For
example, it includes a provision that will enable us, if we choose, to distribute as operating surplus up to $20.0 million of cash we receive in the future from
non-operating
sources such as asset sales,
issuances of securities and long-term borrowings that would otherwise be distributed as capital surplus. In addition, the effect of including, as described above, certain cash distributions on equity securities in operating surplus would be to
increase operating surplus by the amount of any such cash distributions. As a result, we may also distribute as operating surplus up to the amount of any such cash distributions we receive from
non-operating
sources.
5
If a working capital borrowing, which increases operating surplus, is not repaid during the
twelve-month period following the borrowing, it will be deemed repaid at the end of such period, thus decreasing operating surplus at such time. When such working capital borrowing is in fact repaid, it will not be treated as a reduction in
operating surplus because operating surplus will have been previously reduced by the deemed repayment.
We define operating
expenditures in the glossary, and it generally means all of our cash expenditures, including, but not limited to, taxes, payments made in the ordinary course of business under commodity hedge contracts, manager and officer compensation, repayment of
working capital borrowings, debt service payments and estimated maintenance capital expenditures, provided that operating expenditures will not include:
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repayment of working capital borrowings deducted from operating surplus pursuant to the last bullet point of the definition of operating surplus when
such repayment actually occurs;
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payments (including prepayments and prepayment penalties) of principal of and premium on indebtedness, other than working capital borrowings;
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expansion capital expenditures;
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actual maintenance capital expenditures;
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investment capital expenditures;
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payment of transaction expenses relating to interim capital transactions; or
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distributions to our members (including distributions in respect of our Class D interests and management incentive interests).
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Capital Expenditures
For purposes of determining operating surplus, maintenance capital expenditures are those capital expenditures required to maintain, including over the long term, our asset base, and expansion capital
expenditures are those capital expenditures that we expect will increase our asset base over the long term. Examples of maintenance capital expenditures include capital expenditures associated with the replacement of equipment and oil and natural
gas reserves (including
non-proved
reserves attributable to undeveloped leasehold acreage), whether through the development, exploitation and production of an existing leasehold or the acquisition or
development of a new oil or natural gas property. Maintenance capital expenditures will also include interest (and related fees) on debt incurred and distributions on equity issued to finance all or any portion of a replacement asset during the
period from such financing until the earlier to occur of the date any such replacement asset is placed into service or the date that it is abandoned or disposed of. Plugging and abandonment costs will also constitute maintenance capital
expenditures. Capital expenditures made solely for investment purposes will not be considered maintenance capital expenditures.
Because our maintenance capital expenditures can be very large and irregular, the amount of our actual maintenance capital expenditures
may differ substantially from period to period, which could cause similar fluctuations in the amounts of operating surplus, adjusted operating surplus and cash available for distribution to our unitholders if we subtracted actual maintenance capital
expenditures from operating surplus. As a result, to eliminate the effect on operating surplus of these fluctuations, our limited liability company agreement requires that an estimate of the average quarterly maintenance capital expenditures
(including estimated plugging and abandonment costs) necessary to maintain our asset base over the long term be subtracted from operating surplus each quarter as opposed to the actual amounts spent. The amount of estimated maintenance capital
expenditures deducted from operating surplus is subject to review and
6
change by our board of managers at least once a year,
provided
that any change is approved by our conflicts committee. The estimate is made at least annually and whenever an event occurs
that is likely to result in a material adjustment to the amount of our maintenance capital expenditures, such as a major acquisition or the introduction of new governmental regulations that will impact our business. For purposes of calculating
operating surplus, any adjustment to this estimate will be prospective only.
The use of estimated maintenance capital
expenditures in calculating operating surplus has the following effects:
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it reduces the risk that maintenance capital expenditures in any one quarter will be large enough to render operating surplus less than the IQD to be
paid on all the units for that quarter and subsequent quarters;
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it increases our ability to distribute as operating surplus cash we receive from
non-operating
sources;
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it is more difficult for us to raise our distribution above the IQD and pay management incentive distributions on our management incentive interests;
and
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it reduces the likelihood that a large maintenance capital expenditure during the First MII Earnings Period (as defined in Management
Incentive Interests below) or Later MII Earnings Period (as defined in Management Incentive Interests below) will prevent the payment of a management incentive distribution in respect of the First MII Earnings Period or
Later MII Earnings Period since the effect of an estimate is to spread the expected expense over several periods, thereby mitigating the effect of the actual payment of the expenditure on any single period.
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Expansion capital expenditures are those capital expenditures that we expect will increase our asset base. Examples of expansion capital
expenditures include the acquisition of reserves or equipment, the acquisition of new leasehold interest, or the development, exploitation and production of an existing leasehold interest, to the extent such expenditures are incurred to increase our
asset base. Expansion capital expenditures will also include interest (and related fees) on debt incurred and distributions on equity issued to finance all or any portion of such capital improvement during the period from such financing until the
earlier to occur of the date any such capital improvement is placed into service or the date that it is abandoned or disposed of. Capital expenditures made solely for investment purposes will not be considered expansion capital expenditures.
Investment capital expenditures are those capital expenditures that are neither maintenance capital expenditures nor
expansion capital expenditures. Investment capital expenditures largely will consist of capital expenditures made for investment purposes. Examples of investment capital expenditures include traditional capital expenditures for investment purposes,
such as purchases of securities, as well as other capital expenditures that might be made in lieu of such traditional investment capital expenditures, such as the acquisition of a capital asset for investment purposes or development of our
undeveloped properties in excess of maintenance capital expenditures, but which are not expected to expand for more than the short term our asset base.
As described above, none of actual maintenance capital expenditures, investment capital expenditures or expansion capital expenditures are subtracted from operating surplus. Because actual maintenance
capital expenditures, investment capital expenditures and expansion capital expenditures include interest payments (and related fees) on debt incurred and distributions on equity issued to finance all of the portion of the construction, replacement
or improvement of a capital asset (such as equipment or reserves) during the period from such financing until the earlier to occur of the date any such capital asset is placed into service or the date that it is abandoned or disposed of, such
interest payments and equity distributions are also not subtracted from operating surplus (except, in the case of maintenance capital expenditures, to the extent such interest payments and distributions are included in estimated maintenance capital
expenditures).
7
Capital expenditures that are made in part for maintenance capital purposes and in part for
investment capital or expansion capital purposes will be allocated as maintenance capital expenditures, investment capital expenditures or expansion capital expenditures by our board of managers, based upon its good faith determination, subject to
approval by our conflicts committee.
Definition of Capital Surplus
We also define capital surplus in the glossary, and it will generally be generated only by:
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borrowings other than working capital borrowings;
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sales of debt and equity securities; and
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sales or other disposition of assets for cash, other than inventory, accounts receivable and other current assets sold in the ordinary course of
business or as part of normal retirements or replacements of assets.
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Characterization of Cash
Distributions
We treat all available cash distributed as coming from operating surplus until the sum of all available
cash distributed since we began operations equals the operating surplus as of the most recent date of determination of available cash. We treat any amount distributed in excess of operating surplus, regardless of its source, as capital surplus. We
do not anticipate that we will make any distributions from capital surplus.
Distributions of Available Cash from Operating Surplus
We make distributions of available cash from operating surplus for any quarter in the following manner:
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first
, 98% to the common unitholders, pro rata, and 2% to the holder(s) of our Class A units, pro rata, until we distribute for each
outstanding unit an amount equal to the Target Distribution (that is, our $0.4625 IQD plus $0.0694), which aggregate amount we refer to as the Target Distribution, for that quarter; and
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thereafter
, any amount distributed in respect of such quarter in excess of the Target Distribution per unit will be distributed 98% to the
holders of the common units, pro rata, and 2% to the holder(s) of our Class A units until distributions become payable in respect of our management incentive interests as described in Management Incentive Interests below.
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The Class A units are entitled to 2% of all cash distributions from operating surplus, without any
requirement for future capital contributions by the holders of such Class A units, even if we issue additional common units or other senior or subordinated equity securities in the future. The percentage interests shown above for the
Class A units assume they have not been converted into common units. If the Class A units have been converted, the common units will receive the 2% of distributions originally allocated to the Class A units.
8
Management Incentive Interests
Management incentive interests represent the right to receive 15% of quarterly distributions of available cash from operating surplus
after the Target Distribution has been achieved and certain other tests have been met. CEPM currently holds the management incentive interests, which are evidenced by the Class C limited liability company interests, but may transfer these rights
separately from its Class A units, subject to restrictions in our limited liability company agreement. The earliest that we could be required to make distributions in respect of the management incentive interests is after a period of 12
consecutive quarters after we pay per unit cash distributions from operating surplus to holders of Class A and common units in an amount equal or greater than the Target Distribution. For the third quarter 2007, we increased our distribution
rate to $0.5625 per unit. This increase in the distribution rate commenced a management incentive interest vesting period under our operating agreement. Through December 31, 2008, a cash reserve of $0.7 million had been established to fund
future distributions on the management incentive interests. In February 2009, we reduced our distribution rate to $0.13 per unit. This decrease in the distribution rate terminated the initial management incentive interest vesting period. After the
February 13, 2009 distribution was paid, the reserve was reduced to zero. For the nine months ended September 30, 2010, none of these applicable tests have been met, and, as a result, CEPM was not entitled to receive any management
incentive interest distributions. We are not able to predict the future amount of the distributions in respect of the management incentive interests.
Prior to the end of the First MII Earnings Period or Later MII Earnings Period, which are defined below, we will not pay any management incentive distributions. To the extent, however, that during the
First MII Earnings Period or Later MII Earnings Period we distribute available cash from operating surplus in excess of the Target Distribution, our board of managers intends to cause us to reserve an amount for payment of the EP MID, which is
defined below, earned during the First MII Earnings Period or Later MII Earnings Period, as the case may be, after such period ends. If during the First MII Earnings Period or Later MII Earnings Period we fail to satisfy a condition specified in the
next paragraph, our board of managers will cause any such reserved amount to be released from that reserve and restored to available cash.
Payments to the holder of our management incentive interests are subject to the satisfaction of certain requirements. The first requirement is the
12-Quarter
Test,
which requires that for the 12 full, consecutive,
non-overlapping
calendar quarters that begin with the first calendar quarter in respect of which we pay per unit cash distributions from operating surplus to
holders of Class A and common units in an amount equal to or greater than the Target Distribution (we refer to such
12-quarter
period as the First MII Earnings Period):
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we pay cash distributions from operating surplus to holders of our outstanding Class A and common units in an amount that on average exceeds the
Target Distribution on all of the outstanding Class A units and common units over the First MII Earnings Period;
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we generate adjusted operating surplus (which is summarized below and is defined in the glossary included as Appendix A) during the First MII Earnings
Period that on average is in an amount at least equal to 100% of all distributions on the outstanding Class A and common units up to the Target Distribution plus 117.65% of all such distributions in excess of the Target Distribution; and
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we do not reduce the amount distributed per unit in respect of any such 12 quarters.
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The second requirement is the
4-Quarter
Test, which requires that for each of the last four full,
consecutive,
non-overlapping
calendar quarters in the First MII Earnings Period:
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we pay cash distributions from operating surplus to the holders of our outstanding Class A and common units that exceed the Target Distribution on
all of the outstanding Class A and common units;
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we generate adjusted operating surplus in an amount at least equal to 100% of all distributions on the outstanding Class A and common units up to
the Target Distribution plus 117.65% of all such distributions in excess of the Target Distribution; and
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we do not reduce the amount distributed per unit in respect of any such four quarters.
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If both the
12-Quarter
Test and the
4-Quarter
Test have
been met, then: (i) we will make a
one-time
management incentive distribution (contemporaneously with the distribution paid in respect of the Class A and common units for the twelfth calendar quarter
in the First MII Earnings Period) to the holder of our management incentive interests equal to 17.65% of the sum of the cumulative amounts, if any, by which quarterly cash distributions per unit part on the outstanding Class A and common units
during the First MII Earnings Period exceeded the Target Distribution on all of the outstanding Class A and common units (we refer to this
one-time
management incentive distribution as an EP
MID); and (ii) for each calendar quarter after the First MII Earnings Period, the holders of our Class A units and common units and management incentive interests will receive 2%, 83% and 15%, respectively, of cash distributions from
available cash from operating surplus that we pay for such quarter in excess of the Target Distribution.
If the
12-Quarter
Test is not met and except as described below, management incentive distributions will not be payable in respect of the First MII Earnings Period and the holder of the management incentive interests will
forfeit any and all rights to any management incentive distributions in respect of the First MII Earnings Period. An EP MID may become payable, however, with respect to a Later MII Earnings Period, if the
12-Quarter
Test and the
4-Quarter
Test are met in respect of such Later MII Earnings Period. A Later MII Earnings Period may begin with the first quarter following the
quarter in which the
12-Quarter
Test is not met, or, where we do not meet the
12-Quarter
Test because we reduced our cash distribution in a particular quarter, the Later
MII Earnings Period may begin with the quarter in which such reduction is made. If both tests are met with respect to a Later MII Earnings Period, then for each calendar quarter after the Later MII Earnings Period, the holders of the Class A
units and common units and management incentive interests will receive 2%, 83% and 15%, respectively, of cash distributions from available cash from operating surplus that we pay for such quarter in excess of the Target Distribution.
However, if (a) the
12-Quarter
Test has been met in respect of the First MII Earnings Period
or any Later MII Earnings Period, but not the
4-Quarter
Test; (b) the
4-Quarter
Test has been met in any period of four full, consecutive and
non-overlapping
quarters occurring after the end of the First MII Earnings Period or Later MII Earnings Period, as the case may be, up to three of which quarters can fall within the First MII Earnings Period or
Later MII Earnings Period, as the case may be (we refer to such four-quarter period as the MII
4-Quarter
Earnings Period); and (c) we have paid at least the IQD in each calendar quarter
occurring between the end of the First MII Earnings Period or Later MII Earnings Period, as the case may be, and the beginning of the MII
4-Quarter
Earnings Period:
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the holders of our Class A units and common units and management incentive interests will receive 2%, 83% and 15%, respectively, of cash
distributions from available cash from operating surplus that we pay in excess of the Target Distribution for each calendar quarter after the MII
4-Quarter
Earnings Period; and
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the holder of our management incentive interests will receive an EP MID with respect to the First MII Earnings Period or Later MII Earnings Period, as
the case may be.
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Our board of managers has adopted a policy that it will raise our quarterly cash
distribution only when it believes that (i) we have sufficient reserves and liquidity for the proper conduct of our business, including the maintenance of our asset base, and (ii) we can maintain such increased distribution level for a
sustained period. While this is our current policy, our board of managers may alter such policy in the future when and if it determines such alteration to be appropriate.
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Definition of Adjusted Operating Surplus
We define adjusted operating surplus in the glossary and for any period it generally means:
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operating surplus generated with respect to that period less any amounts described in the fifth bullet point under Definition of Operating
Surplus above; less
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any net increase in working capital borrowings with respect to that period (excluding any such borrowings to the extent the proceeds are distributed to
the record holder of our Class D interests); less
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any net reduction in cash reserves for operating expenditures with respect to that period not relating to an operating expenditure made with respect to
that period; plus
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any net decrease in working capital borrowings with respect to that period; plus
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any net increase in cash reserves for operating expenditures made with respect to that period required by any debt instrument for the repayment of
principal, interest or premium.
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Adjusted operating surplus is intended to reflect the cash generated from
our operations during a particular period and therefore excludes net increases in working capital borrowings and net drawdowns of reserves of cash generated in prior periods.
Percentage Allocations of Available Cash from Operating Surplus
The
following table illustrates the percentage allocations of the additional available cash from operating surplus between the unitholders and CEPM as the owner of our management incentive interests up to various distribution levels. The amounts set
forth under Marginal Percentage Interest in Distributions are the percentage interests of our Class A unitholders and common unitholders and the holders of our management incentive interests in any available cash from operating
surplus we distribute up to and including the corresponding amount in the column Quarterly Distribution Level, until available cash from operating surplus we distribute reaches the next distribution level, if any. The percentage
interests shown for the IQD are also applicable to quarterly distribution amounts that are less than the IQD. The percentage interests shown in the table below assume that the Class A units have not been converted into common units as described
herein.
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Marginal Percentage Interest in
Distributions
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Quarterly Distribution
Level
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Class A
Unitholders
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Common
Unitholders
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Management
Incentive
Interests
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IQD
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$0.4625
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2
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%
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98
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%
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0
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%
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Target Distribution
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above $0.4625 up to $0.5319
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2
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%
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98
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%
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0
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%
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Thereafter*
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above $0.5319
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2
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%
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83
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%
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15
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%
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*
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Assumes the management incentive interests have met the
12-Quarter
Test and the
4-Quarter
Test. Until the
12-Quarter
Test and the
4-Quarter
Test are met and distributions in respect of the management incentive
interests become payable, quarterly distributions in excess of the $0.5319 Target Distribution will be made 2% to the holder of the Class A units and 98% to the holders of common units, pro rata.
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Distributions from Capital Surplus
How Distributions from Capital Surplus Are Made
We make distributions of available cash from capital surplus, if any, in the following manner:
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first
, 2% to the holder of our Class A units and 98% to all common unitholders, pro rata, until we distribute for each common unit that was
issued in our initial public offering an amount of available cash from capital surplus equal to the initial public offering price; and
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thereafter
, we will make all distributions of available cash from capital surplus as if they were from operating surplus.
