EnerMatix Article

Current Issues on Rights of First Refusal
October 22nd, 2008 | Categories : Business Practises, Land A&D, Oil & Gas

At summer camp I remember singing Michael, Row the Boat Ashore, in endless rounds as the orange glow of the crackling fire lit the night while we kids were safely seated so far away from the conflagration that we felt no heat and mostly spent the night swatting mosquitoes, shivering, and yearning for the torture to end. Amid these sweet memories I recall that a fireside buddy once asked me, “Where’s Michael rowing?” and I quickly answered, “Fer shore dummy, he’s rowin’ fer shore”. Years later, as a newbie evaluations engineer in the oil patch, I was asked if there were any “row fer’s” on some land. I was very confused. “Row fer?” The first thing I thought of was Michael’s endless row fer shore to get to that milk and honey on the other side, or sometimes to meet someone’s mother.

Now, I’ve at least got the name sorted. Turns out that “row fer” has nothing to do with Michael’s quest for milk and honey, or anybody’s mother. It’s all about rights of first refusal, or “ROFR” as folks in the business like to say.

Article XXIV of the 1990, 1981, and 1974 CAPL Operating Procedures, and article XXVI of the 1971 CAPL Operating Procedure, is entitled “Disposition of Interests” and election (B) at paragraph 2401 (paragraph 2601 in the 1971 CAPL) is the most common source of ROFR’s in the oil and gas industry. This article only focuses on this CAPL-type of ROFR. Non-CAPL agreements can also create ROFR’s, but they are non-standard and need to be analyzed individually.

There have been several good articles written about ROFR issues in the Canadian oil and gas industry. If you’re interested in digging into the topic, please see Perell (1991), Smith and Denstedt (1992), Flannigan (1997), Johnson and Stanford (1999), and Tarnowsky, Pittman, and Wilton (2007), as referenced below. There is also an article by Bryan Duguid and Gavin Matthews in The Negotiator, October 2008, that discusses a recent Alberta Court of Appeal decision in Canadian Natural Resources Ltd. v. EnCana Oil and Gas Partnership about how ROFR’s are triggered by farmouts in the 1990 CAPL operating procedure. However, there are four operational A&D issues about ROFR’s that I would like to focus on here that extend some of the discussions in those previous articles.

1. A&D ROFR Triggers, about when a ROFR should be issued in a non-farmout context, such as in acquisition and divestiture transactions;

2. Cherry Picking, about how to value multiple parcels that have been divided by segregation;

3. Underlying Agreements, about how to manage ROFR’s when two agreements on the same land have different ROFR requirements, and

4. ROFR’s to GOR Parties, about whether or not GOR parties are entitled to receive ROFR’s.

1. A&D ROFR Triggers.

In the leading case on this issue, Canadian Long Island Petroleum v. Irving Industries, [1975] 2 S.C.R. 715, the Supreme Court of Canada said that ROFR’s are usually triggered by receipt of an offer the vendor is prepared to accept. That would seem to be a pretty clear instruction. However, parties can draft ROFR clauses that set different triggers. So, in practice, it doesn’t seem to be as simple as Canadian Long Island Petroleum suggests.

Each of the CAPL style of ROFR-generating paragraphs starts off with the phrase, “a party shall not dispose of any of its working interest by assignment, sale, trade, lease, sublease, farmout or otherwise, without first complying with the provisions” of the operating procedure. This is a bit troublesome because there is ambiguity about what part of the disposition process is the trigger to set things in motion. As discussed by Duguid and Matthews (2008), the Alberta Court of Appeal decision in Canadian Natural Resources Ltd. v. EnCana Oil and Gas Partnership looked at disposition by farmout. CNRL argued that the ROFR was triggered when EnCana intended to farmout its working interest. EnCana said no, the ROFR wasn’t triggered until earning was immanent. The Court of Appeal found both arguments reasonable and recently turned the case back to the Court of Queen’s Bench to trial on the issues, including evidence on industry practice. The courts may find industry consensus elusive. The outcome will be interesting to follow.

