LLC Form Of Consolidation Agreement

This Agreement dated this _______ day of September, 1996, by and between:


Costilla Energy, Inc. (the "Company") - a Delaware
corporation;


Costilla Energy, L.L.C. (the "LLC") - a Texas limited
liability company;


CSL Management Corporation ("CSL") - a Texas corporation;


Valley Gathering Company ("Valley") - a Texas corporation;


Cadell S. Liedtke ("Liedtke") - an individual of Midland
County, Texas;


Michael J. Grella ("Grella") - an individual of Midland
County, Texas;


Henry G. Musselman ("Musselman") - an individual of Midland
County Texas; and


NationsBanc Capital Corporation ("NBCC") - a Texas
corporation.


R E C I T A L S


WHEREAS, the Company has been formed to acquire and consolidate (the "Consolidation") the following assets or entities:


(1) the outstanding common stock of Valley through a cash purchase;


(2) the assets of CSL through a cash purchase;


(3) the LLC (following the redemption by the LLC of NBCC's redeemable interests in the LLC (the "Redeemable Interest") owned by NBCC), including: (a) the stock of the three corporate subsidiaries of the LLC, being Statewide Minerals, Inc. ("Statewide"); Costilla Petroleum Corporation ("CPC"); and Costilla Pipeline Corporation ("Pipeline"), all Texas corporations, and (b) the membership interests of the LLC in two Texas limited liability companies, Costilla Redeco Energy, L.L.C. ("Energy") and Costilla Redeco Operating, L.L.C. ("Operating") through a merger (the "Merger") of the LLC into the Company pursuant to Part Ten of Art. 1528n V.A.T.S., and Section 264 of the Delaware General Corporation Laws.


WHEREAS, immediately prior to the Merger, the LLC will distribute $4,218,215 in cash to the Members of the LLC in the amounts set forth herein;


WHEREAS, concurrently with the Consolidation, the Company will close offerings (collectively, the "Offerings") of $100,000,000 ____% senior subordinated notes due 2006, and 4,000,000 shares of its common stock par value $.10 per share (the "Company Common Stock") pursuant to the Securities Act of 1933, as amended (the "Securities Act"), as described in those certain Registration Statements on Form S-1, Registration Nos. 333-08909 and 333-08913, respectively, (as amended at the time each becomes effective, the "Registration Statements") of the Company, each filed with the Securities and Exchange Commission on July 26, 1996; and


WHEREAS, the parties hereto desire to set forth the terms and conditions of the Consolidation and provide for certain relationships and obligations among the parties hereto following the Effective Date (as defined herein).


NOW, THEREFORE, in consideration of the foregoing and of the mutual covenants set forth herein, and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, and intending to be legally bound hereby, the aforesaid parties hereby agree as follows:


I. REDEMPTION, DISTRIBUTIONS AND ACQUISITIONS


A. REDEMPTION OF REDEEMABLE INTERESTS OF NBCC


1. Immediately prior to the Merger, NBCC shall convey, transfer, assign and sell to the LLC its Redeemable Interest for $15,486,914 (the "Redemption") payable in cash. The source of the cash payment required by this Section I.A.1. shall be an advance to the LLC by the Company from the net proceeds from the Offerings.


2. The Redemption shall be accomplished pursuant to an Assignment of NBCC's Redeemable Interest substantially in the form attached hereto as Exhibit "A" (the "Assignment").


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3. NBCC represents that


(a) the Redeemable Interest is free and clear of all encumbrances, security interests and liens and are subject only to those obligations arising from its membership in the LLC, as defined in the LLC's Regulations.


(b) NBCC will, upon execution of the Assignment, convey good and indefeasible title to the Redeemable Interests as well as all rights to profits and capital in respect thereof.


(c) NBCC further represents that it has taken all required corporate action to convey the Redeemable Interests and has acquired all necessary consents and approvals to consummate the Assignment. No notice to or approval by any other person, firm, entity (including governmental authorities), is required by NBCC to execute and deliver the Assignment.


B. CASH DISTRIBUTION TO MEMBERS


Immediately prior to the Merger, the LLC shall make a cash distribution to each of its Members as follows:


NBCC $ 759,279
Liedtke $1,936,669
Grella $1,051,244
Musselman $ 471,023


The source of the cash payment required by this Section I.B. shall be an advance to the LLC by the Company from the net proceeds from the Offerings.