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Effect of a Distribution from Capital Surplus
Our limited liability company agreement treats a distribution of capital surplus as the repayment of the initial common unit price from
our initial public offering, which is a return of capital. The initial public offering price less any distributions of capital surplus per common unit is referred to as the unrecovered capital per initial common unit. Each time a
distribution of capital surplus is made, the IQD and the Target Distribution will be reduced in the same proportion as the corresponding reduction in the unrecovered capital per common unit. Because distributions of capital surplus will reduce the
IQD, after any of these distributions are made, it may be easier for CEPM to receive management incentive distributions. However, any distribution of capital surplus before the unrecovered capital per common unit is reduced to zero cannot be applied
to the payment of the IQD.
Once we distribute capital surplus on a common unit in an amount equal to the unrecovered capital
per common unit, we will reduce the IQD and the Target Distribution to zero. We will then make all future distributions from operating surplus, with 2% being distributed to the holder of our Class A units, 83% being distributed to our common
unitholders, pro rata, and 15% being distributed to the holder of our management incentive interests. The percentage interests shown above for the Class A units assume they have not been converted into common units. If the Class A units
have been converted, the common units will receive the 2% of distributions originally allocated to the Class A units.
Adjustment to the IQD and Target Distribution
In addition to adjusting the IQD and Target Distribution to reflect a distribution of capital surplus, if we combine our common units into fewer common units or subdivide our common units into a greater
number of common units, we will proportionately adjust:
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the Target Distribution; and
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the unrecovered capital per common unit.
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For example, if a
two-for-one
split of the common units should occur, the Target Distribution and the unrecovered capital
per common unit would each be reduced to 50% of its initial level. We will not make any adjustment by reason of the issuance of additional units for cash or property.
In addition, if legislation is enacted or if existing law is modified or interpreted by a court of competent jurisdiction, so that we become taxable as a corporation or otherwise subject to taxation as an
entity for federal, state or local income tax purposes, we will reduce the IQD and the Target Distribution for each quarter by multiplying each by a fraction, the numerator of which is available cash for that quarter (after
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deducting our board of managers estimate of our aggregate liability for the quarter for such income taxes payable by reason of such legislation or interpretation) and the denominator of
which is the sum of available cash for that quarter plus our board of managers estimate of our aggregate liability for the quarter for such income taxes payable by reason of such legislation or interpretation. To the extent that the actual tax
liability differs from the estimated tax liability for any quarter, the difference will be accounted for in subsequent quarters.
Quarterly
Cash Distributions on Our Class D Interests
In order to address the risk of early termination, without the prior consent
of board of managers, prior to December 31, 2012, of the sharing arrangement under the gas purchase contract pertaining to the calculation of amounts payable to the Trust for the NPI, and the potential reduction in our revenues resulting
therefrom, at the closing of our initial public offering CHI contributed $8.0 million to us for all of our Class D interests. For each full calendar quarter during the period commencing January 1, 2007 and ending on December 31, 2012 that
the sharing arrangement remains in effect, we will distribute to the holder of the Class D interests $333,333.33, as a partial return of the $8.0 million capital contribution made for the Class D interests, which payment will be made concurrently
with the quarterly cash distribution to our unitholders for that quarter. The Class D interests will be cancelled upon the payment of the final distribution of $333,333.41 to CHI for the quarter ending December 31, 2012, unless the special
distribution right has been terminated earlier. Such special quarterly cash distributions will be made 45 days after the end of each calendar quarter.
If the amounts payable by us to the Trust are not calculated based on the sharing arrangement through December 31, 2012, unless such change is approved in advance by our board of managers and our
conflicts committee, the special distribution right for future quarters will terminate and the remaining portion of the $8.0 million original contribution not so returned in special cash distributions will be retained by us to partially offset the
reduction in our revenues resulting from termination of the sharing arrangement. In the case of such termination of the special distribution right, CHI will have the right only under specific circumstances upon our liquidation to receive the unpaid
portion of the $8.0 million capital contribution that has not then been distributed to CHI in such special distributions. See Distributions of Cash Upon Liquidation below. If the sharing arrangement in respect of the specified
wells in the Robinsons Bend Field (the Trust Wells) is terminated during a quarter, the special distribution to CHI as the holder of our Class D interests will be prorated for that quarter based on the ratio of the number of days
in such quarter prior to the effective date of such termination to 90. If we and any of the Trust, the trustee of the Trust, or any subsequent holder of the NPI become involved in a dispute or proceeding in which such person asserts that prior to
December 31, 2012 the sharing arrangement ceased to be applicable in calculating amounts payable in respect of production from the Trust Wells, special cash distributions in respect of the Class D interests for periods commencing at the
inception of such dispute will be suspended, and such suspended amounts will only be paid to the holder of the Class D interests to the extent it is finally determined that the sharing arrangement remained applicable during some or all of the
suspension period.
In connection with litigation related to the Torch NPI, we have suspended all quarterly cash distributions
with respect to our Class D interests. This suspension, approved by our board of managers, includes the $0.3 million quarterly cash distribution for the three months ended September 30, 2010 and $3.3 million which represents the distributions
that were suspended for the quarterly periods ended June 30, 2010, March 31, 2010, and December 31, September 30, June 30, and March 31, 2009, and December 31, September 30, June 30, and March 31,
2008. Including the suspended distributions, the remaining undistributed amount of the Class D interests is $6.7 million.
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Distributions of Cash Upon Liquidation
General
If we dissolve in accordance with our limited liability company agreement, we will sell or otherwise dispose of our assets in a process called liquidation. We will first apply the proceeds of liquidation
to the payment of our creditors. We will distribute any remaining proceeds to the unitholders, to CHI, the entity that contributed $8.0 million to us in exchange for the Class D interests, CEPH and CEPM in accordance with their capital account
balances, as adjusted to reflect any gain or loss upon the sale or other disposition of our assets in liquidation.
Manner of Adjustments for Gain
The manner of the adjustment for gain is set forth in our limited liability company agreement, and requires that we will allocate any gain to the unitholders and holders of the Class A units in the
following manner:
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first
, to the holders of common units who have negative balances in their capital accounts to the extent of and in proportion to those negative
balances;
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second
, 2% to the holder of our Class A units and 98% to the common unitholders, pro rata, until the capital account for each common unit
is equal to the sum of:
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(1)
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the unrecovered initial common unit price; and
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(2)
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the amount of the IQD for the quarter during which our liquidation occurs; and
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third
, 100% to the holder of our Class D interests, until the capital account of the Class D interests equals, in the aggregate, the excess, if
any, of (i) the $8.0 million capital contribution made to us by CHI at the closing of our initial public offering for all of our Class D interests over (ii) the cumulative amount distributed as a special distribution to the holder of the
Class D interests in accordance with the description under
-Quarterly
Cash Distributions On Our Class D interests above;
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fourth
, 2% to the holder of our Class A units and 98% to the common unitholders, pro rata, until the capital account for each common unit
is equal to the sum of:
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(1)
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the amount described above under the second bullet point of this paragraph; and
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(2)
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the excess of (I) over (II), where
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(I)
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equals the sum of the excess of the Target Distribution per common unit over the IQD for each quarter of our existence; and
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(II)
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equals the cumulative amount per common unit of any distributions of available cash from operating surplus in excess of the IQD per common unit that we distributed 98%
to our common unitholders, pro rata, for each quarter of our existence; and
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thereafter
, 2% to the holder of our Class A units, 83% to all common unitholders, pro rata, and 15% to the holder of our management
incentive interests.
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Manner of Adjustments for Losses
Upon our liquidation, we will generally allocate any loss 2% to the holder of the Class A units and 98% to the holders of the
outstanding common units, pro rata.
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Adjustments to Capital Accounts
We will make adjustments to capital accounts upon the issuance of additional common units. In doing so, we will allocate any unrealized
and, for tax purposes, unrecognized gain or loss resulting from the adjustments to the holder of the Class A units, the common unitholders, the holders of Class D interests and the holders of the management incentive interests in the same
manner as we allocate gain or loss upon liquidation. In the event that we make positive adjustments to the capital accounts upon the issuance of additional common units, we will allocate any later negative adjustments to the capital accounts
resulting from the issuance of additional common units or upon our liquidation in a manner which results, to the extent possible, in the capital account balances of the holders of the management incentive interests equaling the amount which they
would have been if no earlier positive adjustments to the capital accounts had been made.
CONFLICTS OF INTEREST AND FIDUCIARY DUTIES
Conflicts of Interest
Affiliates of
Constellation own all of our Class A units, 5,918,894 common units, our management incentive interests and our Class D interests. Conflicts of interest exist and may arise in the future as a result of the relationships between us and our
unaffiliated unitholders and our board of managers and executive officers and Constellation and its affiliates, including CEPM and CEPH. These potential conflicts may relate to the divergent interests of these parties.
Whenever a conflict arises between Constellation and its affiliates, on the one hand, and us or any other unitholder, on the other hand,
our board of managers will resolve that conflict. Our limited liability company agreement limits the remedies available to unitholders in the event a unitholder has a claim relating to conflicts of interest.
No breach of obligation will occur under our limited liability company agreement in respect of any conflict of interest if the resolution
of the conflict is:
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approved by the conflicts committee of our board of managers, although our board of managers is not obligated to seek such approval;
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approved by the vote of a majority of the outstanding units, excluding any common or Class A units owned by CEPM, CEPH or any of their affiliates,
although our board of managers is not obligated to seek such approval;
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on terms no less favorable to us than those generally provided to or available from unaffiliated third parties; or
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fair and reasonable to us, taking into account the totality of the relationships between the parties involved, including other transactions that may be
particularly favorable or advantageous to us.
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We anticipate that our board of managers will submit for
review and approval by our conflicts committee any acquisitions of properties or other assets that we propose to acquire from Constellation or any of its affiliates.
If our board of managers does not seek approval from the conflicts committee of our board of managers and our board determines that the resolution or course of action taken with respect to the conflict of
interest satisfies either of the standards set forth in the third and fourth bullet points above, then it will be presumed that, in making its decision, the board of managers, including board members affected by the conflict of interest, acted in
good faith, and in any proceeding brought by or on behalf of any member or the company, the person bringing or prosecuting such proceeding will have the burden of overcoming such presumption. Unless the resolution of a conflict is specifically
provided for in our limited liability company agreement, our board of managers or its conflicts committee may consider any factors in good faith when resolving a conflict. When our limited liability company agreement requires someone to act in good
faith, it requires that person to reasonably believe that he is acting in our best interests, unless the context otherwise requires.
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Conflicts of interest could arise in the situations described below, among others.
Constellation and its affiliates may compete with us and have no obligations to offer us the opportunity to purchase or
own interests in any assets.
None of Constellation or any of its affiliates is restricted from competing with us.
Constellation and its affiliates may acquire, invest in or dispose of exploration and production or other assets, including those that might be in direct competition with us. In addition, neither Constellation nor its affiliates has any obligation
to offer us the opportunity to purchase or own interests in any assets.
Affiliates of Constellation not only have the
exclusive right to elect two members of our board of managers but also may influence the election of the other three members of our board of managers.
CEPM, as the holder of our Class A units will have the exclusive right to elect two members of our board of managers, and CEPH, as the largest holder of our common units, may be able to influence any
vote of common unitholders, including the election of the three members of our board of managers that are elected by the common unitholders. In turn, our board of managers shall have the power to appoint our officers. Situations in which the
interests of our management and Constellation and its affiliates may differ from interests of our unaffiliated unitholders include the following situations:
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our limited liability company agreement gives our board of managers broad discretion in establishing cash reserves for the proper conduct of our
business, which will affect the amount of cash available for distribution. For example, our management will use its reasonable discretion to establish and maintain cash reserves sufficient to fund our drilling program;
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our management team determines the timing and extent of our drilling program and related capital expenditures, asset purchases and sales, borrowings,
issuances of additional membership interests and reserve adjustments, all of which will affect the amount of cash that we distribute to our unitholders;
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our board of managers may cause us to borrow funds in order to permit us to pay cash distributions to our unitholders, even if the purpose or effect of
the borrowing is to make management incentive distributions; and
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our board of managers is allowed to take into account the interest of parties other than us, such as Constellation and its affiliates, in resolving
conflicts of interest, which has the effect of limiting the fiduciary duty to our unaffiliated unitholders.
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Our Class A managers may also serve as managers, directors, officers, employees or contractors of Constellation or its other
affiliates as a result of which conflicts of interest may exist and may arise in the future.
Our Class A managers
may also be managers, directors, officers, employees or contractors of Constellation or its affiliates (other than us). In making decisions in such persons capacity as a manager, director, officer, employee or contractor of Constellation or
such affiliate, such person may make a decision that favors the interests of Constellation or such affiliate over your interests and may be to our detriment, notwithstanding that in making decisions in such persons capacity as our manager such
person is required to act in good faith and in accordance with the standards set forth in our limited liability company agreement. If in resolving a conflict of interest any of our Class A managers satisfies the applicable standards set forth
in our limited liability company agreement for resolving a conflict of interest, you will not be able to assert that such resolution constituted a breach of fiduciary duty owed to us or to you by such Class A manager.
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We may compete for the time and effort of our managers who are also managers,
directors, officers employees or contractors of Constellation and its affiliates.
Constellation and its affiliates
conduct business and activities of their own in which we have no economic interest. Certain of our managers may serve as managers, directors, officers, employees or contractors of Constellation and its affiliates. Our managers are not required to
work full time on our business and affairs and may devote significant time to the affairs of Constellation and its affiliates. There could be material competition for the time and effort of our managers who provide services to Constellation and its
affiliates.
Unitholders will have no right to enforce obligations of Constellation and its affiliates under agreements
with us.
Any agreements between us, on the one hand, and Constellation and its affiliates, on the other hand, will not
grant to our unitholders any right to enforce the obligations of Constellation and its affiliates in our favor.
Contracts between us, on the one hand, and Constellation and its affiliates, on the other, will not be the result of
arms-length negotiations.
Neither our limited liability company agreement nor any of the other contracts or
arrangements between us and Constellation and its affiliates are or will be the result of arms-length negotiations.
Fiduciary Duties
Our limited liability company agreement provides that our business and affairs shall be managed under
the direction of our board of managers, which shall have the power to appoint our officers. Our limited liability company agreement further provides that the authority and function of our board of managers and officers shall be identical to the
authority and functions of a board of directors and officers of a corporation organized under the Delaware General Corporation Law (DGCL). However, our managers and officers do not owe us the same duties that the directors and officers
of a corporation organized under the DGCL would owe to that corporation. Rather, our limited liability company agreement provides that the fiduciary duties and obligations owed to us and to our members by our managers and officers is generally to
act in good faith in the performance of their duties on our behalf. Our limited liability company agreement permits affiliates of our managers to invest or engage in other businesses or activities that compete with us. In addition, if our conflicts
committee approves a transaction involving potential conflicts, or if a transaction is on terms generally available from unaffiliated third parties or an action is taken that is fair and reasonable to the company, unitholders will not be able to
assert that such approval constituted a breach of fiduciary duties owed to them by our managers and officers.
DESCRIPTION OF THE COMMON UNITS
The Common Units
The common units represent limited liability company interests in us. The holders of common units are entitled to participate in
distributions and exercise the rights or privileges provided under our limited liability company agreement. For a description of the relative rights and preferences of holders of common units in and to distributions, please read this section and
How We Make Cash Distributions. For a description of the rights and privileges of holders of common units under our limited liability company agreement, including voting rights, please read The Limited Liability Company
Agreement.
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Transfer Agent and Registrar
Computershare Trust Company, N.A. serves as registrar and transfer agent for the common units. We pay all fees charged by the transfer
agent for transfers of common units, except the following fees that will be paid by holders of common units:
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surety bond premiums to replace lost or stolen certificates, taxes and other governmental charges;
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special charges for services requested by a holder of a common unit; and
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other similar fees or charges.
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There is no charge to unitholders for disbursements of our cash distributions. We will indemnify the transfer agent, its agents and each of their shareholders, managers, officers and employees against all
claims and losses that may arise out of acts performed or omitted in that capacity, except for any liability due to any gross negligence or intentional misconduct of the indemnified person or entity.
The transfer agent may at any time resign, by notice to us, or be removed by us. The resignation or removal of the transfer agent will
become effective upon our appointment of a successor transfer agent and registrar and its acceptance of the appointment. If no successor has been appointed and has accepted the appointment within 30 days after notice of the resignation or removal,
we are authorized to act as the transfer agent and registrar until a successor is appointed.
Transfer of Common
Units
By transfer of common units in accordance with our limited liability company agreement, each transferee of common
units shall be admitted as a unitholder of our company with respect to the common units transferred when such transfer and admission is reflected on our books and records. Additionally, each transferee of common units:
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becomes the record holder of the common units;
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automatically agrees to be bound by the terms and conditions of, and is deemed to have executed our limited liability company agreement;
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represents that the transferee has the capacity, power and authority to enter into the limited liability company agreement;
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grants powers of attorney to our officers and any liquidator of our company as specified in the limited liability company agreement; and
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makes the consents and waivers contained in our limited liability company agreement.
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A transferee will become a unitholder of our company for the transferred common units upon the recording of the name of the transferee on
our books and records.
Until a common unit has been transferred on our books, we and the transfer agent, notwithstanding any
notice to the contrary, may treat the record holder of the common unit as the absolute owner for all purposes, except as otherwise required by law or stock exchange regulations.
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THE LIMITED LIABILITY COMPANY AGREEMENT
The following is a summary of the material provisions of our limited liability company agreement. Our limited liability company agreement
is incorporated by reference as an exhibit to the registration statement of which this prospectus constitutes a part. We will provide prospective investors with a copy of the form of this agreement upon request at no charge.