The A&D side of the business operates a bit differently than farmouts. So, the CNRL v. EnCana case may not apply directly. However, the A&D process shares the ambiguity about interpreting when a disposition has taken place. Remember, paragraph 2401 says that a party “‘shall not dispose’ without first complying the provisions” of either alternate A or B. The issue is the requirement to first comply. If it just said that ROFR’s should be issued after disposing, there would be little controversy. In A&D, a ROFR would go out after the purchase and sale agreement (PSA) was executed. Unfortunately, that’s not what it says. It says, “first compiling.” So, the plain meaning seems to be that sometime before the disposition, the vendor must comply with the expectations of the ROFR paragraph. This seems to place the timing of the ROFR triggering event in the murky waters of uncertainty that precede disposition. There’s the rub. A&D teams to respond in two distinct ways. Some see the trigger as signing a letter of intent (LOI). Others see the trigger as execution of the PSA.

1. Letter of Intent.

This approach recognizes the trigger as execution of the LOI. It seems reasonable. Signing the LOI morally commits the parties to follow through with a disposition transaction and provides authorization and guidance to the company’s administrative and technical teams. Depending on how it’s written, it may create a beneficial right where the vendor becomes obligated to hold the transaction lands and rights in trust for the purchaser. ROFR’s are then issued even though the exact terms of the PSA haven’t been worked out yet. All the key information is available: purchaser’s name, price, effective date, land description, etc.

This approach seems to fit with the Supreme Court of Canada’s view in Canadian Long Island Petroleum because the ROFR is issued soon after the vendor receives an offer it is prepared to accept. It also fits nicely with the expectation in the ROFR clause to issue the ROFR before disposition because an LOI probably isn’t a binding contract.

Formation of a contract must proceed through offer, acceptance, and consideration. An LOI that is subject to senior management approval may be a conditional acceptance and not binding. One that is not accompanied by a deposit may lack consideration. Other forms of consideration are possible. A simple one is to sign under seal. But, as a general rule LOI’s are not signed under seal. Also, an LOI may be only an agreement to agree—which is no agreement at all. So, if a vendor went ahead and disposed of the transaction lands to a different party, or refused to follow through with the deal, it would be difficult for the purchaser to rely on contract law to successfully sue on the strength of most LOI’s. It would be equally difficult for a vendor to sue a purchaser who backed out. There may be equitable solutions, but it still stands that interpreting an LOI as a disposition is a bit premature. So, either because you are comfortable following the guidance of the Supreme Court of Canada or because you like fitting with the terms of the ROFR clause, it’s probable that issuing a ROFR on the strength of an LOI is a good tactical choice.

Many A&D transactions also proceed on the strength of an LOI because it offers administrative and operational advantages. First of all, the parties can get going with title review, resolution of defects and deficiencies, and issuance of ROFR’s in parallel with negotiation of the finer nuances of the PSA. It takes a lot of pressure off the team drafting the PSA. The land, well, facilities, and other schedules attached to the final PSA, end up being reliable records of the transaction. This is because the PSA isn’t finalized until all ROFR exercise activity has been netted out. That is to say, the final schedules show the lands, wells, and facilities that really form part of the final deal after all the dust has settled from lands being taken out by parties exercising ROFR’s. This avoids the need for the PSA to be amended after ROFR’s are exercised. It makes it much easier for administrators of both the vendor and purchaser to accurately update their corporate records because it’s one-stop shopping. They don’t have to chase after elusive amendments, or have to deduce the net lands in the deal by tracking down all the ROFR responses on their own.

2. Sale Agreement.

This approach recognizes the trigger as execution of the purchase and sale agreement. This is typically accompanied by payment of a deposit, or is signed under seal, and legally commits the parties to follow through with the transaction because a contract has been formed. If either party backed out, the other could sue. Most would agree that execution of a PSA is a disposition of interest. Companies following this approach only issue ROFR’s after the PSA is executed and a copy of the PSA is usually included with the ROFR letter.

