Given the rising price of oil and natural gas in recent years, M&A activity in the industry, particularly the number of deals, has been on the rise. An unfortunate side effect of this hectic environment has been a generalized decrease in the quality of due diligence and compliance with existing contracts.

There are few oversights more serious and costly than non-compliance with a preferential right which can, depending upon the movement of prices over a given period, result in significant liability.

What is a preferential right? A preferential right, also known as a preemptive right, is basically a right of first refusal. If a property is burdened by a preferential right, before it can be sold, the owner must offer the property to the holder of the preferential right on the same terms and conditions as those offered by the third party. In other words, once the owner receives an offer to buy an asset that it would like to accept, the holder of the preferential right acquires an option to purchase the asset on the same terms and conditions.

In the oil and gas context, a preferential-right provision usually applies to an ownership interest in leases and/or pooled units and can appear in joint operating agreements (JOAs) and purchase and sale agreements (PSAs). A common form of preferential right reads as follows:

"After closing, should the buyer desire to sell all or any part of its interests in the property, it shall promptly give written notice to the seller, with full information concerning its proposed sale, which is to include the name and address of the prospective purchaser (who must be ready, willing and able to purchase), the purchase price and all other terms of the offer.

"The seller is to have an optional prior right, for a period of 10 days after receipt of the notice, to purchase on the same terms and conditions the interest the buyer proposes to sell. However, there is no preferential right to purchase in those cases where the buyer wishes to mortgage its interests, or to dispose of its interests to a subsidiary or parent company, or to any company in which buyer owns a majority of the stock."

Many preferential-right provisions, including the one above, fail to address certain areas and lead to a set of recurring disagreements, and it is important to realize that parties to a preferential right, by their actions or inactions, can easily waive their rights.

What follows are some examples of recurring disagreements and potential missteps.



Notice and response

A party wishing to sell assets subject to a preferential right must provide notice to the holder of the right. The sufficiency of this notice, and its associated response, is a common issue in litigation involving preferential-right provisions.

A typical preferential-right provision, including the one above, requires that the notice to the holder contain all of the terms and conditions of the proposed sale. A party can usually satisfy this provision by simply enclosing the proposed contract for sale with the notice.

However, in a surprising number of instances, the notice is inadequate. Sellers often include only basic information-the identification of the assets and the proposed sale price-even though many preferential-right clauses require more comprehensive disclosure.

Does an incomplete notice trigger the holder's option period? This is a critical question because often the deadline to respond is quite short, typically seven to 14 days. Does the holder of a preferential right have the right to require more complete disclosure, and how should it respond when the initial notice appears to be incomplete?

In many jurisdictions, although an incomplete notice does not specifically trigger the option period, it does obligate the holder to act to preserve its right. For instance, under Texas law, once a party makes a reasonable disclosure of the terms of an offer, the holder of the preferential right has a duty to undertake a reasonable investigation of any unclear terms.

What does this mean? If you receive a notice that does not contain all of the required information, do not assume that you can do nothing. Immediately upon receipt of the notice, review, or have your attorney review, the relevant state law to ascertain your responsibilities. You may be required to act within the option period by responding in writing to indicate your interest and inquire as to the lacking information. If you wait too long to respond or do not respond at all, a court may find that you waived your preferential right.

What if there is no notice at all and the holder of the preferential right finds out about a proposed or consummated sale? Some courts have held that a holder's knowledge of a sale, whether proposed or completed, triggers its duty of reasonable investigation. Thus, any information suggesting that a preferential right has been triggered, formal or informal, complete or incomplete, should prompt immediate and informed action by the holder to preserve the preferential right.



Sales, allocation, exercise

Properties subject to a preferential right are often sold together with other properties in what is sometimes referred to as a package sale or a bulk sale. How does a preferential right work in this situation, where the holder may not even be able to determine the sales price for the property subject to the preferential right? What are the rights and obligations of the parties with respect to the other properties?

It is relatively clear in many states that including property burdened by a preferential right in a larger package of properties does not create any rights or obligations with respect to properties not burdened by the preferential right. In other words, if properties subject to a preferential right are lumped together with entirely unrelated properties that are not similarly burdened, the holder of the right is not required, or entitled, to purchase the entire package. The rights and obligations associated with the preferential right clause are confined to the property it burdens.

What if multiple properties that are burdened by the same preferential right are transferred in a package? May the holder of the preferential right selectively exercise that right as to less than all of the properties? The answer to this question will depend entirely on the specific language contained in the preferential right. However, many common clauses have been construed to require the holder of the preferential right to exercise that right as to all of the properties. In other words, "cherry picking" was not permitted.