We summarize the following provisions of our limited liability company agreement elsewhere in this prospectus:
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with regard to distributions of available cash, please read How We Make Cash Distributions.
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with regard to the transfer of common units, please read Description of the Common UnitsTransfer of Common Units; and
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with regard to allocations of taxable income and taxable loss, please read Material Tax Consequences.
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Organization
Our company was formed in February 2005 and will remain in existence until dissolved in accordance with our limited liability company agreement.
Purpose
Under our limited liability company
agreement, we are permitted to engage, directly or indirectly, in any activity that our board of managers approves and that a limited liability company organized under Delaware law lawfully may conduct;
provided
, that our board of managers
shall not cause us to engage, directly or indirectly, in any business activities that it determines would cause us to be treated as an association taxable as a corporation or otherwise taxable as an entity for federal income tax purposes.
Although our board of managers has the ability to cause us and our operating subsidiaries to engage in activities other than
the acquisition, development and exploitation of oil and natural gas properties and related midstream assets, our board of managers has no current plans to do so. Our board of managers is authorized in general to perform all acts it deems to be
necessary or appropriate to carry out our purposes and to conduct our business.
Fiduciary Duties
Our limited liability company agreement provides that the fiduciary duties and obligations owed to us and to our members
by our managers and officers is generally limited to their acting in good faith in the performance of their duties on our behalf. For a description of fiduciary duties, please read Conflicts of Interest and Fiduciary Duties.
Agreement to be Bound by Limited Liability Company Agreement; Power of Attorney
By purchasing a common unit in us, you will be admitted as a member of our company and will be deemed to have agreed to be bound by the
terms of our limited liability company agreement. Pursuant to this agreement, each holder of common units and each person who acquires a common unit from a holder of common units grants to our board of managers (and, if appointed, a liquidator) a
power of attorney to, among other things, execute and file documents required for our qualification, continuance or dissolution. The power of attorney also grants our board of managers the authority to make certain amendments to, and to make
consents and waivers under and in accordance with, our limited liability company agreement.
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Capital Contributions
Unitholders (including holders of common units) are not obligated to make additional capital contributions, except as described below
under Limited Liability.
Limited Liability
Unlawful Distributions
The Delaware Limited Liability Company Act (the Delaware Act) provides that any unitholder who receives a distribution and knew at the time of the distribution that the distribution was in
violation of the Delaware Act shall be liable to the company for the amount of the distribution for three years. Under the Delaware Act, a limited liability company may not make a distribution to any unitholder if, after the distribution, all
liabilities of the company, other than liabilities to unitholders on account of their limited liability company interests and liabilities for which the recourse of creditors is limited to specific property of the company, would exceed the fair value
of the assets of the company. For the purpose of determining the fair value of the assets of a company, the Delaware Act provides that the fair value of property subject to liability for which recourse of creditors is limited shall be included in
the assets of the company only to the extent that the fair value of that property exceeds the nonrecourse liability. Under the Delaware Act, an assignee who becomes a substituted unitholder of a company is liable for the obligations of his assignor
to make contributions to the company, except the assignee is not obligated for liabilities unknown to him at the time he became a unitholder and that could not be ascertained from the limited liability company agreement.
Failure to Comply with the Limited Liability Provisions of Jurisdictions in Which We Do Business
Our subsidiaries may be deemed to conduct business in Alabama, Kansas, Nebraska, Oklahoma and Texas. We may decide to conduct business in
other states, and maintenance of limited liability for us, as a member of our operating subsidiaries, may require compliance with legal requirements in the jurisdictions in which the operating subsidiaries conduct business, including qualifying our
subsidiaries to do business there. Limitations on the liability of unitholders for the obligations of a limited liability company have not been clearly established in many jurisdictions. We will operate in a manner that our board of managers
considers reasonable and necessary or appropriate to preserve the limited liability of our unitholders.
Voting
Rights
Holders of our common units and our Class A units have voting rights on most matters. The following matters
require the unitholder vote specified below:
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Election of members of the board of managers
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Our board of managers consists of five members, as required by our limited liability company agreement. Except as set forth below, at each annual meeting of our unitholders,
Class A unitholders, voting as a single class, will elect two managers and the holders of our common units, voting together as a single class, will elect the remaining three managers. Please read Election of Members of Our Board of
Managers, Removal of Members of Our Board of Managers and Elimination of Special Voting Rights of Class A Units.
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Issuance of additional securities including common units
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No approval right.
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Amendment of the limited liability company agreement
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Certain amendments may be made by our board of managers without unitholder approval. Other amendments generally require the approval of both a common unit majority and Class A
unit majority. Please read Amendment of Our Limited Liability Company Agreement.
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Merger of our company or the sale of all or substantially all of our assets
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Common unit majority and Class A unit majority. Please read
Merger, Sale or Other Disposition of Assets.
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Dissolution of our company
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Common unit majority and Class A unit majority. Please read
Termination and Dissolution.
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Matters requiring the approval of a common unit majority require the approval of at least a
majority of the outstanding common units voting together as a single class. In addition, matters requiring the approval of a Class A unit majority require the approval of at least a majority of the outstanding Class A units voting
together as a single class.
Issuance of Additional Securities
Our limited liability company agreement authorizes us to issue an unlimited number of additional securities and authorizes us to buy
securities for the consideration and on the terms and conditions determined by our board of managers without the approval of our unitholders.
It is possible that we will fund acquisitions through the issuance of additional common units or other equity securities. Holders of any additional common units we issue will be entitled to share equally
with the then-existing holders of common units, Class A units and management incentive interests in our distributions of available cash. Also, the issuance of additional common units or other equity securities may dilute the value of the
interests of the then-existing holders of common units in our net assets.
In accordance with Delaware law and the provisions
of our limited liability company agreement, we may also issue additional securities that, as determined by our board of managers, may have special voting or other rights to which the common and Class A units are not entitled.
The holders of common and Class A units will not have preemptive or preferential rights to acquire additional units or other securities.
Election of Members of Our Board of Managers
At our first annual meeting of the holders of our Class A units and our common unitholders following our initial public offering:
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two members of our board of managers were elected by CEPM, as the holder of all of our Class A units; and
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three members of our board of managers were elected by our common unitholders.
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The board of managers will be subject to
re-election
on an annual basis in this manner at our annual meeting of
the holders of our Class A units and our common unitholders.
Removal of Members of Our Board of Managers
Any manager elected by the holder of our Class A units may be removed, with or without cause, by the holders of
66 2/3% of the outstanding Class A units then entitled to vote at an election of managers. Any manager elected by the holders of our common units may be removed, with or without cause, by the holders of at least a majority of the outstanding
common units then entitled to vote at an election of managers.
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Increase in the Size of Our Board of Managers
The size of our board of managers may increase only with the approval of the holders of 66 2/3% outstanding Class A units. If the
size of our board of managers is so increased, the vacancy created thereby shall be filled by a person appointed by our board of managers or a nominee approved by a majority vote of our common unitholders, unless such vacancy is specified by an
amendment to our limited liability company agreement as a vacancy to be filled by our Class A unitholders, in which case such vacancy shall be filled by a person approved by our Class A unitholders.
Elimination of Special Voting Rights of Class A Units
The holders of our Class A units have the right, voting as a separate class, to elect two of the five members of our board of
managers and any replacement of either of such members, subject to the matters described under Election of Members of Our Board of ManagersIncrease in the Size of Our Board of Managers above. This right can be eliminated only
upon a proposal submitted by or with the consent of our board of managers and the vote of the holders of not less than 66 2/3% of our outstanding common units. If such elimination is so approved and Constellation and its affiliates do not vote their
common units in favor of such elimination, the Class A units will be converted into common units on a
one-for-one
basis and CEPM will have the right to convert its
management incentive interests into common units based on the then-fair market value of such interests.
Amendment of Our Limited Liability Company Agreement
General
Amendments to our limited liability company agreement may be proposed only by or with the consent of our board of managers. To adopt a proposed amendment, other than the amendments discussed below, our
board of managers is required to seek written approval of the holders of the number of units required to approve the amendment or call a meeting of our unitholders to consider and vote upon the proposed amendment. Except as described below, an
amendment must be approved by a common unit majority and a Class A unit majority.
Prohibited Amendments
No amendment may be made that would:
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enlarge the obligations of any unitholder without its consent, unless approved by at least a majority of the type or class of member interests so
affected;
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provide that we are not dissolved upon an election to dissolve our company by our board of managers that is approved by a common unit majority and a
Class A unit majority;
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entitle members holding common units and/or Class A units to more or less than one vote per unit;
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prohibit the holders of Class A units from acting without a meeting;
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change the procedures for notice to members of business to be brought before a meeting and nominations to board of managers;
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require some percentage other than a majority of votes cast affirmatively or negatively by members holding units for approval of matters submitted for
a member vote;
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allow the calling of a special meeting by other than a majority of the board of managers;
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change the term of existence of our company;
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give any person the right to dissolve our company other than our board of managers right to dissolve our company with the approval of a common
unit majority and a Class A unit majority; or
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enlarge the size of our board of managers without the approval of the holders of 66 2/3% of our Class A units.
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The provision of our limited liability company agreement preventing the amendments having the effects described in any of the clauses
above can be amended upon the approval of the holders of at least 75% of the outstanding common units, voting together as a single class, and 75% of the outstanding Class A units, voting together as a single class.
No Unitholder Approval
Our board of managers may generally make amendments to our limited liability company agreement without unitholder approval to reflect:
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a change in our name, the location of our principal place of our business, our registered agent or our registered office;
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the admission, substitution, withdrawal or removal of members in accordance with our limited liability company agreement;
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a change that our board of managers determines to be necessary or appropriate for us to qualify or continue our qualification as a company in which our
members have limited liability under the laws of any state or to ensure that neither we, our operating subsidiaries nor any of its subsidiaries will be treated as an association taxable as a corporation or otherwise taxed as an entity for federal
income tax purposes;
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the merger of our company or any of its subsidiaries into, or the conveyance of all of our assets to, a newly formed entity if the sole purpose of that
merger or conveyance is to effect a mere change in our legal form into another limited liability entity;
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an amendment that is necessary, in the opinion of our counsel, to prevent us, members of our board, or our officers, agents or trustees from in any
manner being subjected to the provisions of the Investment Company Act of 1940, the Investment Advisors Act of 1940, or plan asset regulations adopted under the Employee Retirement Income Security Act of 1974 (ERISA) whether
or not substantially similar to plan asset regulations currently applied or proposed;
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an amendment that our board of managers determines to be necessary or appropriate for the authorization of additional securities or rights to acquire
securities;
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any amendment expressly permitted in our limited liability company agreement to be made by our board of managers acting alone;
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an amendment effected, necessitated or contemplated by a merger agreement that has been approved under the terms of our limited liability company
agreement;
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any amendment that our board of managers determines to be necessary or appropriate for the formation by us of, or our investment in, any corporation,
partnership or other entity, as otherwise permitted by our limited liability company agreement;
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a change in our fiscal year or taxable year and related changes;
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a merger, conversion or conveyance effected in accordance with the limited liability company agreement; and
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any other amendments substantially similar to any of the matters described in the clauses above.
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In addition, our board of managers may make amendments to our limited liability company agreement without unitholder approval if our
board of managers determines that those amendments:
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do not adversely affect the unitholders (including any particular class of unitholders as compared to other classes of unitholders) in any material
respect;
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are necessary or appropriate to satisfy any requirements, conditions or guidelines contained in any opinion, directive, order, ruling or regulation of
any federal or state agency or judicial authority or contained in any federal or state statute;
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are necessary or appropriate to facilitate the trading of common units or to comply with any rule, regulation, guideline or requirement of any
securities exchange on which the common units are or will be listed for trading, compliance with any of which our board of managers deems to be in the best interests of us and our common unitholders;
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are necessary or appropriate for any action taken by our board of managers relating to splits or combinations of units under the provisions of our
limited liability company agreement; or
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are required to effect the intent expressed in this prospectus or the intent of the provisions of our limited liability company agreement or are
otherwise contemplated by our limited liability company agreement.
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Opinion of Counsel and Unitholder
Approval
Our board of managers will not be required to obtain an opinion of counsel that an amendment will not result
in a loss of limited liability to our unitholders or result in our being treated as an entity for federal income tax purposes if one of the amendments described above under No Unitholder Approval should occur. No other amendments
to our limited liability company agreement will become effective without the approval of holders of at least 90% of the common units and Class A units unless we obtain an opinion of counsel to the effect that the amendment will not affect the
limited liability under applicable law of any unitholder of our company.
Any amendment that would have a material adverse
effect on the rights or preferences of any type or class of outstanding units in relation to other classes of units will require the approval of at least a majority of the type or class of units so affected. Any amendment that reduces the voting
percentage required to take any action is required to be approved by the affirmative vote of unitholders whose aggregate outstanding units constitute not less than the voting requirement sought to be reduced.
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Merger, Sale or Other Disposition of Assets; Conversion
Our board of managers is generally prohibited, without the prior approval of a common unit majority and a Class A unit majority from
causing us to, among other things, sell, exchange or otherwise dispose of all or substantially all of our assets in a single transaction or a series of related transactions, including by way of merger, consolidation or other combination, or
approving on our behalf the sale, exchange or other disposition of all or substantially all of the assets of our subsidiaries, provided that our board of managers may mortgage, pledge, hypothecate or grant a security interest in all or substantially
all of our assets without that approval. Our board of managers may also sell all or substantially all of our assets under a foreclosure or other realization upon the encumbrances above without that approval.
If the conditions specified in the limited liability company agreement are satisfied, our board of managers may merge our company or any
of its subsidiaries into, or convey all of our assets to, a newly formed entity if the sole purpose of that merger or conveyance is to effect a mere change in our legal form into another limited liability entity. Additionally, the Company may
convert into any other entity as defined in the Delaware Limited Liability Company Act, whether such entity is formed under the laws of the State of Delaware or any other state in the United States of America. Our unitholders are not
entitled to dissenters rights of appraisal under the limited liability company agreement or applicable Delaware law in the event of a merger or consolidation, a sale of all or substantially all of our assets or any other transaction or event.
Termination and Dissolution
We will continue as a company until terminated under our limited liability company agreement. We will dissolve upon: (1) the election of our board of managers to dissolve us, if approved by a common
unit majority and a Class A unit majority; (2) the sale, exchange or other disposition of all or substantially all of the assets and properties of our company and our subsidiaries; or (3) the entry of a decree of judicial dissolution
of our company.
Liquidation and Distribution of Proceeds
Upon our dissolution, the liquidator authorized to wind up our affairs will, acting with all of the powers of our board of managers that
the liquidator deems necessary or desirable in its judgment, liquidate our assets and apply the proceeds of the liquidation as provided in How We Make Cash DistributionsDistributions of Cash Upon Liquidation. The liquidator may
defer liquidation or distribution of our assets for a reasonable period of time or distribute assets to unitholders in kind if it determines that a sale would be impractical or would cause undue loss to our unitholders.
Anti-Takeover Provisions
Our limited liability company agreement contains specific provisions that are intended to discourage a person or group from attempting to take control of our company without the approval of our board of
managers. Specifically, our limited liability company agreement provides that we will elect to have Section 203 of the DGCL apply to transactions in which an interested common unitholder (as described below) seeks to enter into a merger or
business combination with us. Under this provision, such a holder will not be permitted to enter into a merger or business combination with us unless:
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prior to such time, our board of managers approved either the business combination or the transaction that resulted in the common unitholders
becoming an interested common unitholder;
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upon consummation of the transaction that resulted in the common unitholder becoming an interested common unitholder, the interested common unitholder
owned at least 85% of our outstanding common units at the time the transaction commenced, excluding for purposes of determining the number of common units outstanding those common units owned:
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by persons who are managers and also officers; and
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by employee common unit plans in which employee participants do not have the right to determine confidentially whether common units held subject to the
plan will be tendered in a tender or exchange offer; or
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at or subsequent to such time the business combination is approved by our board of managers and authorized at an annual or special meeting of our
common unitholders, and not by written consent, by the affirmative vote of the holders of at least 66 2/3% of our outstanding voting common units that are not owned by the interested common unitholder.
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Section 203 of the DGCL defines business combination to include:
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any merger or consolidation involving the company and the interested common unitholder;
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any sale, transfer, pledge or other disposition of 10% or more of the assets of the company involving the interested common unitholder;
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subject to certain exceptions, any transaction that results in the issuance or transfer by the company of any common units of the company to the
interested common unitholder;
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any transaction involving the company that has the effect of increasing the proportionate share of the units of any class or series of the company
beneficially owned by the interested common unitholder; or
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the receipt by the interested common unitholder of the benefit of any loans, advances, guarantees, pledges or other financial benefits provided by or
through the company.
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In general, by reference to Section 203, an interested common
unitholder is any person or entity, other than Constellation, CEPM, their affiliates or transferees, that beneficially owns (or within three years did own) 15% or more of the outstanding common units of the company and any entity or person
affiliated with or controlling or controlled by such entity or person.
The existence of this provision would be expected to
have an anti-takeover effect with respect to transactions not approved in advance by our board of managers, including discouraging attempts that might result in a premium over the market price for common units held by common unitholders.
Our limited liability agreement also restricts the voting rights of common unitholders by providing that any units held by a person that
owns 20% or more of any class of units then outstanding, other than Constellation, CEPM, their affiliates or transferees and persons who acquire such units with the prior approval of the board of managers, cannot vote on any matter.
