CHAPTER 7 OIL & GAS TITLE DUE DILIGENCE

JurisdictionUnited States
Due Diligence in Oil and Gas Transactions
(May 2011)

CHAPTER 7
OIL & GAS TITLE DUE DILIGENCE

John Lee
Crowley Fleck PLLP
Billings, Montana

JOHN R. LEE is a Partner in the Natural Resources Department at Crowley Fleck PLLP in Billings. His practice is concentrated on all aspects of oil and gas law, including title examination of federal, fee, state and Indian lands, division orders, formation of federal exploratory and enhanced recovery units, contract matters, and representing clients before state and federal regulatory agencies. Mr. Lee received his Juris Doctorate from the University of North Dakota School of Law, where he was Order of the Coif. John is an active member of the Rocky Mountain Mineral Law Foundation, a Regional Director of the American Association of Professional Landmen and a Past President of the Montana Association of Professional Landmen. He is admitted to practice law in both Montana and North Dakota. Mr. Lee also serves on the faculty of the Rocky Mountain Mineral Law Foundation's Federal Oil and Gas Leasing Short Course, teaching the subject areas of unitization, communication and operations.

"Due diligence" in the oil and gas title context refers to the buyer's examination of the seller's title to confirm the seller owns, and has the capacity to convey, the interests described in the purchase and sale agreement ("PSA"). A title examiner hired by the buyer conducts a due diligence examination to identify any title defects or deficiencies that may exist affecting the seller's title to the properties being acquired by the buyer. If any defects or deficiencies are identified, the title examiner prescribes the curative measures necessary to facilitate a clean title transfer of the properties to the buyer.

Unless the transaction is small in scale, the "title examiner" will actually be a team of landmen and/or attorneys hired to conduct the due diligence examination. In the past, attorneys were routinely engaged to perform due diligence examinations but, over time, the trend has moved towards hiring landmen to perform the majority of the due diligence examination in an effort to keep costs down, among other reasons.1 Regardless of the makeup of the due diligence team, it is essential that it have a designated director who will oversee every step of the process.

The director of the due diligence team must select, organize and instruct the team members, maintain communication between the team, compile the information obtained, and resolve any issues that may arise along the way. The director will also be the principal contact for the buyer and will ensure a constant flow of information between the team and the buyer so that everyone is apprised of the current status of the transaction at all times. The time spent assembling a proper due diligence team is always time well spent. Throughout these materials, references to the "title examiner" refer generally to whomever the buyer has engaged to perform that portion of the examination.

The title portion of the due diligence examination typically consists of two main components: examining the seller's internal records and examining relevant external title records. It is not unusual for one individual or group to perform the search of the seller's records while another individual or group performs the search of the title records. An example of this is the buyer hiring landmen to conduct the search of the seller's records and attorneys to conduct the search of title records. After examining the title records, the attorneys prepare title opinions summarizing their findings from the title records and any other materials examined. After examining the seller's records, the landmen prepare reports summarizing their findings and then compare the information in the attorney title opinions to their reports. The landmen then either provide the information to attorneys to utilize in issuing acquisition title opinions or the landmen may issue ownership reports in lieu of attorney acquisition title opinions. Formal attorney title opinions are generally obtained in situations where the properties to be acquired have high value, are required by a lender, or the buyer simply prefers a formal opinion. Numerous methods of conducting due diligence examinations exist and the method chosen by the buyer depends upon the magnitude of the transaction and the budget available for the examination.

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1. Timing of Examination.

Often, a limited amount of due diligence is conducted prior to the buyer and the seller entering into a PSA. The buyer utilizes this early information in determining whether the properties are a worthwhile acquisition and, if so, the buyer uses the information in negotiating the terms of the PSA.

Generally, a formal due diligence examination is commenced once the PSA has been executed by the buyer and the seller. However, in some cases, particularly when time is especially limited, the letter of intent will permit the buyer to commence the due diligence examination prior to executing the PSA.2 Confidentiality issues may arise in these cases if the pending transaction collapses and a PSA is never executed. The title examiner may have already obtained confidential information from the seller's records so the seller may require the buyer and all agents to execute confidentiality agreements prior to examining any of its records.

In nearly all transactions, the due diligence examination must be completed in a relatively short time frame. As the examination is a key element in every acquisition, it is essential that the title examiner be adequately prepared before commencing the examination.

2. Preparing for Examination.

The title examiner engaged to conduct the due diligence examination must understand the buyer's goals for such examination. Typically, the buyer is not looking for information that will kill the deal but, instead, desires to confirm the information regarding the properties represented by the seller, identify and resolve any title issues affecting the properties, eliminate any undesirable property from the deal and reduce the overall purchase price. It is the title examiner's responsibility to ensure these goals are met, if possible, prior to closing.

In the interest of narrowing the scope of the due diligence examination as much as possible so it is more likely to be completed within the allotted time, the title examiner should obtain directives from the buyer regarding priorities and other parameters. It is beneficial for the buyer to create a valuation list, ranking the properties to be acquired according to their relative value or importance. This assists the title examiner in structuring the examination so that records related to the most valuable or important properties are examined first.3 Another common parameter for prioritizing the properties is the "80/20 rule." The 80/20 rule or the "80% rule" has the title examiner devote the most time to carefully reviewing the records related to properties comprising 80% of the purchase price and using any remaining time to review the records related to the other 20%.4 In very large transactions, there is often no time remaining to devote to the other 20% so the buyer must assume the business risks of acquiring property which may have numerous title defects. Depending on the time frame and cost involved, it may be necessary for the buyer to establish other parameters for the due diligence examination to further limit the scope of the examination.

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As previously indicated, unless the transaction is quite small, the title examiner will need to assemble a team to assist in conducting the due diligence examination in the allotted time. The team must be thoroughly briefed on the properties to be acquired, the parties involved, and the relevant terms of the PSA. In an ideal world, each of the team members would review the entire PSA but, in reality, time is often so limited that the team members are not even apprised of the basic provisions in the PSA. This is unfortunate as the more information the team members have going into the examination, the more efficient they can be. Thus, every effort should be made to fully brief the team members. Proper preparation of the team and constant communication between the team members throughout the examination is essential in conducting a comprehensive yet efficient due diligence examination.

In addition to assembling a suitable due diligence team, another key step in preparing for the due diligence examination is thoroughly reviewing the PSA. As stated previously, all team members, whether they will be searching the seller's records or the title records, should ideally review the PSA. At a minimum, the director of the due diligence team must review the PSA to be able to provide guidance to the team members and to effectively manage the examination.

Utilizing the information contained in the PSA as well as any directives provided by the buyer, the title examiner should develop a checklist for the due diligence examination. The checklist should specify the information to be confirmed and obtained in the examination. This checklist will ensure that nothing is unintentionally overlooked in the examination and will serve as a valuable reference guide for the due diligence team members while they are in the field conducting the examination.

In reviewing the PSA, the title examiner should note the seller's legal name reflected therein. As a preliminary matter, the title examiner should confirm the legal name and identity of the seller. This will aid the examiner in determining whether record title to the properties is properly vested in the seller and not in any predecessors or related entities. This step should be taken as early as possible in the due diligence examination so property can be conveyed to the seller or other necessary steps can be taken if the property to be acquired is not actually vested in the...

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