As noted in our January 2015 Haynes and Boone Alert on “Stretching Your Borrowing Base,” the spring borrowing base redetermination season is upon us. Borrowing base reductions seem a certainty for many oil and gas producers. While E&P companies continue to cut CAPEX and reduce overhead to conserve cash and look for ways to stretch their borrowing bases, many companies will opt for divesting non-core assets to pay down debt and improve liquidity, in order to survive until commodity prices improve. The press is full of reports of investors on the sidelines eagerly evaluating opportunities to acquire oil and gas assets at the lower end of the price cycle. Buyers looking to take advantage of this opportunity may be able to save millions of dollars up front with a well-designed title due diligence plan in place prior to starting their transaction process. And, after acquiring the assets, the new owners will find fewer surprises down the road.
So, Whose Title is it Anyway?
In the oil patch, title is never pristine. In fact, it is often a messy process to evaluate a seller’s title to properties that have been producing for a number of years, if not decades. Particularly in this price environment there is a strong possibility that the seller has not allocated adequate resources to properly manage or administer the properties being sold. With the recent land grab over the last five years, especially companies that actively grew through acquisitions and mergers, some producers have not had the time to fully integrate their holdings within their land department. It is even less likely that the company’s land records have been synchronized with engineering and accounting departments’ data-bases. Moreover, lower valued assets may not have garnered the care and attention to land and title matters that higher valued properties demand. Finally, in today’s environment some of these companies may no longer have the personnel or resources to clear up title matters and organize lease data into their land systems. Companies may have let go employees and contractors who are knowledgeable about the assets while their remaining staff is focused on other matters necessary to the company’s survival. Regardless of the seller’s command of its title information, title due diligence is an essential element of a buyer’s acquisition process.
A recent Oil and Gas Investor article, “Taking The Guesswork Out of Oil and Gas Lease Contracts” by Mikal E. Belicove, notes that most people would never consider buying a car without a clean title, much less an investment like a house without title insurance. But in the $350 billion a year U.S. oil and gas industry, buyers routinely sign off on acquisitions that contain title defects. Title in the oil patch may be messy, but the fact that buyers routinely sign off on contracts with title defects representing tens of millions of dollars is as costly as it is wrong according to new research out of the University of Utah. The November 2014 study from The University of Utah School of Business, Title Clean-Up Analysis, by K. Bown, M. Dixon, J. Ingebritson and K. Rodriguez analyzed title to approximately 5,600 oil and gas leases from two large acquisition deals. The research team discovered that title defects were two times more likely to result in a net loss than in a net gain in acreage. Their analysis of 145 additional public transactions revealed a lack of organization, transparency, and accountability across the industry. Knowing where to look and being able to see through the fog of disorganized title information is more art than science.
Custom Designed Due Diligence
A well-organized title due diligence protocol to protect the buyer from title defects does not have to “break the bank” if done properly. Proper management of the cost of title due diligence is essential to the process. By definition, a due diligence review is a level of investigation appropriate for the specific transaction. Appropriately defined scope and limitations, supervising the interface between all transaction team members, cost controls, and assignment of key personnel and experts should be the foundation of every due diligence review. A carefully designed and implemented title due diligence plan can serve a number of objectives. It can identify costly defects in title that could lead not only to the loss of title to the prospective asset, but it can avoid future costs to defend and remedy pending or threatened third-party claims. It has been our experience over the years that buyers are well advised to budget appropriate dollars up front for due diligence expenses which has the potential to save millions of dollars in purchase price adjustments and in future dispute cost avoidance.
Have a Game Plan
While most title due diligence reviews are associated with the buyer, it is also important for sellers to implement their own title due diligence prior to a sale. In addition to setting up a well-organized data room, a seller should develop a plan to (i) identify consents to assign and preferential rights to purchase and respective notice periods, (ii) assemble the information that will be represented to the buyer on the disclosure schedules to the purchase and sale agreement (i.e., seller’s working and net revenue interests by well/property, material contracts, consents, preferential rights to purchase, pending or threatened litigation, among many others), and (iii) prepare the property description exhibits to the conveyances.
Due diligence reviews should not consist of a checklist out of a book. They should be carefully crafted in conjunction with terms negotiated in the purchase and sale agreement. Negotiating a favorable purchase and sale agreement is the key to providing the proper rights and remedies for title defects. For example, the definition of title defect, permitted encumbrances, the threshold minimum value for individual title defects and aggregate title defects will determine the scope and limitations of the due diligence review. Therefore, it is critical to have the best experts negotiating and drafting these agreements. Equally important, following completion of the due diligence review, is the strategic and technical aspect of asserting and negotiating title defect adjustments or appropriate curative measures. This area too should be delegated to experts with experience in this field.
Put Your Best Team on the Field
One of the biggest changes in the way due diligence is conducted has taken place in the last three to five years. No longer do buyers have to access all of the original land and title files in the majority of transactions. Buyers and sellers alike seem to prefer the speed and convenience of making all the documents and data available digitally particularly when there are significant distances between the buyer, the seller, their agents, representatives and legal counsel. While this may seem more efficient on the surface, it can actually add significant time and expense to the review. In most cases the data is biased. Not every document, correspondence and worksheet is uploaded and someone of the seller’s side has made a unilateral decision about which documents he or she believes are relevant to the title. Follow-up requests are often necessary and it takes a higher degree of expertise to sense what relevant information might be absent from the materials. There may also be a significant number of documents that have been uploaded that are not relevant to the title and viewing documents on a computer screen takes several times longer to view than manually flipping through a three-inch file for only one half-inch of documents that are relevant to the review. This however, is the way of the future and there is no going back, which demonstrates why it is more important today than ever before to employ the best experts to conduct and supervise this process.
Establishing an efficient and effective due diligence team working directly with the company’s A&D team of engineers, legal and finance professionals is critical to creating value in any acquisition or disposition of oil and gas properties. While it is possible to engage land title consultants on an “as needed” basis for each transaction, it is our experience that clients benefit greatly from a legal and due diligence team that has worked together on multiple transactions over a period of time.