Limited Call Right
If at any time any person owns more than 80% of the then-issued and outstanding common units, it will have the right, which it may assign in whole or in part to any of its affiliates or to us, to acquire
all, but not less than all, of the remaining common units held by unaffiliated persons as of a record date to be selected by our board of managers, on at least 10 days but not more than 60 days notice. The common unitholders are not entitled to
dissenters rights of appraisal under the limited liability company agreement or applicable Delaware law if this limited call right is exercised. The purchase price in the event of this purchase is the greater of:
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the highest cash price paid by such person for any common units purchased within the 90 days preceding the date on which such person first mails notice
of its election to purchase the remaining common units; and
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the closing market price of the common units as of the date three days before the date the notice is mailed.
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As a result of this limited call right, a holder of common units may have his limited liability company interests purchased at an
undesirable time or price. The tax consequences to a common unitholder of the exercise of this call right are the same as a sale by that common unitholder of his common units in the market. Please read Material Tax
ConsequencesDisposition of Units.
Meetings; Voting
All notices of meetings of unitholders shall be sent or otherwise given in accordance with Sections 11.4 and 14.1 of our limited liability
company agreement not less than 10 days nor more than 60 days before the date of the meeting. The notice shall specify the place, date and hour of the meeting and (i) in the case of a special meeting, the general nature of the business to be
transacted (no business other than that specified in the notice may be transacted) or (ii) in the case of the annual meeting, those matters which the board of managers, at the time of giving the notice, intends to present for action by the
unitholders (but any proper matter may be presented at the meeting for such action). The notice of any meeting at which managers are to be elected shall include the name of any nominee or nominees who, at the time of the notice, the board of
managers intends to present for election. Any previously scheduled meeting of the unitholders may be postponed, and any special meeting of the unitholders may be cancelled, by resolution of the board of managers upon public notice given prior to the
date previously scheduled for such meeting of unitholders.
Units that are owned by an assignee who is a record holder, but
who has not yet been admitted as a member, shall be voted at the written direction of the record holder by a proxy designated by our board of managers. Absent direction of this kind, the units will not be voted, except that units held by us on
behalf of
non-citizen
assignees shall be voted in the same ratios as the votes of unitholders on other units are cast.
Any action required or permitted to be taken by our common unitholders must be effected at a duly called annual or special meeting of unitholders and may not be effected by any consent in writing by such
common unitholders.
Special meetings of the unitholders may only be called by a majority of our board of managers.
Unitholders may vote either in person or by proxy at meetings. The holders of a majority of the outstanding units for which a meeting has been called represented in person or by proxy shall constitute a quorum unless any action by the unitholders
requires approval by holders of a greater percentage of the units, in which case the quorum shall be the greater percentage.
Each record holder of a unit has a vote according to his percentage interest in us, although additional units having special voting
rights could be issued. Please read Issuance of Additional Securities. Units held in nominee or street name accounts will be voted by the broker or other nominee in accordance with the instruction of the beneficial owner unless the
arrangement between the beneficial owner and its nominee provides otherwise.
Any notice, demand, request, report or proxy
material required or permitted to be given or made to record holders of units under our limited liability company agreement will be delivered to the record holder by us or by the transfer agent.
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Our limited liability agreement also restricts the voting rights of common unitholders by
providing that any units held by a person that owns 20% or more of any class of units then outstanding, other than Constellation, CEPM, their affiliates or transferees and persons who acquire such units with the prior approval of the board of
managers, cannot vote on any matter.
Non-Citizen
Assignees; Redemption
If we or any of our subsidiaries are or become subject to federal, state or local laws or regulations that, in the
reasonable determination of our board of managers, create a substantial risk of cancellation or forfeiture of any property that we have an interest in because of the nationality, citizenship or other related status of any unitholder or assignee, we
may redeem, upon 30 days advance notice, the units held by the unitholder or assignee at their current market price. To avoid any cancellation or forfeiture, our board of managers may require each unitholder or assignee to furnish information
about his nationality, citizenship or related status. If a unitholder or assignee fails to furnish information about his nationality, citizenship or other related status within 30 days after a request for the information or our board of managers
determines after receipt of the information that the unitholder or assignee is not an eligible citizen, the unitholder or assignee may be treated as a
non-citizen
assignee. In addition to other limitations on
the rights of an assignee who is not a substituted unitholder, a
non-citizen
assignee does not have the right to direct the voting of his units and may not receive distributions in kind upon our liquidation.
Indemnification
Under our limited liability company agreement and subject to specified limitations, we will indemnify to the fullest extent permitted by law from and against all losses, claims, damages or similar events
any person who is or was our manager or officer, or while serving as our manager or officer, is or was serving as a tax matters member or, at our request, as a manager, officer, tax matters member, employee, partner, fiduciary or trustee of us or
any of our subsidiaries. Additionally, we shall indemnify to the fullest extent permitted by law and authorized by our board of managers, from and against all losses, claims, damages or similar events, any person who is or was an employee or agent
(other than an officer) of our company.
Any indemnification under our limited liability company agreement will only be out of
our assets. We are authorized to purchase insurance against liabilities asserted against and expenses incurred by persons for our activities, regardless of whether we would have the power to indemnify the person against liabilities under our limited
liability company agreement.
Books and Reports
We are required to keep appropriate books of our business at our principal offices. The books will be maintained for both tax and
financial reporting purposes on an accrual basis. For tax and fiscal reporting purposes, our fiscal year is the calendar year.
We will furnish or make available to record holders of units, within 120 days after the close of each fiscal year, an annual report
containing audited financial statements and a report on those financial statements by our independent public accountants. Except for our fourth quarter, we will also furnish or make available summary financial information within 90 days after the
close of each quarter.
We will furnish each record holder of a unit with information reasonably required for tax reporting
purposes within 90 days after the close of each calendar year. This information is expected to be furnished in summary form so that some complex calculations normally required of unitholders can be avoided. Our ability to furnish this summary
information to unitholders will depend on the cooperation of unitholders in supplying us with specific information. Every unitholder will receive information to assist him in determining his federal and state tax liability and filing his federal and
state income tax returns, regardless of whether he supplies us with information.
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Right To Inspect Our Books and Records
Our limited liability company agreement provides that a unitholder can, for a purpose reasonably related to his interest as a unitholder,
upon reasonable demand and at his own expense, have furnished to him:
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a current list of the name and last known address of each unitholder;
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a copy of our tax returns;
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information as to the amount of cash, and a description and statement of the agreed value of any other property or services, contributed or to be
contributed by each unitholder and the date on which each became a unitholder;
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copies of our limited liability company agreement, the certificate of formation of the company, related amendments and powers of attorney under which
they have been executed;
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information regarding the status of our business and financial condition; and
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any other information regarding our affairs as is just and reasonable.
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Our board of managers may, and intends to, keep confidential from our unitholders information that it believes to be in the nature of
trade secrets or other information, the disclosure of which our board of managers believes in good faith is not in our best interests, information that could damage our company or our business, or information that we are required by law or by
agreements with a third-party to keep confidential.
Registration Rights
We have agreed to register for sale under the Securities Act and applicable state securities laws any common units or other of our
securities held by CEPM, CEPH or any of their affiliates if an exemption from the registration requirements is not otherwise available. These registration rights continue for two years following any termination of the special voting rights of the
holders of our Class A units. We have also agreed to include any of our securities held by CEPM, CEPH or their affiliates in any registration statement that we file to offer our securities for cash, except an offering relating solely to an
employee benefit plan, for the same period. We are obligated to pay all expenses incidental to the registration, excluding underwriting discounts and commissions.
MATERIAL TAX CONSEQUENCES
This section is a
discussion of the material U.S. federal tax consequences that may be relevant to prospective common unitholders who are individual citizens or residents of the United States and, unless otherwise noted in the following discussion, is the opinion of
Andrews Kurth LLP, counsel to us, insofar as it relates to matters of U.S. federal income tax law and legal conclusions with respect to those matters. This section is based on current provisions of the Internal Revenue Code of 1986, as amended,
existing and proposed regulations and current administrative rulings and court decisions, all of which are subject to change. Later changes in these authorities may cause the tax consequences to vary substantially from the consequences described
below. Unless the context otherwise requires, references in this section to us or we are references to Constellation Energy Partners LLC and our limited liability company operating subsidiaries.
This section does not address all U.S. federal income tax matters that affect us or common unitholders. Furthermore, this section focuses
on common unitholders who are individual citizens or residents of the United States whose functional currency is the U.S. dollar and who hold units as a capital asset (generally, property that is held as an investment) and has no application to
corporations, partnerships (and entities
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treated as partnerships for U.S. federal income tax purposes), estates, trusts,
non-resident
aliens or other common unitholders subject to specialized tax
treatment, such as
tax-exempt
institutions, foreign persons, individual retirement accounts (IRAs), employee benefit plans, real estate investment trusts (REITs) or mutual funds. Accordingly, we urge each
prospective common unitholder to consult with his own tax advisor in analyzing the U.S. federal, state, local and foreign tax consequences particular to him of the ownership or disposition of our units.
No ruling has been or will be requested from the IRS regarding any matter that affects us or prospective common unitholders. Instead, we
rely on opinions and advice of Andrews Kurth LLP. Unlike a ruling, an opinion of counsel represents only that counsels best legal judgment and does not bind the IRS or the courts. Accordingly, the opinions and statements made in this
discussion may not be sustained by a court if contested by the IRS. Any contest of this sort with the IRS may materially and adversely impact the market for our units and the prices at which our units trade. In addition, the costs of any contest
with the IRS, principally legal, accounting and related fees, will result in a reduction in cash available for distribution to our common unitholders and thus will be borne directly by our common unitholders. Furthermore, the tax treatment of us, or
of an investment in us, may be significantly modified by future legislative or administrative changes or court decisions. Any modifications may or may not be retroactively applied.
All statements regarding matters of law and legal conclusions set forth below, unless otherwise noted, are the opinion of Andrews Kurth
LLP and are based on the accuracy of the representations made by us. Statements of fact do not represent opinions of Andrews Kurth LLP.
For the reasons described below, Andrews Kurth LLP has not rendered an opinion with respect to the following specific U.S. federal income tax issues:
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the treatment of a common unitholder whose units are loaned to a short seller to cover a short sale of units (please read Tax Consequences
of Unit OwnershipTreatment of Short Sales);
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whether our monthly convention for allocating taxable income and losses is permitted by existing Treasury Regulations (please read
Disposition of UnitsAllocations Between Transferors and Transferees); and
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whether our method for depreciating Section 743 adjustments is sustainable in certain cases (please read Tax Consequences of Unit
OwnershipSection 754 Election and Uniformity of Units).
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Partnership Status
Except as discussed in the following paragraph, a limited liability company that has more than one member and that has not elected to be treated as a corporation is treated as a partnership for U.S.
federal income tax purposes and, therefore, is not a taxable entity and incurs no U.S. federal income tax liability. Instead, each partner is required to take into account his respective share of items of our income, gain, loss and deduction of the
partnership in computing his U.S. federal income tax liability, even if no cash distributions are made to him. Distributions by a partnership to a partner are generally not taxable to the partner unless the amount of cash distributed to him is in
excess of his adjusted basis in his partnership interest.
Section 7704 of the Internal Revenue Code provides that
publicly traded partnerships will, as a general rule, be taxed as corporations. However, an exception, referred to in this discussion as the Qualifying Income Exception, exists with respect to publicly traded partnerships for which 90%
or more of the gross income for every taxable year consists of qualifying income. Qualifying income includes income and gains derived from the exploration, development, mining or production, processing, transportation and marketing of
natural resources, including oil, natural gas, and products thereof. Other types of qualifying
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income include interest (other than from a financial business), dividends, gains from the sale of real property and gains from the sale or other disposition of capital assets held for the
production of income that otherwise constitutes qualifying income. We estimate that less than 3% of our current gross income does not constitute qualifying income; however, this estimate could change from time to time. Based on and subject to this
estimate, the factual representations made by us, and a review of the applicable legal authorities, Andrews Kurth LLP is of the opinion that more than 90% of our current gross income constitutes qualifying income. The portion of our income that is
qualifying income can change from time to time.
No ruling has been or will be sought from the IRS, and the IRS has made no
determination as to our status or the status of our operating subsidiaries for U.S. federal income tax purposes or whether our operations generate qualifying income under Section 7704 of the Internal Revenue Code. Instead, we will
rely on the opinion of Andrews Kurth LLP. Andrews Kurth LLP is of the opinion, based upon the Internal Revenue Code, its regulations, published revenue rulings, court decisions and factual representations made by us, that we are and will continue to
be classified as a partnership, and each of our operating subsidiaries will be disregarded as an entity separate from us, for U.S. federal income tax purposes.
In rendering its opinion, Andrews Kurth LLP has relied on factual representations made by us. The representations made by us upon which Andrews Kurth LLP has relied include, without limitation:
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Neither we nor any of our limited liability company subsidiaries have elected or will elect to be treated as a corporation; and
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For each taxable year, more than 90% of our gross income has been and will be income that Andrews Kurth LLP has opined or will opine is
qualifying income within the meaning of Section 7704(d) of the Internal Revenue Code.
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If
we fail to meet the Qualifying Income Exception, other than a failure that is determined by the IRS to be inadvertent and that is cured within a reasonable time after discovery, we will be treated as if we had transferred all of our assets, subject
to liabilities, to a newly formed corporation, on the first day of the year in which we fail to meet the Qualifying Income Exception, in return for stock in that corporation and then distributed that stock to common unitholders in liquidation of
their interests in us. This deemed contribution and liquidation would be
tax-free
to common unitholders and us so long as we, at that time, do not have liabilities in excess of the tax basis of our assets.
Thereafter, we would be treated as a corporation for U.S. federal income tax purposes.
If we were taxable as a corporation
for U.S. federal income tax purposes in any taxable year, either as a result of a failure to meet the Qualifying Income Exception or otherwise, our items of income, gain, loss and deduction would be reflected only on our tax return rather than being
passed through to common unitholders, and our net income would be taxed to us at corporate rates. In addition, any distribution made to a common unitholder would be treated as taxable dividend income to the extent of our current or accumulated
earnings and profits, or, in the absence of earnings and profits, a nontaxable return of capital to the extent of the common unitholders tax basis in his units, or taxable capital gain, after the common unitholders tax basis in his units
is reduced to zero. Accordingly, taxation as a corporation would result in a material reduction in a common unitholders cash flow and
after-tax
return and thus would likely result in a substantial
reduction of the value of the units.
The remainder of this section assumes that we are and will continue to be classified as
a partnership for U.S. federal income tax purposes.
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Common Unitholder Status
Common unitholders who become members of CEP will be treated as partners of CEP for U.S. federal income tax purposes. Also, common
unitholders whose units are held in street name or by a nominee and who have the right to direct the nominee in the exercise of all substantive rights attendant to the ownership of their units will be treated as partners of CEP for U.S. federal
income tax purposes. A beneficial owner of units whose units have been transferred to a short seller to complete a short sale would appear to lose his status as a partner with respect to those units for U.S. federal income tax purposes. Please read
Tax Consequences of Unit OwnershipTreatment of Short Sales. As there is no direct or indirect controlling authority addressing assignees of common units who are entitled to execute and deliver transfer applications and
thereby become entitled to direct the exercise of attendant rights, but who fail to execute and deliver transfer applications, Andrews Kurth LLPs opinion does not extend to these persons. Furthermore, a purchaser or other transferee of common
units who does not execute and deliver a transfer application may not receive some U.S. federal income tax information or reports furnished to record holders of common units unless the common units are held in a nominee or street name account and
the nominee or broker has executed and delivered a transfer application for those common units.
Items of our income, gain,
loss, or deduction are not reportable by a common unitholder who is not a partner for U.S. federal income tax purposes, and any cash distributions received by a common unitholder who is not a partner for U.S. federal income tax purposes would
therefore be fully taxable as ordinary income. These common unitholders are urged to consult their own tax advisors with respect to their status as partners in us for U.S. federal income tax purposes.
The references to common unitholders in the discussion that follows are to persons who are treated as partners in CEP for
U.S. federal income tax purposes.
Tax Consequences of Unit Ownership
Flow-Through of Taxable Income
Subject to the discussion below under Entity-Level Collections, neither we nor our subsidiaries pay any U.S. federal income tax. Instead, each common unitholder is be required to report
on his income tax return his share of our income, gains, losses and deductions without regard to whether corresponding cash distributions are received by him. Consequently, we may allocate income to a common unitholder even if he has not received a
cash distribution. Each common unitholder is required to include in income his share of our income, gain, loss and deduction for our taxable year or years ending with or within his taxable year. Our taxable year ends on December 31.
Treatment of Distributions
Distributions made by us to a common unitholder generally are not be taxable to the common unitholder for U.S. federal income tax purposes to the extent of his tax basis in his units immediately before
the distribution. Cash distributions made by us to a common unitholder in an amount in excess of his tax basis in his units generally are considered to be gain from the sale or exchange of those units, taxable in accordance with the rules described
under Disposition of Units below. To the extent that cash distributions made by us cause a common unitholders at risk amount to be less than zero at the end of any taxable year, the common unitholder must
recapture any losses deducted in previous years. Please read Limitations on Deductibility of Losses.
Any
reduction in a common unitholders share of our liabilities for which no partner bears the economic risk of loss, known as nonrecourse liabilities, will be treated as a distribution of cash to that common unitholder.