C. PURCHASE OF VALLEY STOCK


1. At the Closing and concurrently with the consummation of the other transactions contemplated by the Consolidation, the Company shall purchase all of the issued and outstanding shares of common stock of Valley from each of Liedtke, Grella and Musselman (collectively, the "Selling Shareholders") for the cash consideration of $660 per share ($660,000, in the aggregate) as follows:


Selling Shareholder No. of Shares Cash Payment Price
------------------- ------------- ------------------
Liedtke 540 $356,400
Grella 317 $204,220
Musselman 143 $ 94,380


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2. Valley and the Selling Shareholders represent, jointly and severally, that:


a. Valley is a corporation duly organized, validly existing and in good standing under the laws of the State of Texas. Valley has all requisite power and authority to own, operate and carry on its business as now being conducted. Valley's capitalization consists of 1,000,000 shares of common stock, par value $1.00 per share (the "Valley Common Stock"), of which 1,000 shares are issued and outstanding. There are no other classes of stock authorized or outstanding. The issued and outstanding shares of Valley Common Stock have been validly issued, and are fully paid and non-assessable. There are no outstanding options, warrants or similar rights to purchase or convert any obligation into Valley Common Stock or other securities of Valley.


b. Valley has good and marketable title to all of its assets and properties, tangible and intangible, that are material to Valley's business and future prospects. All of Valley's assets are free and clear of all mortgages, liens, pledges, security interests, encumbrances, equities, claims, easements, covenants, conditions and restrictions, except as set forth in the financial statements previously delivered to the Company.


c. The Valley Common Stock is owned by each of the Selling Shareholders free and clear of all liens, security interests or encumbrances. Each of the Selling Shareholders has all requisite authority to sell, convey and assign such shares of Valley Common Stock without the consent of any other person, firm, agency or other entity, other than such consents as have been obtained.


d. The financial statements of Valley previously delivered to the Company (i) present fairly the financial position of Valley as at the date indicated and the results of its operations for the periods specified and (ii) have been prepared in conformity with generally accepted accounting principles applied on a consistent basis during the periods involved, except as indicated therein, for the absence of footnotes and for closing adjustments which would not be material in amount. Since the date of such financial statements there has been no material adverse change in Valley.


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3. The sale and assignment of the Valley Common Stock shall be effectuated by the delivery, at Closing, by each of the Selling Shareholders to the Company, of the original common stock certificates endorsed in blank.


D. PURCHASE OF CSL ASSETS


1. At the Closing and concurrently with the consummation of the other transactions contemplated by the Consolidation, the Company shall purchase all of the assets of CSL for $40,000 payable in cash to CSL. The source of the cash payment required by this Section I.D.1. shall be net proceeds from the Offerings.


2. CSL and the Selling Shareholders represent, jointly and severally that:


a. CSL is a corporation duly organized, validly existing and in good standing under the laws of the State of Texas. CSL has all requisite power and authority to own, operate and carry on its business as now being conducted.


b. CSL is the sole owner of the assets conveyed hereunder and has full power and authority to dispose of its assets. CSL has good and marketable title to all of its assets and properties, tangible and intangible, that are material to CSL's business and future prospects. All of CSL's assets are free and clear of all mortgages, liens, pledges, security interests, encumbrances, equities, claims, easements, covenants, conditions and restrictions, except as set forth in the financial statements previously delivered to the Company.


c. The financial statements of CSL previously delivered to the Company (i) present fairly the financial position of CSL as at the date indicated and the results of its operations for the periods specified and (ii) have been prepared in conformity with generally accepted accounting principles applied on a consistent basis during the periods involved, except as indicated therein, for the absence of footnotes and for closing adjustments which would not be material in amount. Since the date of such financial statements there has been no material adverse change in CSL.


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3. This conveyance shall be accomplished by the execution, by a duly authorized officer of CSL, of a bill of sale and assignment substantially in the form attached hereto as Exhibit "B" with a complete description of the assets conveyed attached thereto, including the assets identified on the attachment to Exhibit "B". CSL shall also deliver a certified copy of Directors' and Shareholders' Resolutions authorizing the sale of all its assets.