A key weakness of this approach is that it doesn’t really fit with either the Supreme Court of Canada in Canadian Long Island Petroleum or the plain meaning of paragraph 2401. The ROFR isn’t being issued when the vendor receives an offer it’s prepared to accept, and it’s not being issued before the disposition takes place. Nonetheless, it’s a common industry practice and there are few objections to it.

There are also administrative and operational challenges with this approach that include the need to amend the schedules after ROFR’s have been exercised. The most up-to-date amendments may not circulate to all stakeholders. Sometimes, administrators are left on their own to compile ROFR responses and net out the lands in the transaction. The result can lead to confusion and data integrity issues as administrators rely on incomplete ROFR compilations, and outdated, or inaccurate schedules.

Anecdotally, the LOI approach dominated the industry in the 1990’s. Only after brokers became increasingly involved did the sale agreement approach begin to predominate. This outcome may be associated with the linkage between execution of the sale agreement and payment of the broker’s fee. Proceeding under an LOI postpones execution of the sale agreement and delays fee payment.

2. Cherry Picking.

Article XIII of the 1990, 1981, and 1974 CAPL Operating Procedures, and article XV of the 1971 CAPL Operating Procedure, is entitled “Operation of Lands Segregated from Joint Lands.” It’s generally known as the segregation clause and it says that when any portion of lands subject to the operating procedure are no longer owned in the same percentages of interest, then the lands become governed under separate operating procedures with identical terms, except as to the working interests. The lands will still share the same head agreement and when analysts find one file and one agreement they are tempted to issue a single ROFR. But, there’s some confusion because the industry actually uses two ROFR alternatives where segregation applies.

1. All-or-Nothing.

The ROFR letter is issued under the head agreement listing all lands that are being disposed in one large parcel with a single valuation for the entire parcel. ROFR recipients are then challenged to either exercise their right of first refusal on the whole package, or waive their rights to the whole package in a take-it-or-leave-it fashion.

2. Cherry Picking.

The ROFR letter is issued with an attached schedule of distinctly valued land parcels. ROFR recipients are invited to exercise their rights in respect to any combination of parcels in which they have a working interest. Essentially, the can pick and choose the “cherries” they want from the deal.

To figure out which approach is correct it’s important to understand how the CAPL segregation clause operates. An illustration may be helpful. Consider head agreement “A” shown below. It’s not subject to segregation. It has one head agreement and a single operating procedure schedule attached to it. In comparison, head agreement “B” is segregated. It has multiple little operating procedure clones attached to it. The tricky bit is that on the physical file you’ll only ever see a single operating procedure as you see for “A”. The multiple operating procedures with “B” are legally real, but are file phantoms—invisible to the eye. Only by analysis can we detect the existence of the “B” structure. On land systems, the existence of “subs” or “splits” (sometimes called “equities”) usually highlight the existence of these phantom operating procedures, although there are also other reasons why land system “subs” may exist, so this isn’t a hard-and-fast rule to follow.

Still, the point to take away, is that for CAPL operating procedures both the segregation clause and the ROFR clause are found in the same document and they operate together. If a parcel of land is segregated, then it must be treated as if it was being operated under a different operating procedure than other parcels of land in the same head agreement. It follows, that if there are different operating procedures, then there are also different ROFR’s for each parcel. Each parcel must be valued separately and partners may independently elect on each parcel. Cherry picking is nothing more than proper application of segregation. So, cherry picking is cool. All-or-nothing fails to apply segregation. So, all-or-nothing is bad.

3. Underlying Agreements.

A client recently asked me to help them work through a situation where the company had an active Joint Operating Agreement (JOA) and an active Non Cross-conveyed Pooling Agreement (NCCP) concerning the same land and rights. The NCCP had language that said it superseded the JOA as to the pooled zone. The JOA had a ROFR using 1981 CAPL 2401B, but there was no ROFR on the NCCP. The client noted that they had already seen this handled two different ways and they wanted my recommendation about which approach to follow. As the client put it, the two alternative approaches were to:

1. sever the underling working interest from the pooled interest by scheduling the WI with a footnote that the interest excludes the pooled interest; or

2. schedule the WI with a footnote that the lands were subsequently pooled and that the pooled interest will follow with the working interest.