A decrease in a common unitholders percentage interest in us because of our issuance of additional common units will decrease his
share of our nonrecourse liabilities and thus will result in a corresponding deemed distribution of cash, which may constitute a
non-pro
rata distribution. A
non-pro
rata distribution of money or property may result in ordinary income to a common unitholder, regardless of his tax basis in his
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units, if the distribution reduces the common unitholders share of our unrealized receivables, including recapture of intangible drilling and development costs, depletion and
depreciation recapture, and/or substantially appreciated inventory items, both as defined in Section 751 of the Internal Revenue Code, and collectively, Section 751 Assets. To that extent, he will be treated as having
received his proportionate share of the Section 751 Assets and having exchanged those assets with us in return for the
non-pro
rata portion of the actual distribution made to him. This latter deemed
exchange will generally result in the common unitholders realization of ordinary income. That income will equal the excess of (1) the
non-pro
rata portion of that distribution over (2) the
common unitholders tax basis (generally zero) for the share of Section 751 Assets deemed relinquished in the exchange.
Basis of Units
A common unitholders initial tax basis in his
units will be the amount he paid for the units plus his share of our nonrecourse liabilities. That basis will be increased by his share of our income and by any increases in his share of our nonrecourse liabilities. That basis generally will be
decreased, but not below zero, by distributions to him from us, by his share of our losses, by depletion deductions taken by him to the extent such deductions do not exceed his proportionate share of the adjusted tax basis of the underlying
producing properties, by any decreases in his share of our nonrecourse liabilities and by his share of our expenditures that are not deductible in computing taxable income and are not required to be capitalized. A common unitholders share of
our nonrecourse liabilities will generally be based on his share of our profits. Please read Disposition of UnitsRecognition of Gain or Loss.
Limitations on Deductibility of Losses
The deduction by a common
unitholder of his share of our losses is limited to his tax basis in his units and, in the case of an individual, estate, trust or corporate common unitholder (if more than 50% of the value of its stock is owned directly or indirectly by or for five
or fewer individuals or some
tax-exempt
organizations) to the amount for which the common unitholder is considered to be at risk with respect to our activities, if that amount is less than his tax
basis. A common unitholder subject to these limitations must recapture losses deducted in previous years to the extent that distributions cause his at risk amount to be less than zero at the end of any taxable year. Losses disallowed to a common
unitholder or recaptured as a result of these limitations will carry forward and will be allowable as a deduction in a later year to the extent that his tax basis or at risk amount, whichever is the limiting factor, is subsequently increased. Upon
the taxable disposition of a unit, any gain recognized by a common unitholder can be offset by losses that were previously suspended by the at risk limitation but may not be offset by losses suspended by the basis limitation. Any loss previously
suspended by the at risk limitation in excess of that gain is no longer utilizable.
In general, a common unitholder will be
at risk to the extent of his tax basis in his units, excluding any portion of that basis attributable to his share of our nonrecourse liabilities, reduced by (i) any portion of that basis representing amounts otherwise protected against loss
because of a guarantee, stop loss agreement, or other similar arrangement and (ii) any amount of money the common unitholder borrows to acquire or hold his units, if the lender of those borrowed funds owns an interest in us, is related to
another common unitholder or can look only to the units for repayment. A common unitholders at risk amount will increase or decrease as the tax basis of another common unitholders common units increases or decreases, other than tax basis
increases or decreases attributable to increases or decreases in his share of our nonrecourse liabilities.
The at risk
limitation applies on an
activity-by-activity
basis, and in the case of oil and natural gas properties, each property is treated as a separate activity. Thus, a
taxpayers interest in each oil or gas property is generally required to be treated separately so that a loss from any one property would be limited to the at risk amount for that property and not the at risk amount for all the taxpayers
oil and natural gas properties. It is uncertain how this rule is implemented in the case of multiple oil and natural gas properties owned by a single entity treated as a partnership for U.S. federal income tax purposes. However, for taxable years
ending on or before the date on which further guidance is published, the IRS will permit aggregation
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of oil or gas properties we own in computing a common unitholders at risk limitation with respect to us. If a common unitholder must compute his at risk amount separately with respect to
each oil or gas property we own, he may not be allowed to utilize his share of losses or deductions attributable to a particular property even though he has a positive at risk amount with respect to his units as a whole.
The passive loss limitation generally provides that individuals, estates, trusts and some closely held corporations and personal service
corporations are permitted to deduct losses from passive activities, which are generally defined as trade or business activities in which the taxpayer does not materially participate, only to the extent of the taxpayers income from those
passive activities. The passive loss limitation is applied separately with respect to each publicly traded partnership. Consequently, any passive losses we generate will be available to offset only our passive income generated in the future and will
not be available to offset income from other passive activities or investments, including our investments, a common unitholders investments in other publicly traded partnerships, or a common unitholders salary or active business income.
Passive losses that are not deductible because they exceed a common unitholders share of income we generate may only be deducted by the common unitholder in full when he disposes of his entire investment in us in a fully taxable transaction
with an unrelated party. The passive activity loss limitations are applied after certain other applicable limitations on deductions, including the at risk rules and the tax basis limitation.
A common unitholders share of our net income may be offset by any of our suspended passive losses, but it may not be offset by any
other current or carryover losses from other passive activities, including those attributable to other publicly traded partnerships.
Limitation on Interest Deductions
The deductibility of a
non-corporate
taxpayers investment interest expense is generally limited to the amount of that taxpayers net investment income. Investment interest expense includes:
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interest on indebtedness properly allocable to property held for investment;
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our interest expense attributable to portfolio income; and
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the portion of interest expense incurred to purchase or carry an interest in a passive activity to the extent attributable to portfolio income.
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The computation of a common unitholders investment interest expense will take into account interest
on any margin account borrowing or other loan incurred to purchase or carry a common unit.
Net investment income includes
gross income from property held for investment and amounts treated as portfolio income under the passive loss limitations, less deductible expenses, other than interest, directly connected with the production of investment income, but generally does
not include gains attributable to the disposition of property held for investment. The IRS has indicated that net passive income earned by a publicly traded partnership will be treated as investment income to its common unitholders for purposes of
the investment interest expense limitations. In addition, the common unitholders share of our portfolio income will be treated as investment income.
Entity-Level Collections
If we are required or elect under
applicable law to pay any federal, state or local income tax on behalf of any common unitholder or any former common unitholder, we are authorized to pay those taxes from our funds. That payment, if made, will be treated as a distribution of cash to
the common unitholder on whose behalf the payment was made. If the payment is made on behalf of a common unitholder whose identity cannot be determined, we are authorized to treat the payment as a distribution to all current
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common unitholders. We are authorized to amend our limited liability company agreement in the manner necessary to maintain uniformity of intrinsic tax characteristics of units and to adjust later
distributions, so that after giving effect to these distributions, the priority and characterization of distributions otherwise applicable under our limited liability company agreement is maintained as nearly as is practicable. Payments by us as
described above could give rise to an overpayment of tax on behalf of a common unitholder in which event the common unitholder would be required to file a claim in order to obtain a credit or refund.
Allocation of Income, Gain, Loss and Deduction
In general, if we have a net profit, our items of income, gain, loss and deduction will be allocated among the common unitholders in accordance with their percentage interests in us. If we have a net loss
for an entire year, the loss will be allocated to our common unitholders according to their percentage interests in us to the extent of their positive capital account balances.
Specified items of our income, gain, loss and deduction will be allocated under Section 704(c) of the Internal Revenue Code to
account for the difference between the tax basis and fair market value of our assets at the time we issue common units in an offering, which assets are referred to in this discussion as Contributed Property. These allocations are
required to eliminate the difference between a partners book capital account, credited with the fair market value of Contributed Property, and the tax capital account, credited with the tax basis of Contributed
Property, referred to in this discussion as the
book-tax
disparity. The effect of these allocations to a common unitholder who purchases common units in such an offering will be essentially the
same as if the tax basis of our assets were equal to their fair market value at the time of the offering. In the event we issue additional common units or engage in certain other transactions in the future, Section 704(c) allocations will be
made to all holders of common units to account for the difference between the book basis for purposes of maintaining capital accounts and the fair market value of all property held by us at the time of the future transaction. In
addition, items of recapture income will be allocated to the extent possible to the common unitholder who was allocated the deduction giving rise to the treatment of that gain as recapture income in order to minimize the recognition of ordinary
income by other common unitholders. Finally, although we do not expect that our operations will result in the creation of negative capital accounts, if negative capital accounts nevertheless result, items of our income and gain will be allocated in
an amount and manner sufficient to eliminate the negative balance as quickly as possible.
An allocation of items of our
income, gain, loss or deduction, other than an allocation required by Section 704(c), will generally be given effect for U.S. federal income tax purposes in determining a common unitholders share of an item of income, gain, loss or
deduction only if the allocation has substantial economic effect. In any other case, a common unitholders share of an item will be determined on the basis of his interest in us, which will be determined by taking into account all the facts and
circumstances, including:
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his relative contributions to us;
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the interests of all the common unitholders in profits and losses;
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the interest of all the common unitholders in cash flow; and
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the rights of all the common unitholders to distributions of capital upon liquidation.
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Treatment of Short Sales
A common unitholder whose units are loaned to a short seller to cover a short sale of units may be considered as having
disposed of those units. If so, he would no longer be a partner for tax purposes with respect to those units during the period of the loan and may recognize gain or loss from the disposition. As a result, during this period:
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none of our income, gain, loss or deduction with respect to those units would be reportable by the common unitholder;
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any cash distributions received by the common unitholder with respect to those units would be fully taxable; and
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all of these distributions would appear to be ordinary income.
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Andrews Kurth LLP has not rendered an opinion regarding the treatment of a common unitholder whose common units are loaned to a short
seller. Therefore, common unitholders desiring to assure their status as partners and avoid the risk of gain recognition are urged to modify any applicable brokerage account agreements to prohibit their brokers from borrowing and loaning their
common units. The IRS has announced that it is studying issues relating to the tax treatment of short sales of partnership interests. Please also read Disposition of UnitsRecognition of Gain or Loss.
Alternative Minimum Tax
Each common unitholder is required to take into account his distributive share of any items of our income, gain, loss or deduction for purposes of the alternative minimum tax. The current minimum tax rate
for
non-corporate
taxpayers is 26% on the first $175,000 of alternative minimum taxable income in excess of the exemption amount and 28% on any additional alternative minimum taxable income. Prospective common
unitholders are urged to consult their tax advisors with respect to the impact of an investment in our common units on their liability for the alternative minimum tax.
Tax Rates
Under current law, the highest effective U.S. federal
income tax rate for individuals currently is 35% and the maximum U.S. federal income tax rate for net long-term capital gains (generally, gains from the sale of certain investment assets held for more than one year) of an individual currently is
15%. Both rates are scheduled to remain at their current respective rate for years 2010 through 2012, but may increase beginning January 1, 2013.
The recently enacted Health Care and Education Reconciliation Act of 2010 and the Patient Protection and Affordable Care Act of 2010 is scheduled to impose a 3.8% Medicare tax on certain investment income
earned by individuals, estates, and trusts for taxable years beginning after December 31, 2012. For these purposes, investment income generally includes a common unitholders allocable share of our income and gain realized by a common
unitholder from a sale of common units. In the case of an individual, the tax will be imposed on the lesser of (i) the common unitholders net investment income from all investments, or (ii) the amount by which the common
unitholders modified adjusted gross income exceeds $250,000 (if the common unitholder is married and filing jointly or a surviving spouse) or $200,000 (if the common unitholder is unmarried). In the case of an estate or trust, the tax will be
imposed on the lesser of (i) undistributed net investment income, or (ii) the excess adjusted gross income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.
Section 754 Election
We have made the election permitted by Section 754 of the Internal Revenue Code. That election is irrevocable without the consent of the IRS. That election will generally permit us to adjust a unit
purchasers tax basis in our assets (inside basis) under Section 743(b) of the Internal Revenue Code to reflect his purchase price. The Section 743(b) adjustment applies to a person who purchases common units in an
offering from the selling unitholder, but does not apply to a person who purchases common units
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directly from us, and it belongs only to the purchaser and not to other common unitholders. Please also read, however, Allocation of Income, Gain, Loss and Deduction above. For
purposes of this discussion, a common unitholders inside basis in our assets has two components: (1) his share of our tax basis in our assets (common basis) and (2) his Section 743(b) adjustment to that basis.
The timing and calculation of deductions attributable to Section 743(b) adjustments to our common basis will depend upon
a number of factors, including the nature of the assets to which the adjustment is allocable, the extent to which the adjustment offsets any Internal Revenue Code Section 704(c) type gain or loss with respect to an asset and certain elections
we make as to the manner in which we apply Internal Revenue Code Section 704(c) principles with respect to an asset to which the adjustment is applicable. Please read Allocation of Income, Gain, Loss and Deduction.
The timing of these deductions may affect the uniformity of our common units. Under our limited liability company agreement, our board is
authorized to take a position to preserve the uniformity of common units even if that position is not consistent with these and any other Treasury Regulations or if the position would result in lower annual depreciation or amortization deductions
than would otherwise be allowable to some common unitholders. Please read Uniformity of Units. Andrews Kurth LLP is unable to opine as to the validity of any such alternate tax positions because there is no clear applicable
authority. A common unitholders basis in a common unit is reduced by his share of our deductions (whether or not such deductions were claimed on an individual income tax return) so that any position that we take that understates deductions
will overstate the common unitholders basis in his common units and may cause the common unitholder to understate gain or overstate loss on any sale of such common units. Please read Uniformity of Units.
A Section 754 election is advantageous if the transferees tax basis in his common units is higher than the units share
of the aggregate tax basis of our assets immediately prior to the transfer. In that case, as a result of the election, the transferee would have, among other items, a greater amount of depletion and depreciation deductions and the transferees
share of any gain or loss on a sale of our assets would be less. Conversely, a Section 754 election is disadvantageous if the transferees tax basis in his common units is lower than those units share of the aggregate tax basis of
our assets immediately prior to the transfer. Thus, the fair market value of the common units may be affected either favorably or unfavorably by the election. A basis adjustment is required regardless of whether a Section 754 election is made
in the case of a transfer of an interest in us if we have a substantial
built-in
loss immediately after the transfer, or if we distribute property and have a substantial basis reduction. Generally a
built-in
loss or a basis reduction is substantial if it exceeds $250,000.
The calculations
involved in the Section 754 election are complex and will be made on the basis of assumptions as to the fair market value of our assets and other matters. For example, the allocation of the Section 743(b) adjustment among our assets must
be made in accordance with the Internal Revenue Code. The IRS could seek to reallocate some or all of any Section 743(b) adjustment we allocated to our tangible assets to goodwill instead. Goodwill, as an intangible asset, is generally either
non-amortizable
or amortizable over a longer period of time or under a less accelerated method than our tangible assets. We cannot assure you that the determinations we make will not be successfully challenged by
the IRS or that the resulting deductions will not be reduced or disallowed altogether. Should the IRS require a different basis adjustment to be made, and should, in our opinion, the expense of compliance exceeds the benefit of the election, we may
seek permission from the IRS to revoke our Section 754 election. If permission is granted, a subsequent purchaser of common units may be allocated more income than such purchaser would have been allocated had the election not been revoked.
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Tax Treatment of Operations
Accounting Method and Taxable Year
We use the year ending December 31 as our taxable year and the accrual method of accounting for U.S. federal income tax purposes. Each common unitholder is required to include in income his share of
our income, gain, loss and deduction for our taxable year ending within or with his taxable year. In addition, a common unitholder who has a taxable year ending on a date other than December 31 and who disposes of all of his common units
following the close of our taxable year but before the close of his taxable year must include his share of our income, gain, loss and deduction in income for his taxable year, with the result that he will be required to include in income for his
taxable year his share of more than twelve months of our income, gain, loss and deduction. Please read Disposition of UnitsAllocations Between Transferors and Transferees.
Depletion Deductions
Subject to the limitations on deductibility of losses discussed above, common unitholders are entitled to deductions for the greater of either cost depletion or (if otherwise allowable) percentage
depletion with respect to our oil and natural gas interests. Although the Internal Revenue Code requires each common unitholder to compute his own depletion allowance and maintain records of his share of the adjusted tax basis of the underlying
property for depletion and other purposes, we intend to furnish each of our common unitholders with information relating to this computation for U.S. federal income tax purposes. Each common unitholder, however, remains responsible for calculating
his own depletion allowance and maintaining records of his share of the adjusted tax basis of the underlying property for depletion and other purposes.
Percentage depletion is generally available with respect to common unitholders who qualify under the independent producer exemption contained in Section 613A(c) of the Internal Revenue Code. For this
purpose, an independent producer is a person not directly or indirectly involved in the retail sale of oil, natural gas, or derivative products or the operation of a major refinery. Percentage depletion is calculated as an amount generally equal to
15% (and, in the case of marginal production, potentially a higher percentage) of the common unitholders gross income from the depletable property for the taxable year. The percentage depletion deduction with respect to any property is limited
to 100% of the taxable income of the common unitholder from the property for each taxable year, computed without the depletion allowance. A common unitholder that qualifies as an independent producer may deduct percentage depletion only to the
extent the common unitholders average net daily production of domestic crude oil, or the natural gas equivalent, does not exceed 1,000 barrels. This depletable amount may be allocated between oil and natural gas production, with 6,000 cubic
feet of domestic natural gas production regarded as equivalent to one barrel of crude oil. The 1,000 barrel limitation must be allocated among the independent producer and controlled or related persons and family members in proportion to the
respective production by such persons during the period in question.