II. THE SECTION 351 TRANSACTIONS


At the Closing and concurrently with the other transactions contemplated by the Consolidation, there shall be consummated two transactions pursuant to Section 351 of the Internal Revenue Code of 1986, as amended (the "Code") as follows:


A. THE MERGER OF LLC INTO THE COMPANY


1. ACTIONS TO BE TAKEN. As a part of the Consolidation, the following actions shall be taken by the LLC and the Company:


a. Simultaneous with the execution of this Agreement, the Company and the LLC shall adopt and enter into a Plan and Agreement of Merger (the "Merger Agreement"), a copy of which is attached hereto as Exhibit "C", providing for the Merger of the LLC with and into the Company effective on the Effective Date. For the purposes of this Agreement, the "Effective Date" shall be the date appropriate certificates of merger are filed with the secretaries of the States of Texas and Delaware, which date shall be the same date as the date of Closing, and the "Effective Time" shall be the time the later of such filings is made on the Effective Date. For tax purposes, the Merger will be treated as a contribution of the LLC's assets and liabilities to the Company solely in exchange for Company Common Stock pursuant to Section 351 of the Code, and a distribution of the Company Common Stock from the Company to the former Members of the LLC.


b. At the Effective Time the LLC shall be merged with and into the Company in accordance with the terms and conditions of the Merger Agreement and Section 351 of the Code; and the separate existence of the LLC shall cease and the Company shall continue as the surviving entity. The


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Company and the LLC will cause the Merger to be consummated by filing a Certificate of Merger (the "Merger Certificate") with the secretary of the States of Texas and Delaware as required by the Delaware General Corporation Laws and the Texas Limited Liability Company Act.


c. At the Effective Time, by virtue of the Merger and without any action on the part of any person, the membership interests in the LLC, all of which are owned by Liedtke, Grella, Musselman and NBCC, shall be converted into and shall become the number of shares of Common Stock of the Company determined pursuant to the Merger Agreement and Section II.A.1.e. below. From and after the Effective Time, the Company shall possess all of the rights, privileges and powers of the LLC; all property, rights, privileges, powers and other interests of the LLC shall be thereafter as effectively the property of the Company as they were of the LLC; the title to any and all real or personal property or other interest vested by deed or otherwise in LLC shall vest in the Company and shall not revert or be in any way impaired by reason of the Merger; and all rights of creditors and all liens upon any property of the LLC shall be preserved unimpaired, and all debts, liabilities and duties of the LLC shall thereafter attach to the Company, and may be enforced against it to the same extent as if such debts, liabilities and duties had been contracted by it.


d. On and after the Effective Time by virtue of the Merger and without any further action, the Company shall become the owner of all issued and outstanding shares of Statewide, CPC and Pipeline, and shall become a member in Energy and Operating.


e. Pursuant to the Merger, at the Closing, the Company shall issue an aggregate of 6,000,000 shares of Company Common Stock to the holders of the membership interests in the LLC (the "LLC Members") as follows and all previously issued shares of the Company's Common Stock, if any, in connection with its organization shall be cancelled:


LLC Member No. of Shares of Common Stock to be Issued
---------- ------------------------------------------
Liedtke 2,656,796
Grella 1,558,161
Musselman 705,035
NBCC 1,080,008


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Upon the issuance of such shares of Common Stock, they shall be validly issued, fully paid and nonassessable. Such number of shares may be adjusted prior to the Effective Time by an agreement executed by all of the members, subject to consent of the representatives of the underwriters in the Offerings.


2. Representations and Warranties of the LLC and the LLC Members. The LLC and the LLC Members, jointly and severally, represent that:


a. The LLC is a limited liability company, duly organized, validly existing and in good standing under the laws of the State of Texas. The LLC has all requisite power and authority (including all licenses, franchises, permits and other governmental authorizations as are legally required) to carry on its business as now being conducted, to own, lease and operate its properties and assets, and to enter into and carry out its obligations under this Agreement. The LLC is qualified to do business in all states other than the State of Texas wherein such qualification is required, except when the failure to be so qualified does not have a material adverse effect on the financial condition or results of operation of the LLC. The LLC has taken all action necessary to authorize the execution, delivery and performance of this Agreement and the other agreements and documents contemplated hereby to which it is a party.