Canadian court rulings in connection with ROFR’s are relatively sparse. In 1982, the BC Supreme Court in the Lomac Holdings case (1982), 38 B.C.L.R. 238 (S.C.), said that ROFR’s should be interpreted, “in a large and fair sense so as to give effect to the manifest intention of the parties at the time of contracting.” This case has been somewhat influential outside BC, possibly because it was written by Justice Beverley McLachlin who is currently Chief Justice of the Supreme Court of Canada. Despite some recent cases that may restrict this interpretation a bit, the case suggests that the best rule is to comply with the terms of a ROFR to the fullest extent reasonable.

In 1994, the Alberta Court of Appeal in Mesa Operating Ltd. v. Amoco Canada Resources Ltd., (1994), 149 A. R. 187, looked at ROFR’s and said that, “a party cannot exercise a power granted in a contract in a way that ‘substantially nullifies the contractual objectives or causes significant harm to the other contrary to the original purposes or expectations of the parties.'” It also said that the, “assessment of those expectations should include regard to the commercial context.” So, the reasonable expectations of the parties should be given effect in the commercial context of their agreement. The bottom line appears to be that party conduct must not substantially nullify a ROFR.

Going back to the client’s question, at the time the parties entered into the pooling they knew, or ought to have known, about the underlying JOA. It’s at this point in the contracting process that legal guidance from court decisions needs to be applied. It’s reasonable to expect that the JOA parties bargained for a ROFR with a reasonable expectation that it would have value. So, when the pooling was drafted it had to be done in a way that did not nullify that original contractual ROFR objective or expectation.

The client’s first alternative severs the working interest from the pooled interest. This is a difficult interpretation to operationalize. It means that after exercising the ROFR, a party to the underlying JOA could have an interest in the land, but no right to the revenues from it because the revenue arises through production governed by the pooling. This leaves the ROFR with only the residual value that may remain in the land after the pooling terminates. It’s an outcome that tends to nullify the ROFR by extinguishing its value.

The client’s second alternative avoids severance. It follows the inference that the pooling was drafted with the intention to operationalize the underlying ROFR in a way that maintains the value of its interest in the land. This is probably the best fit with the court’s guidance and makes the second alternative the preferred one to apply.

Johnson and Stanford (1999) briefly addressed this topic. They agree that the ROFR in an underlying agreement like this JOA would persist despite the superseding language in the NCCP, unless all parties, including ROFR holders, agreed otherwise.

4. ROFR’s to GOR Parties.

There is still persistent uncertainty about whether or not parties holding a convertible gross overriding royalty interest in an agreement are entitled to receive a ROFR notice. Of course, the answer always depends on the exact language used in any particular agreement, but for ROFR’s that arise under one of the various CAPL operating procedures, the usual answer is, no. They’re not entitled.

The ROFR clause in a CAPL operating procedure says that the ROFR must be issued to parties to the agreement. The procedure defines a party as, “a person, corporation, partnership; bound by this Operating Procedure.” A convertible GOR interest does not arise because of language in a CAPL operating procedure. Usually, language in the head agreement, or other schedules, creates it. So, prior to exercising the conversion option, the holder of a convertible GOR is not bound by the operating procedure and is not entitled to any of its benefits or obligations, including ROFR’s. Even if they did receive a notice and wanted to exercise, the CAPL ROFR provision only lets them exercise in proportion to their working interest. Working interest is defined as their percentage of undivided interest in a production facility, joint lands, or respective zones. So, because a GOR party holds no working interest their proportion of the interest offered in the ROFR would be zero.