In addition to the foregoing limitations, the percentage
depletion deduction otherwise available is limited to 65% of a common unitholders total taxable income from all sources for the year, computed without the depletion allowance, net operating loss carrybacks, or capital loss carrybacks. Any
percentage depletion deduction disallowed because of the 65% limitation may be deducted in the following taxable year if the percentage depletion deduction for such year plus the deduction carryover does not exceed 65% of the common
unitholders total taxable income for that year. The carryover period resulting from the 65% net income limitation is unlimited.
Common unitholders that do not qualify under the independent producer exemption are generally restricted to depletion deductions based on cost depletion. Cost depletion deductions are calculated by
(i) dividing the common unitholders share of the adjusted tax basis in the underlying mineral property by the number of mineral units (barrels of oil and thousand cubic feet, or Mcf, of natural gas) remaining as of the beginning of the
taxable year and (ii) multiplying the result by the number of mineral units sold within the taxable year. The total amount of deductions based on cost depletion cannot exceed the common unitholders share of the total adjusted tax basis in
the property.
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All or a portion of any gain recognized by a common unitholder as a result of either the disposition by us
of some or all of our oil and natural gas interests or the disposition by the common unitholder of some or all of his common units may be taxed as ordinary income to the extent of recapture of depletion deductions, except for percentage depletion
deductions in excess of the basis of the property. The amount of the recapture is generally limited to the amount of gain recognized on the disposition.
The foregoing discussion of depletion deductions does not purport to be a complete analysis of the complex legislation and Treasury Regulations relating to the availability and calculation of depletion
deductions by the common unitholders. Further, because depletion is required to be computed separately by each common unitholder and not by us, no assurance can be given, and Andrews Kurth LLP is unable to express any opinion, with respect to
the availability or extent of percentage depletion deductions to the common unitholders for any taxable year. Moreover, the availability of percentage depletion may be reduced or eliminated if recently proposed (or similar) tax legislation is
enacted. For a discussion of such legislative proposals, please read Recent Legislative Developments. We encourage each prospective common unitholder to consult his tax advisor to determine whether percentage depletion would be
available to him.
Deductions for Intangible Drilling and Development Costs
We elect to currently deduct intangible drilling and development costs (IDCs). IDCs generally include our expenses for wages,
fuel, repairs, hauling, supplies and other items that are incidental to, and necessary for, the drilling and preparation of wells for the production of oil, natural gas or geothermal energy. The option to currently deduct IDCs applies only to those
items that do not have a salvage value.
Although we elect to currently deduct IDCs, each common unitholder will have the
option of either currently deducting IDCs or capitalizing all or part of the IDCs and amortizing them on a straight-line basis over a
60-month
period, beginning with the taxable month in which the expenditure
is made. If a common unitholder makes the election to amortize the IDCs over a
60-month
period, no IDC preference amount in respect of those IDCs will result for alternative minimum tax purposes.
Integrated oil companies must capitalize 30% of all their IDCs (other than IDCs paid or incurred with respect to oil and natural gas
wells located outside of the United States) and amortize these IDCs over 60 months beginning in the month in which those costs are paid or incurred. If the taxpayer ceases to be an integrated oil company, it must continue to amortize those costs as
long as it continues to own the property to which the IDCs relate. An integrated oil company is a taxpayer that has economic interests in oil and natural gas properties and also carries on substantial retailing or refining operations. An
oil or gas producer is deemed to be a substantial retailer or refiner if it is subject to the rules disqualifying retailers and refiners from taking percentage depletion. In order to qualify as an independent producer that is not subject
to these IDC deduction limits, a common unitholder, either directly or indirectly through certain related parties, may not be involved in the refining of more than 75,000 barrels of oil (or the equivalent amount of natural gas) on average for any
day during the taxable year or in the retail marketing of oil and natural gas products exceeding $5 million per year in the aggregate.
IDCs previously deducted that are allocable to property (directly or through ownership of an interest in a partnership) and that would have been included in the adjusted basis of the property had the IDC
deduction not been taken are recaptured to the extent of any gain realized upon the disposition of the property or upon the disposition by a common unitholder of interests in us. Recapture is generally determined at the common unitholder level.
Where only a portion of the recapture property is sold, any IDCs related to the entire property are recaptured to the extent of the gain realized on the portion of the property sold. In the case of a disposition of an undivided interest in a
property, a proportionate amount of the IDCs with respect to the property is treated as allocable to the transferred undivided interest to the extent of any gain recognized. Please read Disposition of UnitsRecognition of Gain or
Loss.
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Deduction for United States Production Activities
Subject to the limitations on the deductibility of losses discussed above and the limitation discussed below, common unitholders will be
entitled to a deduction, herein referred to as the Section 199 deduction, equal to 6% of our qualified production activities income that is allocated to such common unitholder but not to exceed 50% of such common unitholders actual or
deemed IRS Form
W-2
wages for the taxable year allocable to domestic production gross receipts.
Qualified production activities income is generally equal to gross receipts from domestic production activities reduced by cost of goods sold allocable to those receipts, other expenses directly
associated with those receipts, and a share of other deductions, expenses and losses that are not directly allocable to those receipts or another class of income. The products produced must be manufactured, produced, grown or extracted in whole or
in significant part by the taxpayer in the United States.
For a partnership, the Section 199 deduction is determined at
the partner level. To determine his Section 199 deduction, each common unitholder will aggregate his share of the qualified production activities income allocated to him from us with the common unitholders qualified production activities
income from other sources. Each common unitholder must take into account his distributive share of the expenses allocated to him from our qualified production activities regardless of whether we otherwise have taxable income. However, our expenses
that otherwise would be taken into account for purposes of computing the Section 199 deduction are only taken into account only if and to the extent the common unitholders share of losses and deductions from all of our activities is not
disallowed by the basis rules, the
at-risk
rules or the passive activity loss rules. Please read Tax Consequences of Unit OwnershipLimitations on Deductibility of Losses.
The amount of a common unitholders Section 199 deduction for each year is limited to 50% of the IRS Form
W-2
wages actually or deemed paid by the common unitholder during the calendar year that are deducted in arriving at qualified production activities income. Each common unitholder is treated as having been allocated
IRS Form
W-2
wages from us equal to the common unitholders allocable share of our wages that are deducted in arriving at our qualified production activities income for that taxable year. It is not
anticipated that we or our subsidiaries will pay material wages that will be allocated to our common unitholders, and thus a common unitholders ability to claim the Section 199 deduction may be limited.
This discussion of the Section 199 deduction does not purport to be a complete analysis of the complex legislation and Treasury
authority relating to the calculation of domestic production gross receipts, qualified production activities income, or IRS Form
W-2
Wages, or how such items are allocated by us to common unitholders. Further,
because the Section 199 deduction is required to be computed separately by each common unitholder, no assurance can be given, and Andrews Kurth LLP is unable to express any opinion, as to the availability or extent of the Section 199
deduction to the common unitholders. Moreover, the availability of Section 199 deductions may be reduced or eliminated if recently proposed (or similar) tax legislation is enacted. For a discussion of such legislative proposals, please read
Recent Legislative Developments. Each prospective common unitholder is encouraged to consult his tax advisor to determine whether the Section 199 deduction would be available to him.
Lease Acquisition Costs
The cost of acquiring oil and natural gas leaseholder or similar property interests is a capital expenditure that must be recovered through depletion deductions if the lease is productive. If a lease is
proved worthless and abandoned, the cost of acquisition less any depletion claimed may be deducted as an ordinary loss in the year the lease becomes worthless. Please read Tax Treatment of OperationsDepletion Deductions.
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Geophysical Costs
Geophysical costs paid or incurred in connection with the exploration for, or development of, oil or gas within the United States are
allowed as a deduction ratably over the
24-month
period beginning on the date that such expense was paid or incurred.
Operating and Administrative Costs
Amounts paid for operating a
producing well are deductible as ordinary business expenses, as are administrative costs to the extent they constitute ordinary and necessary business expenses which are reasonable in amount.
Recent Legislative Developments
In early 2010, the White House released President Obamas budget proposal for the Fiscal Year 2011 (the Budget Proposal). Among the changes recommended in the Budget Proposal was the
elimination of certain key U.S. federal income tax preferences relating to oil and natural gas exploration and development. Changes in the Budget Proposal included, but were not limited to, (i) the repeal of the percentage depletion
allowance for oil and natural gas properties, (ii) the elimination of current deductions for intangible drilling and development costs, (iii) the elimination of the deduction for certain domestic production activities, and (iv) an
extension of the amortization period for certain geological and geophysical expenditures. Each of these changes was proposed to be effective for taxable years beginning, or in the case of costs described in (ii) and (iv), costs paid or
incurred, after December 31, 2010. No such changes have been enacted. It is unclear whether these or similar changes will be proposed or enacted and, if enacted, how soon any such changes could become effective. The passage of any legislation
as a result of these proposals or any other similar changes in U.S. federal income tax laws could eliminate or postpone certain tax deductions that are currently available with respect to oil and natural gas exploration and development, and any
such change could increase the taxable income allocable to our common unitholders and negatively impact the value of an investment in our common units.
Tax Basis, Depreciation and Amortization
The tax basis of our
assets, such as casing, tubing, tanks, pumping units and other similar property, will be used for purposes of computing depreciation and cost recovery deductions and, ultimately, gain or loss on the disposition of these assets. The U.S. federal
income tax burden associated with the difference between the fair market value of our assets and their tax basis immediately prior to (i) this offering will be borne by our existing common unitholders, and (ii) any other offering will be
borne by our common unitholders as of that time. Please read Tax Consequences of Unit OwnershipAllocation of Income, Gain, Loss and Deduction.
To the extent allowable, we may elect to use the depreciation and cost recovery methods that will result in the largest deductions being taken in the early years after assets are placed in service.
Property we subsequently acquire or construct may be depreciated using accelerated methods permitted by the Internal Revenue Code.
If we dispose of depreciable property by sale, foreclosure, or otherwise, all or a portion of any gain, determined by reference to the amount of depreciation previously deducted and the nature of the
property, may be subject to the recapture rules and taxed as ordinary income rather than capital gain. Similarly, a common unitholder who has taken cost recovery or depreciation deductions with respect to property we own will likely be required to
recapture some or all of those deductions as ordinary income upon a sale of his interest in us. Please read Tax Consequences of Unit OwnershipAllocation of Income, Gain, Loss and Deduction and Disposition of
UnitsRecognition of Gain or Loss.
The costs incurred in selling our units (called syndication
expenses) must be capitalized and cannot be deducted currently, ratably or upon our termination. There are uncertainties regarding the classification of costs as organization expenses, which we may be able to amortize, and as syndication
expenses, which we may not amortize. The underwriting discounts and commissions we incur will be treated as syndication expenses.
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Valuation and Tax Basis of Our Properties
The U.S. federal income tax consequences of the ownership and disposition of common units will depend in part on our estimates of the
relative fair market values and the tax bases of our assets. Although we may from time to time consult with professional appraisers regarding valuation matters, we will make many of the relative fair market value estimates ourselves. These estimates
and determinations of basis are subject to challenge and will not be binding on the IRS or the courts. If the estimates of fair market value or basis are later found to be incorrect, the character and amount of items of income, gain, loss or
deduction previously reported by common unitholders might change, and common unitholders might be required to adjust their tax liability for prior years and incur interest and penalties with respect to those adjustments.
Disposition of Units
Recognition of Gain or Loss
Gain or loss will be recognized on a
sale of common units equal to the difference between the common unitholders amount realized and the common unitholders tax basis for the common units sold. A common unitholders amount realized will equal the sum of the cash or the
fair market value of other property he receives plus his share of our nonrecourse liabilities. Because the amount realized includes a common unitholders share of our nonrecourse liabilities, the gain recognized on the sale of common units
could result in a tax liability in excess of any cash received from the sale.
Prior distributions from us in excess of
cumulative net taxable income for a common unit that decreased a common unitholders tax basis in that unit will, in effect, become taxable income if the common unit is sold at a price greater than the common unitholders tax basis in that
unit, even if the price received is less than his original cost.
Except as noted below, gain or loss recognized by a common
unitholder, other than a dealer in units, on the sale or exchange of a common unit held for more than one year will generally be taxable as capital gain or loss. A portion of this gain or loss, which will likely be substantial, however,
will be separately computed and taxed as ordinary income or loss under Section 751 of the Internal Revenue Code to the extent attributable to assets giving rise to unrealized receivables or inventory items that we own.
The term unrealized receivables includes potential recapture items, including depreciation, depletion, and IDC recapture. Ordinary income attributable to unrealized receivables and inventory items may exceed net taxable gain realized on
the sale of a common unit and may be recognized even if there is a net taxable loss realized on the sale of a common unit. Thus, a common unitholder may recognize both ordinary income and a capital loss upon a sale of common units. Net capital loss
may offset capital gains and no more than $3,000 of ordinary income, in the case of individuals, and may only be used to offset capital gain in the case of corporations.
The IRS has ruled that a partner who acquires interests in a partnership in separate transactions must combine those interests and maintain a single adjusted tax basis for all those interests. Upon a sale
or other disposition of less than all of those interests, a portion of that tax basis must be allocated to the interests sold using an equitable apportionment method. Treasury Regulations under Section 1223 of the Internal Revenue
Code allow a selling common unitholder who can identify common units transferred with an ascertainable holding period to elect to use the actual holding period of the common units transferred. Thus, according to the ruling, a common unitholder will
be unable to select high or low basis common units to sell as would be the case with corporate stock, but, according to the regulations, may designate specific common units sold for purposes of determining the holding period of common units
transferred. A common unitholder electing to use the actual holding period of common units transferred must consistently use that identification method for all subsequent sales or exchanges of common units. A common unitholder considering the
purchase of additional common units or a sale of common units purchased in separate transactions is urged to consult his tax advisor as to the possible consequences of this ruling and application of the Treasury Regulations.
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Specific provisions of the Internal Revenue Code affect the taxation of some financial
products and securities, including partnership interests, by treating a taxpayer as having sold an appreciated partnership interest, one in which gain would be recognized if it were sold, assigned or terminated at its fair market value,
if the taxpayer or related persons enter(s) into:
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an offsetting notional principal contract; or
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a futures or forward contract with respect to the partnership interest or substantially identical property.
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Moreover, if a taxpayer has previously entered into a short sale, an offsetting notional principal contract or a futures or forward
contract with respect to the partnership interest, the taxpayer will be treated as having sold that position if the taxpayer or a related person then acquires the partnership interest or substantially identical property. The Secretary of the
Treasury is also authorized to issue regulations that treat a taxpayer who enters into transactions or positions that have substantially the same effect as the preceding transactions as having constructively sold the financial position.
Allocations Between Transferors and Transferees
In general, our taxable income or loss will be determined annually, will be prorated on a monthly basis and will be subsequently apportioned among the common unitholders in proportion to the number of
units owned by each of them as of the opening of the applicable exchange on the first business day of the month (the Allocation Date). However, gain or loss realized on a sale or other disposition of our assets other than in the ordinary
course of business will be allocated among the common unitholders on the Allocation Date in the month in which that gain or loss is recognized. As a result, a common unitholder transferring common units may be allocated income, gain, loss and
deduction realized after the date of transfer.
Although simplifying conventions are contemplated by the Code and most
publicly traded partnerships use similar simplifying conventions, the use of this method may not be permitted under existing Treasury Regulations. Recently, however, the Department of the Treasury and the IRS issued proposed Treasury Regulations
that provide a safe harbor pursuant to which a publicly-traded partnership may use a similar monthly simplifying convention to allocate tax items among transferor and transferee unitholders, although such tax items must be prorated on a daily basis.
Nonetheless, the proposed regulations do not specifically authorize the use of the proration method we have adopted. Existing publicly-traded partnerships are entitled to rely on those proposed Treasury Regulations; however, they are not binding on
the IRS and are subject to change until the final Treasury Regulations are issued. Accordingly, Andrews Kurth LLP is unable to opine on the validity of this method of allocating income and deductions between common unitholders. If this method is not
allowed under the Treasury Regulations, or only applies to transfers of less than all of the common unitholders interest, our taxable income or losses might be reallocated among the common unitholders. We are authorized to revise our method of
allocation between common unitholders, as well as among common unitholders whose interests vary during a taxable year, to conform to a method permitted under future Treasury Regulations.
A common unitholder who owns units at any time during a quarter and who disposes of them prior to the record date set for a cash
distribution for that quarter will be allocated items of our income, gain, loss and deductions attributable to that quarter but will not be entitled to receive that cash distribution.
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Notification Requirements
A common unitholder who sells any of his common units, other than through a broker, generally is required to notify us in writing of that
sale within 30 days after the sale (or, if earlier, January 15 of the year following the sale). A purchaser of common units who purchases units from another common unitholder is also generally required to notify us in writing of that purchase
within 30 days after the purchase. Upon receiving such notifications, we are required to notify the IRS of that transaction and to furnish specified information to the transferor and transferee. Failure to notify us of a transfer of common
units may, in some cases, lead to the imposition of penalties. However, these reporting requirements do not apply to a sale by an individual who is a citizen of the United States and who effects the sale or exchange through a broker who will satisfy
such requirements.
