The Purchase and Sale Agreement (PSA) for energy properties usually contains a deadline called the Defect Notice Date. A Buyer must conduct its title review by that date and notify the Seller of any Title Defects. The Due Diligence Period, which may continue past the Defect Notice Date, allows the Buyer access to the Seller’s files – either hard copy or electronic. This in-house due diligence is usually accompanied by a review of the public real property records in the counties (or parishes) in which the Properties are located. The field work is to verify whether any documentation has been filed after the dates of the documents in the due diligence files.
The Buyer must notify the Seller on or before the Defect Notice Date to assert a Title Defect (as it is defined in the PSA). Usually, the Notice must (1) be in writing, (2) identify the affected Property, (3) describe the Title Defect in detail, and (4) indicate the amount that the Buyer believes the value of the affected property should be reduced by the defect.
See wikinvest.com for examples of defect notice clauses from PSAs by Linn Energy, Veraco, XMO, etc.
Clause for Calculation of Defect Value:
PSAs usually contain the method for calculation of a Title Defect Value. If the Defect is due to a Net Revenue Interest (NRI) or Working Interest (WI) shortage, there may be a formula for reducing the percentage of the Allocated Value. The Allocated Value is usually contained in the exhibits to the PSA. If the Title Defect is due to a lien, the reduction will usually be the full amount to discharge the debt. If the Defect is due to another type of issue, the PSA may allow for a reduction equal to the difference between the Allocated Value and the “newly” calculated value with the defect. The clause is usually qualified so that that the defect value for a single property cannot exceed the property’s Allocated Value.
Seller’s Response to Notice:
The Seller will usually cure the Title Defect prior to Closing, indemnify the Buyer, or reduce the Purchase Price by the applicable Title Defect Value. Many PSAs also allow the Seller to cure the Title Defect after Closing. If so, the property may be included in the closing at a negotiated value, or held until the Title Defect has been cured to the Buyer’s reasonable satisfaction. A common compromise is to include the property at its Allocated Value less the Title Defect Value; if the Title Defect is then cured, the Purchase Price reduction is credited back to the Seller in the Postclosing or Final Accounting. In some cases, the Seller may contest Title Defects according to a procedure spelled out in the PSA.
Additions to Value:
Sellers may include a provision for a price increase if the actual NRI of a Property is greater than represented (often defined as an “Interest Addition” or “Title Benefit”). Usually the method for calculating the amount of the price increase is reciprocal to the method for calculating the Title Defect Value.
In most cases, Purchase Price adjustments for Title Defects are subject to certain deductibles or thresholds. These amounts can be stated either in actual dollar amounts, or as a percentage of the Purchase Price. There may be both individual and aggregate limit thresholds in the PSA.
At some point, downward price adjustments can make the adjusted Purchase Price so low that either or both parties would prefer to cancel the transaction under a “walkaway” provision, which may be included in the PSA.