Preferential Rights Clauses Are an Important Consideration in M&A

Clear and well-drafted preferential purchase rights serve the interest of parties in mergers and acquisitions, as well as project interests, by encouraging risk-taking and setting expectations for transfers.

A preferential purchase right is a covenant giving each party to an agreement the right to acquire the ownership of a party that’s proposing to transfer ownership. These clauses are implicated in almost every oil and gas M&A and acquisition and divestment transaction.

However, the recently resolved conflict between Exxon Mobile Corp. and Hess Corp. from Chevron Corp.'s acquisition of Hess brought the issue into sharp focus.

Preferential purchase rights must be considered in most transactions involving oil and gas joint operating agreements—even enterprise-level transactions. Most non-US operating agreements contain commonly included options for preferential rights that apply to both a direct sale of the assets and transactions resulting in a change of ownership of the relevant company (or a “change of control”). This allows a third party to acquire the right to control the relevant party to a joint operating agreement.

Recent versions of these agreements are more likely to contain exceptions for transactions where the subject asset comprises less than a certain percentage of overall value, such as parent company mergers. Earlier versions may not contain this limitation.

Exercising Rights

US onshore agreements generally phrase the requirement to notify preferential right holders in terms of a “desire” to sell, while offshore and non-US agreements trigger notice on reaching a definitive agreement. In practice, notice generally is given only once the parties reach a definitive agreement.

In either case, the sale transaction usually is subject to the rights of the preferential right holders, and the exercise of rights results in the removal of the affected asset from the deal.

Notice of the preferential purchase right generally includes detailed terms and conditions of the triggering transaction. In practice, the notifying party provides a redacted sale agreement applying to the specific asset that is subject to the preferential right.

When the triggering transaction includes multiple assets, a dollar value typically is allocated among them to determine the purchase price for each asset that is subject to the preferential right.

The preferential purchase right generally must be exercised within 10 to 45 days. If multiple holders exercise their rights, each is entitled to its proportionate share of the affected asset.

Exercise of the right is akin to the exercise of an option. However, jurisdictions vary on whether the holder must buy on identical or substantially the same terms as the original offer. While exercise alone arguably creates a binding agreement, most parties execute a separate purchase agreement.

Closing a preferential right transaction typically occurs alongside the triggering transaction, though this may not be the case where the preferential right was exercised close to the closing date of (or even after) the triggering transaction.

If the triggering transaction is terminated, it’s often unclear whether the seller likewise can terminate the preferential right transaction. While some recent non-US operating agreements deal with this, it isn’t expressly handled in many common industry forms of operating agreements.

Transaction Considerations

Understanding that preferential rights exist is vital for M&A practitioners. These rights offer legitimate protection for parties in a project, including affording a means to keep out undesirable third parties and reward the original risk-takers.

Sometimes, however, they complicate M&A transactions to the point of making an asset or business unsellable. This is why it’s common to structure deals around preferential rights.

In the US, this may be as simple as structuring a deal as a change of control transaction, though this may not avoid the application of preferential rights in transactions involving non-US assets. As a rule, the less valuable a particular asset is relative to the larger M&A transaction, and the higher up the corporate chain the M&A transaction goes, the less likely the transaction will trigger preferential rights.

If preferential rights are to be triggered, the parties shouldn’t structure the transaction to intentionally make the preferential right difficult or impossible to exercise—this is a major source of preferential right disputes. In M&A transactions targeting a single asset burdened by a preferential right, sellers should anticipate needing to accommodate a buyer to engage in a transaction at all.

Few preferential rights deal with this issue, but potential buyers may be unwilling to spend the time and money to negotiate a transaction that functionally benefits the preferential right holders. Solutions in this case include negotiating a “break fee” and obtaining a prospective waiver prior to starting the M&A process.

Considerations in Drafting

Preferential right language common in US agreements is often vague and doesn’t track common industry practice. Practitioners should consider clarifying:

• The application to change control transactions (if this is intended)
• The mechanism that triggers a preferential right (beyond a “desire” to transact)
• Whether full or substantial compliance with the triggering transaction terms is required
• What, if any, remedies exist for terms (such as allocated value) that aim to defeat the preferential right

For non-US agreements, parties should consider excluding parent company-level transactions and certain other transactions (such as the granting of a lien or a non-working interest, such as an override). In both cases, parties should deal with terminated triggering transactions and consider placing a time limit on the existence of a preferential right.

Terms that may provide legitimate protection at early stages of a project may become unduly burdensome quickly.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

David Sweeney is a partner in Clifford Chance’s Houston office and is global co-head of the energy and resources sector.

Joclynn Marsh is counsel at Clifford Chance specializing in the oil and gas and M&A groups.

Melissa K. Sanchez, an associate at Clifford Chance, contributed to this article.

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