Constructive Termination
We will be considered to have constructively terminated for federal income tax purposes if there is a sale or exchange of 50% or more of
the total interests in our capital and profits within a twelve-month period. A constructive termination results in the closing of our taxable year for all common unitholders. In the case of a common unitholder reporting on a taxable year other than
a fiscal year ending December 31, the closing of our taxable year may result in more than 12 months of our taxable income or loss being includable in his taxable income for the year of termination. A constructive termination occurring on a date
other than December 31 will result in us filing two tax returns for one calendar year and the cost of the preparation of these returns will be borne by all common unitholders. However, pursuant to an IRS relief procedure for publicly traded
partnerships that have technically terminated, the IRS may allow, among other things, that we provide a single Schedule
K-1
for the tax year in which a termination occurs. We would be required to make new tax
elections after a constructive termination, including a new election under Section 754 of the Internal Revenue Code, and a constructive termination would result in a deferral of our deductions for depreciation. A constructive termination could
also result in penalties if we were unable to determine that the constructive termination had occurred. Moreover, a constructive termination might either accelerate the application of, or subject us to, any tax legislation enacted before the
constructive termination.
Uniformity of Units
Because we cannot match transferors and transferees of common units, we must maintain uniformity of the economic and tax characteristics
of the units to a purchaser of these units. In the absence of uniformity, we may be unable to completely comply with a number of U.S. federal income tax requirements, both statutory and regulatory. A lack of uniformity can result from a literal
application of Treasury Regulation Section 1.167(c)-1(a)(6) and Treasury Regulation Section 1.197-2(g)(3), neither of which is anticipated to apply to a material portion of our assets. Any
non-uniformity
could have a negative impact on the value of the common units. Please read Tax Consequences of Unit OwnershipSection 754 Election.
Our limited liability company agreement permits us to take positions in filing our tax returns that preserve the uniformity of our common
units even under circumstances like those described above. These positions may include reducing for some common unitholders the depreciation, amortization or loss deductions to which they would otherwise be entitled or reporting a slower
amortization of Section 743(b) adjustments for some common unitholders than that to which they would otherwise be entitled. Andrews Kurth LLP is unable to opine as to validity of such filing positions. A common unitholders basis in common
units is reduced by his share of our deductions (whether or not such deductions were claimed on an individual income tax return) so that any position that we take that understates deductions will overstate the common unitholders basis in his
common units, and may cause the common unitholder to understate gain or overstate loss on any sale of such common units. Please read Disposition of Units Recognition of Gain or Loss and Tax Consequences of
Unit Ownership Section 754 Election. The IRS may challenge one or more of any positions we take to preserve the uniformity of common units. If such a challenge were sustained, the uniformity of common units might be affected,
and, under some circumstances, the gain from the sale of common units might be increased without the benefit of additional deductions.
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Tax-Exempt
Organizations and Other
Investors
Ownership of units by employee benefit plans, other
tax-exempt
organizations,
non-resident
aliens, foreign corporations and other foreign persons raises issues unique to those investors and, as described below, may have substantially adverse tax consequences to them.
Prospective common unitholders who are
tax-exempt
entities or
non-U.S.
persons should consult their tax advisor before investing in our common units.
Employee benefit plans and most other organizations exempt from U.S. federal income tax, including individual retirement accounts and
other retirement plans, are subject to U.S. federal income tax on unrelated business taxable income. Virtually all of our income allocated to a common unitholder that is a
tax-exempt
organization will be
unrelated business taxable income and will be taxable to them.
Non-resident
aliens
and foreign corporations, trusts or estates that own units will be considered to be engaged in business in the United States because of the ownership of units. As a consequence they will be required to file federal tax returns to report their share
of our income, gain, loss or deduction and pay U.S. federal income tax at regular rates on their share of our net income or gain. Under rules applicable to publicly traded partnerships, we will withhold tax, at the highest effective applicable rate,
from cash distributions made quarterly to foreign common unitholders. Each foreign common unitholder must obtain a taxpayer identification number from the IRS and submit that number to our transfer agent on a Form
W-8
BEN or applicable substitute form in order to obtain credit for these withholding taxes. A change in applicable law may require us to change these procedures.
In addition, because a foreign corporation that owns units will be treated as engaged in a United States trade or business, that
corporation may be subject to the United States branch profits tax at a rate of 30%, in addition to regular U.S. federal income tax, on its share of our income and gain, as adjusted for changes in the foreign corporations U.S. net
equity, which is effectively connected with the conduct of a United States trade or business. That tax may be reduced or eliminated by an income tax treaty between the United States and the country in which the foreign corporate common
unitholder is a qualified resident. In addition, this type of common unitholder is subject to special information reporting requirements under Section 6038C of the Internal Revenue Code.
A foreign common unitholder who sells or otherwise disposes of a common unit will be subject to U.S. federal income tax on gain realized
on the sale or disposition of that unit to the extent the gain is effectively connected with a United States trade or business of the foreign common unitholder. Under a ruling published by the IRS interpreting the scope of effectively
connected income, a foreign unitholder would be considered to be engaged in business in the United States by virtue of the ownership of common units, and part or all of that common unitholders gain would be effectively connected with
that unitholders indirect U.S. trade or business. Moreover, under the Foreign Investment in Real Property Tax Act, a foreign common unitholder generally will be subject to U.S. federal income tax upon the sale or disposition of a
unit if (i) he owned (directly or constructively applying certain attribution rules) more than 5% of our units at any time during the five-year period ending on the date of such disposition and (ii) 50% or more of the fair market value of
all of our assets consisted of U.S. real property interests at any time during the shorter of the period during which such common unitholder held the units or the
5-year
period ending on the date of
disposition. Currently, more than 50% of our assets consist of U.S. real property interests and we do not expect that to change in the foreseeable future. Therefore, foreign common unitholders may be subject to U.S. federal income tax on gain
from the sale or disposition of their common units.
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Administrative Matters
Information Returns and Audit Procedures
We intend to furnish to each common unitholder, within 90 days after the close of each calendar year, specific tax information, including a Schedule
K-1,
which
describes his share of our income, gain, loss and deduction for our preceding taxable year. In preparing this information, which will not be reviewed by counsel, we will take various accounting and reporting positions, some of which have been
mentioned earlier, to determine each common unitholders share of income, gain, loss and deduction.
We cannot assure you
that those positions will yield a result that conforms to the requirements of the Internal Revenue Code, Treasury Regulations or administrative interpretations of the IRS. Neither we nor Andrews Kurth LLP can assure prospective common unitholders
that the IRS will not successfully contend in court that those positions are impermissible. Any challenge by the IRS could negatively affect the value of the units.
The IRS may audit our U.S. federal income tax information returns. Adjustments resulting from an IRS audit may require each common unitholder to adjust a prior years tax liability and possibly may
result in an audit of his own return. Any audit of a common unitholders return could result in adjustments not related to our returns as well as those related to our returns.
Partnerships generally are treated as separate entities for purposes of federal tax audits, judicial review of administrative adjustments
by the IRS and tax settlement proceedings. The tax treatment of partnership items of income, gain, loss and deduction are determined in a partnership proceeding rather than in separate proceedings with the partners. The Internal Revenue Code
requires that one partner be designated as the Tax Matters Partner for these purposes. The limited liability company agreement appoints CEPM as our Tax Matters Partner, subject to redetermination by our board of managers from time to
time.
The Tax Matters Partner will make some elections on our behalf and on behalf of common unitholders. In addition, the
Tax Matters Partner can extend the statute of limitations for assessment of tax deficiencies against common unitholders for items in our returns. The Tax Matters Partner may bind a common unitholder with less than a 1% profits interest in us to a
settlement with the IRS unless that common unitholder elects, by filing a statement with the IRS, not to give that authority to the Tax Matters Partner. The Tax Matters Partner may seek judicial review, by which all the common unitholders are bound,
of a final partnership administrative adjustment and, if the Tax Matters Partner fails to seek judicial review, judicial review may be sought by any common unitholder having at least a 1% interest in profits or by any group of common unitholders
having in the aggregate at least a 5% interest in profits. However, only one action for judicial review will go forward, and each common unitholder with an interest in the outcome may participate in that action.
A common unitholder must file a statement with the IRS identifying the treatment of any item on his U.S. federal income tax return that
is not consistent with the treatment of the item on our return. Intentional or negligent disregard of this consistency requirement may subject a common unitholder to substantial penalties.
Nominee Reporting
Persons who hold an interest in us as a nominee for another person are required to furnish to us:
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the name, address and taxpayer identification number of the beneficial owner and the nominee;
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a statement regarding whether the beneficial owner is:
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a person that is not a United States person,
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a foreign government, an international organization or any wholly-owned agency or instrumentality of either of the foregoing, or
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the amount and description of units held, acquired or transferred for the beneficial owner; and
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specific information including the dates of acquisitions and transfers, means of acquisitions and transfers, and acquisition cost for purchases, as
well as the amount of net proceeds from sales.
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Brokers and financial institutions are required to furnish
additional information, including whether they are United States persons and specific information on units they acquire, hold or transfer for their own account. A penalty of $50 per failure, up to a maximum of $100,000 per calendar year, is imposed
by the Internal Revenue Code for failure to report that information to us. The nominee is required to supply the beneficial owner of the units with the information furnished to us.
Accuracy-related Penalties
An additional tax equal to 20% of the amount of any portion of an underpayment of tax that is attributable to one or more specified causes, including negligence or disregard of rules or regulations,
substantial understatements of income tax and substantial valuation misstatements, is imposed by the Internal Revenue Code. No penalty will be imposed, however, for any portion of an underpayment if it is shown that there was a reasonable cause for
the underpayment of that portion and that the taxpayer acted in good faith regarding the underpayment of that portion.
For
individuals, substantial understatement of income tax in any taxable year exists if the amount of the understatement exceeds the greater of 10% of the tax required to be shown on the return for the taxable year or $5,000. The amount of any
understatement subject to penalty generally is reduced if any portion is attributable to a position adopted on the return:
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for which there is, or was, substantial authority, or
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as to which there is a reasonable basis and the relevant facts of that position are disclosed on the return.
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If any item of income, gain, loss or deduction included in the distributive shares of common unitholders could result in that kind of an
understatement of income for which no substantial authority exists, we must disclose the pertinent facts on our return. In addition, we will make a reasonable effort to furnish sufficient information for common unitholders to
make adequate disclosure on their returns to avoid liability for this penalty. More stringent rules would apply to an understatement of tax resulting from ownership of units if we were classified as a tax shelter, which we do not believe
includes us, or any of our investments, plans or arrangements.
A substantial valuation misstatement exists if (a) the
value of any property, or the tax basis of any property, claimed on a tax return is 150% or more of the amount determined to be the correct amount of the valuation or tax basis, (b) the price for any property or services (or for the use of
property) claimed on any such return with respect to any transaction between persons described in Section 482 of the Internal Revenue Code is 200% or more (or 50% or less) of the amount determined under Section 482 to be the correct amount
of such price, or (c) the net Section 482 transfer price adjustment for the taxable year exceeds the lesser of $5 million or 10% of the taxpayers gross receipts. No penalty is imposed unless the portion of the underpayment
attributable to a substantial valuation misstatement exceeds $5,000 ($10,000 for a corporation other than an S Corporation or a personal holding company). The penalty is increased to 40% in the event of a gross valuation misstatement. We do not
anticipate making any valuation misstatements.
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Reportable Transactions
If we were to engage in a reportable transaction, we (and possibly you and others) would be required to make a detailed
disclosure of the transaction to the IRS. A transaction may be a reportable transaction based upon any of several factors, including the fact that it is a type of transaction publicly identified by the IRS as a listed transaction or that
it produces certain kinds of losses for partnerships, individuals, S corporations, and trusts in excess of $2 million in any single taxable year, or $4 million in any combination of six successive tax years. Our participation in a reportable
transaction could increase the likelihood that our U.S. federal income tax information return (and possibly a common unitholders tax return) is audited by the IRS. Please read Information Returns and Audit Procedures above.
Moreover, if we were to participate in a reportable transaction with a significant purpose to avoid or evade tax or a listed
transaction, our common unitholders could be subject to the following provisions of the American Jobs Creation Act of 2004:
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accuracy-related penalties with a broader scope, significantly narrower exceptions, and potentially greater amounts than described above at
Accuracy-related Penalties,
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for those persons otherwise entitled to deduct interest on federal tax deficiencies,
non-deductibility
of
interest on any resulting tax liability, and
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in the case of a listed transaction, an extended statute of limitations.
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We do not expect to engage in any reportable transactions.
State, Local and Other Tax Considerations
In
addition to U.S. federal income taxes, you will be subject to other taxes, including state and local income taxes, unincorporated business taxes, and estate, inheritance or intangible taxes that may be imposed by the various jurisdictions in which
we do business or own property or in which you are a resident. We currently do business and own property in Nebraska, Kansas, Oklahoma and Alabama. We are registered to do business in Texas. We may also own property or do business in other states in
the future. Although an analysis of those various taxes is not presented here, each prospective common unitholder should consider their potential impact on his investment in us. You may not be required to file a return and pay taxes in some states
because your income from that state falls below the filing and payment requirement. You will be required, however, to file state income tax returns and to pay state income taxes in many of the states in which we may do business or own property, and
you may be subject to penalties for failure to comply with those requirements. In some states, tax losses may not produce a tax benefit in the year incurred and also may not be available to offset income in subsequent taxable years. Some of the
states may require us, or we may elect, to withhold a percentage of income from amounts to be distributed to a common unitholder who is not a resident of the state. Withholding, the amount of which may be greater or less than a particular common
unitholders income tax liability to the state, generally does not relieve a nonresident common unitholder from the obligation to file an income tax return. Amounts withheld may be treated as if distributed to common unitholders for purposes of
determining the amounts distributed by us. Please read Tax Consequences of Unit OwnershipEntity-Level Collections. Based on current law and our estimate of our future operations, we anticipate that any amounts required to be
withheld will not be material.
It is the responsibility of each common unitholder to investigate the legal and tax
consequences, under the laws of pertinent states and localities, of his investment in us. Andrews Kurth LLP has not rendered an opinion on the state local, or foreign tax consequences of an investment in us. We strongly recommend that each
prospective common unitholder consult, and depend on, his own tax counsel or other advisor with regard to those matters. It is the responsibility of each common unitholder to file all tax returns, that may be required of him.
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INVESTMENT IN OUR COMPANY BY EMPLOYEE BENEFIT PLANS
An investment in us by an employee benefit plan is subject to additional considerations because the investments of these
plans are subject to the fiduciary responsibility and prohibited transaction provisions of ERISA and restrictions imposed by Section 4975 of the Internal Revenue Code. For these purposes, the term employee benefit plan includes, but
is not limited to, qualified pension, profit-sharing and stock bonus plans, Keogh plans, simplified employee pension plans and tax deferred annuities or IRAs established or maintained by an employer or employee organization. Among other things, the
person with investment discretion with respect to the assets of an employee benefit plan, often called a fiduciary, should consider:
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whether the investment is prudent under Section 404(a)(1)(B) of ERISA;
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whether in making the investment, that plan will satisfy the diversification requirements of Section 404(a)(l)(C) of ERISA; and
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whether the investment will result in recognition of unrelated business taxable income by the plan and, if so, the potential
after-tax
investment return.
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A plan fiduciary should determine whether an
investment in us is authorized by the appropriate governing instrument and is a proper investment for the plan.
Section 406 of ERISA and Section 4975 of the Internal Revenue Code prohibits employee benefit plans, and IRAs that are not
considered part of an employee benefit plan, from engaging in specified transactions involving plan assets with parties that are parties in interest under ERISA or disqualified persons under the Internal Revenue
Code with respect to the plan.
In addition to considering whether the purchase of common units is a prohibited transaction, a
fiduciary of an employee benefit plan should consider whether the plan will, by investing in us, be deemed to own an undivided interest in our assets, with the result that CEPM also would be a fiduciary of the plan and our operations would be
subject to the regulatory restrictions of ERISA, including its prohibited transaction rules, as well as the prohibited transaction rules of the Internal Revenue Code.
The Department of Labor regulations and Section 3(42) of ERISA provide guidance with respect to whether the assets of an entity in which employee benefit plans acquire equity interests would be
deemed plan assets under some circumstances. Under these rules, an entitys assets would not be considered to be plan assets if, among other things:
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the equity interests acquired by employee benefit plans are publicly offered securitiesi.e., the equity interests are widely held by 100 or more
investors independent of the issuer and each other, freely transferable and registered under some provisions of the federal securities laws;
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the entity is an operating company,i.e., it is primarily engaged in the production or sale of a product or service other than the
investment of capital either directly or through a majority owned subsidiary or subsidiaries; or
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there is no significant investment by benefit plan investors, which is defined to mean that less than 25% of the value of each class of equity
interest, disregarding some interests held by CEPM, its affiliates, and some other persons, is held by employee benefit plans subject to Part 4 of Title I of ERISA, IRAs and other plans subject to Section 4975 of the Code and any entity whose
underlying assets include plan assets by reason of such plans investment in such entity.
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Our assets should not be considered plan assets under these regulations because
it is expected that the investment will satisfy the requirements in the first bullet above.
Plan fiduciaries contemplating a
purchase of our common units should consult with their own counsel regarding the consequences under ERISA and the Internal Revenue Code in light of the serious penalties imposed on persons who engage in prohibited transactions or other violations.
PLAN OF DISTRIBUTION
We are registering the common units on behalf of the selling unitholder. As used in this prospectus, selling unitholder
includes donees and pledgees selling common units received from a named selling unitholder after the date of this prospectus.