This leads to the logical question of how one determines the purchase price for a single property, or subset of properties, that is part of a larger package. There are two issues to consider here.

First, it is not uncommon for the parties to the proposed transaction to allocate values to each property. These allocated values are designed to permit adjustment to the purchase price in the event it is later determined that there is a title problem, or, of particular relevance here, a preferential right is exercised.

Is the holder of the preferential right bound to accept the value allocated by the owner and proposed buyer? After all, the property is not being "sold" for its allocated value; it is simply part of a larger bulk sale. The allocated value itself may not even have been a negotiated term, but rather a unilateral designation by one party.

Clearly, there is an opportunity to manipulate the allocations in a manner that defeats the preferential right. Is the holder of the preferential right required to treat this as a "true sale" and treat the allocated value as a sales price?

Generally speaking, the answer is often "yes." Many states require that the holder of the preferential right treat the allocated value just as if it were a true purchase price. However, in some states, an allocation made in bad faith or with the specific intention of defeating a preferential right may be invalid. In addition, there is some law that suggests that "commercially unreasonable" conditions, such as grossly disproportionate allocations, may be ineffective.

What if the proposed sale does not contain any allocated values, so that it is impossible to ascertain the price of the particular property subject to the preferential right? Jurisdictions differ on this issue, but in some states, if the parties cannot negotiate a price, the court will set a price for them.

How should the holder of a preferential right respond to a notice with an allocated value that appears to be unreasonable? Holders have responded to seemingly high allocations by rejecting the offer as invalid, or attempting to accept the offer as to a portion of the properties and reject it to the others. Both responses are problematic. For reasons already discussed earlier, rejecting or ignoring an offer is dangerous.

Furthermore, general contract law requires that a valid acceptance of an offer must "mirror" the terms of the offer. An "acceptance" that is conditional, changes the terms of the offer or imposes new terms is generally treated as a rejection and a counter-offer. Thus, unless special care is taken, anything other than unconditional acceptance risks waiver of the preferential right.

A holder may consider a written response in which it accepts the offer subject to a formal objection regarding the offending terms, reserves its right to enforce the preferential right pursuant to its terms and applicable law, and requests a dialogue as to the offending terms.

Or, the holder could accept the offer and pay the consideration subject to a formal objection (bad faith allocation, commercial unreasonability or the like). Under both response options, if the offending term was price, then the holder would assert that the price term is invalid and attempt to negotiate a lower price. At that point, the parties could discuss the validity of the term, or the parties may litigate the issue. However, what is critical is the holder's timely and appropriately response to avoid waiving its right.



Overlooking a right

What happens when an owner forgets, and the third party buyer fails to uncover in its due diligence, that a property is subject to a preferential right? The transaction then closes without the holder ever being offered the property. One of the parties eventually realizes what has happened, and the parties then attempt to enforce the preferential right or establish defenses to circumvent the preferential right.

A third-party buyer who has purchased a property subject to a preferential right may be forced by a court to convey the property to the holder of the right. At that point, while the third-party buyer gets the allocated funds back from the holder, it is usually left with the hollow consolation of a breach-of-contract action against the former owner.

Along those lines, a third-party buyer should not rely on an owner's representation as to existing preferential rights. Rather, a buyer should review the contracts applicable to the relevant property carefully for any preferential rights. The buyer must take the initiative because it is the buyer who will have to convey the property back to the holder if a preferential right is not discovered prior to closing.



Preventing problems

Of course, the easiest route to preventing preferential-right problems is to remove the preferential right provision from the applicable agreement before it is signed. Preferential rights can be undesirable because they can complicate a party's ability to sell a property in the future.

However, assuming the parties want a preferential right, how do they minimize the risk of these problems arising? One solution is negotiation and precise drafting at the front end of a transaction. The typical provision does not always fully address certain areas-such as sufficiency of notice, method of response, allocation issues and partial exercise-and the parties should consider discussing these particular areas to tailor the language of the preferential-right provision accordingly.

Lastly, due diligence to uncover preferential rights in existing agreements is critical, and if problems do arise, parties should recognize potential pitfalls, retain counsel if necessary, and take informed and expeditious action.



James Thompson is an attorney with Watt Beckworth Thompson & Henneman LLP in Houston. His practice focuses on oil and gas litigation and commercial litigation. This article is a general discussion of some of the legal issues related to preferential-right provisions and is not a comprehensive guide to dealing with these issues.