b. This Agreement has been, and the other agreements and documents contemplated hereby have been or at Closing will be, duly executed by the LLC and each constitutes the legal, valid and binding obligation of the LLC, enforceable in accordance with its respective terms and conditions, except as enforceability may be limited by bankruptcy, conservatorship, insolvency, moratorium, reorganization, receivership or similar laws and judicial decisions affecting the rights of creditors generally and by general principals of equity. The LLC has full power and authority to execute, deliver and perform this Agreement which will not violate any requirement of law or its articles of association, regulations or other organizational documents, nor will it violate any applicable law, regulation or order of any governmental authority nor any agreement, indenture, mortgage, deed of trust, voting


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agreement, loan agreement, note agreement or other evidence of indebtedness, lease, contract or other instrument to which it is a party or by which its property is bound.


c. The LLC has good and defensible title to its assets to be vested in the Company pursuant to the Merger except for:


i. undeveloped oil and gas leases;


ii. personal property and equipment located on property subject to oil and gas leases and used in connection with the operation and development of oil and gas leases; and


iii. defects which collectively would not have a material adverse effect on the business, properties, business prospects, condition (financial or otherwise) or results of operation of the Company.


For purposes of this Agreement, good and defensible title shall mean title that is free from defects as would cause a reasonable doubt in the mind of a reasonable and prudent purchaser in the area where the property interest is situated and cause him, if he were purchasing such interest, to refuse to accept the same at its full agreed value. The title to certain assets may be subject to drilling obligations in leases, farmout agreements, operating agreements, gas purchase contracts, covenants, restrictions, rights, easements, liens and encumbrances which are valid and in full force and effect as to such properties, and minor irregularities in title which, collectively, do not interfere with the operation, use and enjoyment of any such asset in the normal course of business as presently conducted by the LLC or materially impair the value thereof for such business.


d. The LLC's assets (except for undeveloped oil and gas leases and personal property and equipment located on property subject to oil and gas leases and used in connection with the operation and development of oil and gas leases) are held by the LLC free and clear of any security interests, mortgages, pledges, liens, encumbrances, charges, defects or restrictions of any kind or character other than (i) those described in the preceding paragraph c and; (ii) those granted to NationsBridge, L.L.C. and its affiliates pursuant to security agreements, mortgages, assignments and other instruments to secure


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the obligation of the LLC under various loan arrangements. The oil and gas interests of the LLC were acquired in a manner customary in the oil and gas industry using reasonable diligence used by prudent purchasers in the area, and the developed portion of the oil and gas leases are valid, subsisting and enforceable against each of the parties thereof and are in full force and effect in accordance with their respective terms (except for such leases that have partially terminated as to certain nonproducing lands and/or depths pursuant to the terms thereto) and where the failure of such leases to be enforceable or to be in full force and effect would not, in either instance, have a material adverse effect on the LLC or its business, properties, business prospects, conditions (financial or otherwise) or results of operations, taken as a whole.


e. There are no actions, suits or proceedings pending or threatened against or affecting the LLC, or its officers, directors or members in their capacities as such, before any federal, state or local body or authority, domestic or foreign, wherein an unfavorable ruling, decision or finding would have a material adverse effect on its business, properties, business prospects, conditions (financial or otherwise) or results of operations.


B. THE PUBLIC OFFERING


Concurrently with the other transactions contemplated by the Consolidation, and as a condition precedent thereto, the Company shall have closed an initial public offering (the "Common Stock Offering") of shares of the Company Common Stock pursuant to the Securities Act, as described in that certain Registration Statement on Form S-1, Registration No. 333-08913 filed with the Securities and Exchange Commission. Proceeds from the Common Stock Offering shall constitute "property" contributed to the Company solely in exchange for common stock as defined in Code Section 351 and shall be the result of an "underwriting" as described in the Regulations to the Code at Section 1.351-1(a)(3).


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III. REPRESENTATIONS AND WARRANTIES OF THE COMPANY


In connection with transactions contemplated under Article I and II hereof, the Company represents to each of the LLC, Valley, CSL, Liedtke, Grella, Musselman and NBCC that the following representations and warranties are true and correct as of the closing:


A. The Company is a corporation duly organized and validly existing, in good standing, under the laws of the State of Delaware, with all requisite corporate power and authority to own and to lease its property and to carry on its business as now conducted, and is duly qualified and authorized to do business as a foreign corporation and is in good standing in each jurisdiction wherein the failure to be so qualified and authorized would have a material adverse effect on the financial condition or results of operations of the Company.