However, there seems to be some inclination to focus on the idea that a convertible GOR includes an option, at payout, on a future right to a working interest. There is a willingness to contort the operative language of the various CAPL operating procedures and imagine that a convertible GOR party should be able to exercise on the ROFR as if they had already exercised their payout option to surrender their GOR interest and take a working interest. We see evidence of this thinking at paragraph 12.02 of the 1997 CAPL Farmout and Royalty Procedure. It says that if certain elections have been made, then a 2401B ROFR will be applied, “as if the Royalty Owner had elected to convert its Overriding Royalty to a Working Interest in that portion of the Royalty Lands immediately prior to the issuance of any required disposition notice.” There is case law such as Calcrude Oils Limited v. Langiven Resources, (2004), 349 A.R. 353 (Q.B.), and DeBeers Canada Inc. v. Shore Gold Inc. (2006), 285 Sask. R. 152 (C.A.), where courts have said that one of the reasons that ROFR’s exist is partly to allow working interest partners to manage who their partners will be. So, here we would have an operational need being extended to parties that are not participating in operations. Wild stuff. Nonetheless, this outcome does occur within the limited scope of elections in the 1997 CAPL Farmout and Royalty Procedure. If it was generally true—if this was the common way to apply ROFR’s—I believe the 1997 CAPL Farmout and Royalty Procedure wouldn’t need to go out of its way to construct it.

Without the authority of the 1997 CAPL Farmout and Royalty Procedure, or a similar agreement, there is no support for an interpretation that extends ROFR’s to convertible GOR parties. It would be risky to offer a ROFR to them by pretending that they had converted. It would deprive other working interest parties of their full entitlement and the ROFR issuer would be exposed to liability.

Summary
In summary, for A&D transactions, it’s probably best practice to issue ROFR’s at the letter of intent stage. However, issuing ROFR’s after execution of the purchase and sale agreement is probably okay. It has become a common industry practice, but it creates administrative, and data integrity challenges. Cherry picking is allowed by segregation. Underlying agreements persist despite the superseding language of later agreements, unless all parties, including ROFR holders, agreed otherwise. GOR parties are not entitled to ROFR’s unless the language of the agreement specifically says so.

ROFR’s are a complex restriction on disposition and this article has only highlighted four operational A&D issues. Those interested in more information on the topic may consult the reference articles. However, as companies quest for their own milk and honey in the oil patch it’s recommended that legal counsel be directly involved in the development and management of policies about the application of ROFR’s and ROFR processes.

REFERENCES

Duguid, B., Matthews, G., 2008. “Key Right of First Refusal Provision Ambiguous”. The Canadian Association of Petroleum Landmen. The Negotiator, October 2008.

Flannigan, R., 1997. “The Legal Construction of Rights of First Refusal.” (1997) 76 Can. Bar Rev. 1.

Johnson, C. D.; Stanford D. J., 1999. “Rights of First Refusal in Oil and Gas Transaction: A Progressive Analysis”. 37 Alta. L. Rev. 316, 1999.

Perell, P. M., 1991. “Options, Rights of Repurchase and Rights of First Refusal as Contracts and as Interests in Land.” (1991) 70 Can. Bar Rev. 1.

Smith K. T.; Denstedt S. H. T., 1992. “Preemptive Rights and the Sale of Resource Properties: Practical Problems and Solutions.” 30 Alta. L. Rev. 57, 1992.

Tarnowsky, G. L.; Pittman, M. F.; Wilton, C., 2007. “Restrictions on Disposition in the Oil and Gas Industry: The Extinction of the Species?” 44 Alta. L. Rev. 477, 2006-2007.

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Tracey Stock, LL.B., M.B.A., P.Eng. practices oil and gas law, land administration, and systems management. He has extensive experience in law, engineering, land, information technology, and has combined his background and experience in all disciplines for several of leading energy companies. His practice has included thousands of transactions throughout Canada and the United States with total value of several billion dollars involving oil and gas mineral acquisitions and divestitures, land title review, management of preferential rights, energy partnerships, joint ventures, economic analysis, and evaluations. He is a notable leader in significantly reducing administrative costs by designing and implementing information and GIS mapping systems that successfully support business processes. Tracey has extensive negotiating experience and has lead data aggregation, mapping, analysis, and interpretation in support of strategic business opportunities in strategic land acquisitions and trend optimization. Tracey has successfully managed corporate departments, project teams, and his own private law practice focusing on oil and gas and land title transactions and has provided legal and business support for successful trade missions to China.

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