Under this prospectus, the selling unitholder intends to offer our securities to the public:
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through one or more broker-dealers;
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through underwriters; and
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The selling unitholder may price the common units offered from time to time:
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at market prices prevailing at the time of any sale under this registration statement;
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at prices related to market prices; or
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We will pay the costs and expenses of the registration and offering of the common units offered hereby. We will not pay any underwriting fees, discounts and selling commissions allocable to the selling
unitholders sale of its securities, which will be paid by the selling unitholder. Broker-dealers may act as agent or may purchase securities as principal and thereafter resell the securities from time to time:
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in or through one or more transactions (which may involve crosses and block transactions) or distributions;
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in the
over-the-counter
market; or
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in private transactions.
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Broker-dealers or underwriters may receive compensation in the form of underwriting discounts or commissions and may receive commissions from purchasers of the securities for whom they may act as agents.
If any broker-dealer purchases the securities as principal, it may effect resales of the securities from time to time to or through other broker-dealers, and other broker-dealers may receive compensation in the form of concessions or commissions
from the purchasers of securities for whom they may act as agents.
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To the extent required, the names of the specific managing underwriter or underwriters, if
any, as well as other important information, will be set forth in prospectus supplements. In that event, the discounts and commissions the selling unitholder will allow or pay to the underwriters, if any, and the discounts and commissions the
underwriters may allow or pay to dealers or agents, if any, will be set forth in, or may be calculated from, the prospectus supplements. Any underwriters, brokers, dealers and agents who participate in any sale of the securities may also engage in
transactions with, or perform services for, us or our affiliates in the ordinary course of their businesses.
In addition, the
selling unitholder has advised us that it may sell the common units in compliance with Rule 144, if available, or pursuant to other available exemptions from the registration requirements under the Securities Act, rather than pursuant to this
prospectus.
We have agreed to indemnify the selling unitholder and each underwriter, selling agent or other securities
professional, if any, against certain liabilities to which they may become subject in connection with the sale of the common units owned by the selling unitholder and registered under this prospectus, including liabilities arising under the
Securities Act of 1933.
Because the Financial Industry Regulatory Authority (FINRA) views our common units as
interests in a direct participation program, any offering of common units under the registration statement of which this prospectus forms a part will be made in compliance with Rule 2310 of the FINRA Conduct Rules.
To the extent required, this prospectus may be amended or supplemented from time to time to describe a particular plan of distribution.
The place and time of delivery for the securities in respect of which this prospectus is delivered will be set forth in the accompanying prospectus supplement.
In connection with offerings of securities under the registration statement of which this prospectus forms a part and in compliance with applicable law, underwriters, brokers or dealers may engage in
transactions that stabilize or maintain the market price of the securities at levels above those that might otherwise prevail in the open market. Specifically, underwriters, brokers or dealers may over-allot in connection with offerings, creating a
short position in the securities for their own accounts. For the purpose of covering a syndicate short position or stabilizing the price of the securities, the underwriters, brokers or dealers may place bids for the securities or effect purchases of
the securities in the open market. Finally, the underwriters may impose a penalty whereby selling concessions allowed to syndicate members or other brokers or dealers for distribution of the securities in offerings may be reclaimed by the syndicate
if the syndicate repurchases previously distributed securities in transactions to cover short positions, in stabilization transactions or otherwise. These activities may stabilize, maintain or otherwise affect the market price of the securities,
which may be higher than the price that might otherwise prevail in the open market, and, if commenced, may be discontinued at any time.
In compliance with FINRA guidelines, the maximum consideration or discount to be received by any FINRA member or independent broker dealer may not exceed 8% of the aggregate amount of the securities
offered pursuant to this prospectus and any applicable prospectus supplement.
SELLING UNITHOLDER
This prospectus covers the offer and sale of up to 5,918,894 common units by the selling unitholder identified below.
These common units represent securities received by the selling unitholder upon conversion of its limited liability company interests in us immediately prior to the closing of our initial public offering in November 2006. The total amount of common
units that may be sold hereunder will not exceed the number of units offered hereby. Please read Plan of Distribution.
51
The following table sets forth information about the maximum number of common units that may
be offered from time to time by the selling unitholder under this prospectus. The selling unitholder identified below may currently hold or acquire at any time common units in addition to those registered hereby. Accordingly, we cannot give an
estimate as to the number of units that will be held by the selling unitholder upon termination of this offering.
Information
concerning the selling unitholder may change from time to time and, if necessary, we will supplement this prospectus accordingly.
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|
|
|
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Selling Unitholder
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Total Number of
Common
Units
Beneficially Owned
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|
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Percentage
of
(2)
Units
Outstanding
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|
Number of
Units That May
Be Sold
|
|
|
Number of Units
Beneficially Owned
After Offering(3)
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|
Constellation Energy Partners Holdings, LLC (1)
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|
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5,918,894
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24.3
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%
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|
|
5,918,894
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|
|
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(1)
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According to Schedule 13D dated December 5, 2006 (the Schedule 13D) filed jointly by Constellation Energy Group, Inc. (CEG) and
Constellation Energy Partners Holdings, LLC (CEPH), CEPH is the record and beneficial owner of 5,918,894 common units of Constellation Energy Partners LLC (CEP). CEG, which indirectly owns 100% of CEPHs outstanding
limited liability company interests, may be deemed to be the beneficial owner of 5,918,894 common units.
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(2)
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Calculated based on 23,899,758 common units outstanding as of December 31, 2010.
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(3)
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Assumes all units are sold.
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Related Party Transactions
Management Services Agreement.
In November 2006, we entered into a management services agreement
with CEPM, a subsidiary of Constellation, to provide certain management, technical and administrative services. CEPM terminated the management services agreement effective December 15, 2009. Each quarter, CEPM charged us an amount for services
provided to us. This amount was agreed to annually and included a portion of the compensation paid by CEPM and its affiliates to personnel who spent time on our business and affairs. The conflicts committee of our board of managers determined that
the amounts paid by us for the services performed were fair to and in the best interests of CEP. These costs totaled approximately $1.4 million for the year ended December 31, 2009. No costs were incurred during 2010.
We had a payable to Constellation of $0.2 million as of December 31, 2009. This payable balance related to our final billings under
the management service agreement was included in current liabilities on our balance sheet.
Relationship with our Former Sponsor
. The
termination of the management services agreement effectively ended Constellations tenure as our sponsor and we do not expect Constellation to provide us with any significant services, support, financing, or acquisition opportunities in the
future. Constellation still owns all of our outstanding Class A units, approximately 5.9 million Class B Common Units, all of our Class D interests, and all of the Management Incentive Interests.
Constellation previously announced that it had impaired the fair value of its investment in CEP due to various factors, including the possible sale of
its investment in CEP. We are not aware of any efforts that Constellation has undertaken to sell its investment in us and to date Constellation has not announced any plan or transaction.
Natural Gas Purchases.
Through March 31, 2009, CCG purchased natural gas from us in the Cherokee Basin. The arrangement was reviewed by the conflicts committee of our board of managers. The
committee found that the arrangement was fair to and in the best interests of CEP. For the year ended December 31, 2009, CCG paid CEP $5.7 million for natural gas purchases. There were no natural gas purchases in 2010.
52
LEGAL MATTERS
Certain legal matters in connection with the securities will be passed upon for us by Andrews Kurth LLP, Houston, Texas. If certain legal
matters in connection with an offering of the securities made by this prospectus and a related prospectus supplement are passed on by counsel for the underwriters of such offering, that counsel will be named in the applicable prospectus supplement
related to that offering.
EXPERTS
The financial statements and managements assessment of the effectiveness of internal control over financial reporting (which is
included in Managements Report on Internal Control over Financial Reporting) incorporated in this prospectus by reference to the Annual Report on Form
10-K
for the year ended December 31, 2009 have
been so incorporated in reliance on the reports of PricewaterhouseCoopers LLP, an independent registered public accounting firm, given on the authority of said firm as experts in auditing and accounting.
Certain information included or incorporated by reference in this prospectus regarding our estimated quantities of natural gas reserves
was prepared by Netherland, Sewell & Associates, Inc.
WHERE YOU CAN FIND MORE
INFORMATION
We have filed a registration statement with the SEC under the Securities Act of 1933, as amended, that
registers the offer and sale of the securities covered by this prospectus. The registration statement, including the attached exhibits, contains additional relevant information about us. In addition, we file annual, quarterly and other reports and
other information with the SEC. You may read and copy any document we file with the SEC at the SECs Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Please call the SEC at
1-800-SEC-0330
for further information on the operation of the SECs Public Reference Room. The SEC maintains an Internet site that contains reports, proxy and
information statements and other information regarding issuers that file electronically with the SEC. Our SEC filings are available on the SECs web site at http://www.sec.gov. You also can obtain information about us at the offices of the New
York Stock Exchange, 20 Broad Street, New York, New York 10005.
The SEC allows us to incorporate by reference the
information we have filed with the SEC. This means that we can disclose important information to you without actually including the specific information in this prospectus by referring you to other documents filed separately with the SEC. The
information incorporated by reference is an important part of this prospectus. Information that we later provide to the SEC, and which is deemed to be filed with the SEC, will automatically update information previously filed with the
SEC, and may replace information in this prospectus and information previously filed with the SEC.
We incorporate by
reference in this prospectus the following documents that we have previously filed with the SEC:
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Annual Report on Form
10-K
(File
No. 1-33147)
for the year ended
December 31, 2009 filed on February 25, 2010;
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53
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Quarterly Reports on Form
10-Q
(File
No. 1-33147)
for the quarter
ended March 31, 2010 filed on May 7, 2010, for the quarter ended June 30, 2010 filed on August 6, 2010 and for the quarter ended September 30, 2010 filed on November 5, 2010;
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Current Reports on Form
8-K
(File
No. 1-33147)
filed on
December 22, 2010 (except for the information under Item 7.01 and the related exhibit), December 7, 2010 (except for the information under Item 7.01 and the related exhibit), October 28, 2010, July 30, 2010, and
March 3, 2010; and
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The description of our common units contained in our registration statement on Form
8-A
(File
No. 1-33147)
filed on November 13, 2006.
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All documents that we
file pursuant to Section 13(a), 13(c), 14 or 15(d) of the Securities Exchange Act of 1934, as amended, after the date of the prospectus and until the offerings hereunder have been completed will be deemed to be incorporated by reference into
this prospectus and will be a part of this prospectus from the date of filing of the document. Nothing in this prospectus shall be deemed to incorporate information furnished to, but not filed with, the SEC pursuant to Item 2.02 or
Item 7.01 of Form
8-K
(or corresponding information furnished under Item 9.01 or included as an exhibit).
We make available free of charge on or through our Internet website, http:
//www.constellationenergypartners.com
, our Annual Report on Form
10-K,
Quarterly
Reports on Form
10-Q,
Current Reports on Form
8-K
and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon
as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Information contained on our Internet website is not part of this prospectus.
You may obtain any of the documents incorporated by reference in this prospectus from the SEC through the SECs website at the
address provided above. You also may request a copy of any document incorporated by reference in this prospectus (excluding any exhibits to those documents, unless the exhibit is specifically incorporated by reference in this document), at no cost,
by visiting our Internet website at http:
//www.constellationenergypartners.com
, or by writing or calling us at the following address:
Investor Relations
Constellation Energy Partners LLC
1801 Main Street, Suite 1300
Houston, TX 77002
Telephone: (877) 847-0009
You should rely only on the information incorporated by reference or provided in this prospectus. We have not authorized anyone else to
provide you with any information. You should not assume that the information incorporated by reference or provided in this prospectus is accurate as of any date other than the date on the front of each document.
54
APPENDIX A
GLOSSARY OF TERMS
Adjusted Operating Surplus
for any period means:
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(a)
|
Operating Surplus generated with respect to that period;
less
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(b)
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any net increase in working capital borrowings with respect to that period (excluding any such borrowings to the extent the proceeds are distributed to the record
holder of the Class D interests);
less
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(c)
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any net reduction in cash reserves for operating expenditures with respect to that period not relating to an operating expenditure made with respect to that period;
plus
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(d)
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any net decrease in working capital borrowings with respect to that period;
plus
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(e)
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any net increase in cash reserves for operating expenditures made with respect to that period required by any debt instrument for the repayment of principal, interest
or premium.
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Available Cash
means, for any quarter ending prior to liquidation:
(i) all cash and cash equivalents of Constellation Energy Partners LLC and its subsidiaries (or the Companys
proportionate share of cash and cash equivalents in the case of subsidiaries that are not wholly-owned) on hand at the end of that quarter; and
(ii) all additional cash and cash equivalents of Constellation Energy Partners LLC and its subsidiaries (or the Companys proportionate share of cash and cash equivalents in the case of
subsidiaries that are not wholly-owned) on hand on the date of determination of available cash for that quarter resulting from working capital borrowings made subsequent to the end of such quarter,
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(b)
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less the amount of any cash reserves established by the board of managers (or the Companys proportionate share of cash reserves in the case of subsidiaries that
are not wholly-owned) to
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(i) provide for the proper conduct of the business of
Constellation Energy Partners LLC and its subsidiaries (including reserves for future capital expenditures including drilling and acquisitions and for anticipated future credit needs) subsequent to such quarter,
(ii) comply with applicable law or any loan agreement, security agreement, mortgage, debt instrument or other
agreement or obligation to which Constellation Energy Partners LLC or any of its subsidiaries is a party or by which it is bound or its assets are subject; or
(iii) provide funds for distributions (1) to our unitholders or (2) in respect of our Class D interests or management incentive interests with respect to any one or more of the next four
quarters;
provided, however
, that the board of managers may not establish cash reserves pursuant to (iii) above if the effect of
such reserves would be that the Company is unable to distribute the Initial Quarterly Distribution on all Common Units and Class A Units with respect to such Quarter; and
provided
further
, that disbursements made by us or any of
our subsidiaries or cash reserves established, increased or reduced after the end of that quarter but on or before the date of determination of available cash for that quarter shall be deemed to have been made, established, increased or reduced, for
purposes of determining available cash, within that quarter if our board of managers so determines.
Capital Surplus
is
generated by:
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(a)
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borrowings other than working capital borrowings;
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(b)
|
sales of debt and equity securities; and
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A-1
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(c)
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sales or other disposition of assets for cash, other than inventory, accounts receivable and other current assets sold in the ordinary course of business or as a part
of normal retirements or replacements of assets.
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Operating expenditures
means all expenditures of
Constellation Energy Partners LLC and its subsidiaries (or Constellation Energy Partners LLCs proportionate share in the case of subsidiaries that are not wholly-owned), including taxes, payments made in the ordinary course of business under
commodity hedge contracts (other than payments in connection with termination of same prior to its termination date), provided that with respect to amounts paid in connection with the initial purchase or placing of a commodity hedge contract, such
amounts shall be amortized over the life of the applicable commodity hedge contract and upon its termination, if earlier, manager and officer compensation, compensation paid to our board of managers, repayment of working capital borrowings, debt
service payments, and estimated maintenance capital expenditures, provided that operating expenditures will not include:
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repayment of working capital borrowings deducted from operating surplus pursuant to subparagraph (h) of the definition of operating surplus when
such repayment actually occurs;
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payments (including prepayments) of principal of and premium on indebtedness, other than working capital borrowings;
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capital expenditures made for acquisitions or for capital improvements, or expansion capital expenditures;
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actual maintenance capital expenditures;
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investment capital expenditures;
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payment of transaction expenses relating to interim capital transactions; or
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distributions to members (including distributions in respect of our Class D interests and management incentive interests).
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Where capital expenditures are made in part for acquisitions or for capital improvements and in part for
other purposes, our board of managers, with the concurrence of the conflicts committee, shall determine the allocation between the amounts paid for each.
Operating surplus
for any period means:
|
(a)
|
$20.0 million (if we choose to distribute as operating surplus up to $20.0 million of cash we receive in the future from
non-operating
sources such as asset sales, issuances of securities and long-term borrowings); plus
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|
(b)
|
all of our cash receipts, excluding cash from (1) borrowings that are not working capital borrowings, (2) sales of equity and debt securities and
(3) sales or other dispositions of assets outside the ordinary course of business; plus
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|
(c)
|
working capital borrowings made after the end of a quarter but before the date of determination of operating surplus for the quarter; plus
|
|
(d)
|
cash distributions paid on equity issued to finance all or a portion of the construction, replacement or improvement of a capital asset (such as
equipment or reserves) during the period beginning on the date that the group member enters into a binding obligation to
|
A-2
|
commence the construction, acquisition or improvement of a capital improvement or replacement of a capital asset and ending on the earlier to occur of the date the capital improvement or capital
asset commences commercial service or the date that it is abandoned or disposed of; plus
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|
(e)
|
if the right to receive distributions (other than distributions in liquidation) on the Class D interests terminates before December 31, 2012, the excess of the
amount of the original $8.0 million contribution by CHI for the Class D interests over the cumulative cash distributions paid on the Class D interests before such termination shall be included in operating surplus, such inclusion to occur over a
series of quarters with the amount included in each quarter to be equal to the amount of the payment a group member makes to the Trust in respect of the NPI for such quarter that would not have been paid but for termination of the sharing
arrangement; less
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|
(f)
|
our operating expenditures; less
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(g)
|
the amount of cash reserves established by our board of managers to provide funds for future operating expenditures; less
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(h)
|
all working capital borrowings not repaid within twelve months after having been incurred.
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Working capital borrowings
. Borrowings used solely for working capital purposes or to pay distributions to members made pursuant
to a credit facility, commercial paper facility or other similar financing arrangement, provided that when it is incurred it is the intent of the borrower to repay such borrowings within 12 months from other than Working Capital Borrowings.
A-3
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