B. It has full requisite corporate and other power and authority to enter into this Agreement and to perform its obligations hereunder. The execution and delivery of this Agreement by the Company and the consummation by the Company of the transactions contemplated hereby have been duly authorized by the Board of Directors of the Company and no other corporate proceeding on the part of the Company is necessary for the execution and delivery of this Agreement by it. This Agreement has been duly executed and delivered by the Company and constitutes a legal, valid and binding obligation of the Company, enforceable against it in accordance with its terms.


IV. REGISTRATION RIGHTS


A. INCIDENTAL REGISTRATION.


1. REQUEST FOR REGISTRATION. If at any time the Company proposes to file a registration statement under the Securities Act (other than a registration statement on Form S-4 or Form S-8 or other similar forms providing for the registration of employee benefits plans) with respect to an offering of shares of Company Common Stock (the "Shares") for its own account or for the account of any of Liedtke, Grella, Musselman or NBCC (collectively, the "Affiliated Holders") (including, without limitation, a "Demand Registration" pursuant to Section IV.B.), then the Company shall give written notice of such


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proposed filing and its distribution plan to each Affiliated Holder owning more than five percent (5%) of the total outstanding Company Common Stock (each, an "Eligible Holder") as soon as practicable (but in no event less than twenty (20) days before the anticipated filing date of such registration statement). Such notice shall offer each Eligible Holder the opportunity to have all or any part of the Shares owned by such Eligible Holder included in the registration statement proposed to be filed by the Company, and thereby be registered under the Securities Act (and any related qualification under any applicable state securities or "blue sky" laws or other compliance) or, at the Company's option, in a separate registration statement to be filed concurrently with such registration statement (in either case, "Incidental Registration"). Within fifteen (15) days after receiving such notice, each Eligible Holder may make a written request to the Company that any or all of the Eligible Holder's Shares be included in the Incidental Registration, which notice shall specify the precise portion of such Eligible Holder's Shares to be so included. Subject to the provisions of Section IV.A.2., the Company shall include in the Incidental Registration all Shares in the Company with respect to which the Company has received such a written request by an Eligible Holder. Any Eligible Holder shall be permitted to withdraw all or part of his Shares in the Company from an Incidental Registration at any time prior to the effective date of the registration statement filed with respect to such Incidental Registration.


2. PRIORITY ON INCIDENTAL REGISTRATION. The Company shall use its best efforts to cause the managing underwriter or underwriters of a proposed underwritten offering by the Company, in connection with which Incidental Registration is requested, to permit the inclusion of all Shares in the Company requested by the Eligible Holders (the "Selling Incidental Holders") to be included in the Incidental Registration on the same terms and conditions as similar securities of the Company included therein to the extent appropriate. Notwithstanding the foregoing, if the managing underwriter or underwriters of such offering deliver a written opinion to the Company that, because of the size of the offering which the Selling Incidental Holders, the Company and any other security holders of the Company intend to make, the success of the offering would be materially and adversely affected by inclusion of more than a specific


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number of the Shares requested to be so included, then such registration shall be comprised of the following Shares:


a. PRIMARY REGISTRATION. If such Incidental
Registration is incident to a primary registration on behalf
of the Company, then the Shares to be included in such
primary registration shall be as follows:


(i) first, the Shares intended to be offered by the
Company;


(ii) second, the Shares owned and requested to be
registered by NBCC; and


(iii) third, the Shares owned, and requested to be
registered, by the other Selling Incidental
Holders in proportion to the ratio that the
number of Shares owned by each such remaining
Selling Incidental Holder (excluding any
Shares to be registered pursuant to
subparagraph IV.A.2(a)(ii)) bears to the
total number of Shares owned by all such
Selling Incidental Members (excluding any
Shares to be registered pursuant to
subparagraph IV.A.2.(a)(ii)) (or as otherwise
agreed); and


b. SECONDARY REGISTRATIONS. If such Incidental
Registration is incident to a secondary registration on behalf of
Affiliated Holders owning Shares ...