DEFAULT PROVISIONS UNDER A JOINT OPERATING AGREEMENT

By Nkaepe Etteh

Default is a major issue for the petroleum industry as E&P (Exploration & Production) is extremely capital intensive. Most E&P is carried out by JV (Joint Venture) governed by JOAs (Joint Operating Agreements). While the PL (Production License) authorizes the licensees to carry out petroleum operations, the JOA is the core agreement which governs the relations between the licensees in the JV. Each JOA enables the co-venturers to share the financial burden of the joint operations. Amongst other things, the JOA sets out remedies for default.[1]

Under a JOA default occurs when a party breaches its financial obligations and fails to make a payment due following a cash call. In order to secure cash flow, the operator will issue periodic cash-calls. Where a party defaults, such breach will cause real financial difficulty to the other parties who will have to make good the shortfall.[2] Default provisions in the JOA aim to discourage default and protect the non-defaulting parties from having to bear the burden of funding the default.[3]

The question addressed in this article is very important as default can put the project in jeopardy and place unwanted financial pressure on the remaining parties who may be required to make up the shortfall. Normal remedies (such as damages, injunction and specific performance) are available to a party who suffers loss because of a co-venturer’s default. These remedies may not be sufficient to compensate the non-defaulting parties who fund the shortfall. Further, the non-defaulting parties wouldn’t want to rely on the defaulter for future expenditure.[4] As a consequence, contractual remedies are built into a JOA that recognise the expense, timeframes and risk associated with exploration programme. This analysis will look at default in relation to JOAs. It will begin with a brief discussion about default provisions including forfeiture. 

DEFAULT PROVISIONS 

Contractual devices can be used to deal with the possibility of default in a JOA. These include; forfeiture of the defaulting party’s interest, abatement or dilution of the defaulting party’s interest (also known as withering), rights of purchase by the other co-venturers of the defaulting party’s interest, the loss or suspension of rights, Lien over each party’s joint venture interest given by each party in favour of the operator and liability for the defaulting party to pay interest and/or a premium on the shortfall.[5]

Forfeiture 

Forfeiture involves the forced transfer of the defaulting party's interest in the licensed area to the non-defaulting parties (in proportion to their respective PI <Percentage Interest>s). The JOA may provide that each party irreversibly appoints the other co-venturers as its attorney, for the purpose of concluding such a transfer if the need arises, instead of having to force the defaulting party to complete the transfer documents after the event, running the risk of the defaulting party refusing to do so.[6] The AIPN JOA (the Association of International Petroleum Negotiators model form international operating agreement 2002) provides an option for forfeiture in the event of default.[7] However, forfeiture provisions may be unenforceable in certain circumstances. A forfeiture provision may be held to be penal because the transfer of defaulter’s PI compared to the amount in default may be extravagant, unconscionable.[8] Another consideration is that such a clause may be seen to frustrate the operations of insolvency law. In English law forfeiture[9] may be struck down as an unfair provision which denies an insolvent defaulting party’s creditors of their right to share in its assets. There is yet to be a UK case on the validity of a JOA forfeiture clause. However an Australian court in Mosaic Oil NL v Angaari Pty Ltd held that in the event of the defaulting party’s insolvency, a forfeiture of the defaulter’s interest would not be upheld.[10] The defaulter may also seek relief from forfeiture therefore having the effect of making the forfeiture provision unenforceable. This will be discussed in greater detail in my subsequent article. 

Withering Clauses 

This is a provision where default leads to a loss of a share of the defaulter’s interest in proportion to the amount in default, rather than the loss of the defaulter entire interest. It is usually based on a formula by reference to the expenditure of one party as a percentage of the total expenditure of the JV parties. Roberts suggest that by adopting a ‘withering interest’ forfeiture clause, the risk of unenforceability due to penalty can be reduced. Under such a clause the defaulting party’s interest is decreased in proportion to the amount by which it is in default. [11] Withering clauses permit the defaulter to re-acquire the interest which it had forfeited by making good the amount of the default at a later date. This is attractive for the defaulting party but unattractive for the non-defaulting parties because of the right to re-acquire. 

Suspension of Rights 

In the event of a default, the JOA may provide for the suspension of the defaulting party’s rights. These rights could include the right to take product, the right to receive information, the right to attend and vote in the JOC (Joint Operating Committee) and/or the right to participate in areas of mutual interest acquisitions. Boigon argues that legally, it may be impossible to suspend only some performance while at the same time continuing to insist on performance of other JOA provisions. As practical solution, the threat of selective suspension may discourage default.[12] The AIPN JOA provides for suspension during a ‘default period’.[13] If the defaulter remains in default then its PI can be forfeited to the non-defaulting parties. This provision gives the defaulter time to remedy the default as forfeiture is a last resort. 

Buying-Out the Defaulting Party’s Interest 

The JOA can provide for the buying-out of the defaulter’s PI by non-defaulting co-venturers. The consideration for such sale would be assessed on a fair market value with recourse to an independent expert in the event of a dispute between the parties. The AIPN JOA[14] includes a buy-out alternative to forfeiture to allow parties completely ignore forfeiture enforceability issues as the transfer of the interest for value should not fall foul of insolvency laws. The CAPL JOA (the Canadian Association of Petroleum Landmen operating procedure 2007)[15] requires a forced sale of the defaulting party's JOA interest on the open market. Both of these JOAs also adopt a deduction of a set percentage of the amount which would have otherwise been paid to the defaulter after the sale. Roberts argues that this re-introduces an element of penalization into a mechanism which was supposed to avoid the punitive nature of forfeiture.[16] However, deducting a percentage interest can hardly be extravagant in comparison with the actual loss and inconvenience suffered by the non-defaulting parties. Such deduction is necessary and adequate compensation. Relief for forfeiture should not be applicable because the proceeds are used to cover the default and deduction with the remainder paid to the defaulter. 

Lien Over Party’s Interest 

This is similar to the buy-out provision. The operator may be granted a first-ranking lien over each co-venturer’s interest in order to secure payment by that party of its share of the costs of the joint-operations. The operator may take possession of the defaulting party's interest pursuant to the JOA and sell that interest on reasonable commercial terms. The proceeds of the sale are then used to remedy the default and the balance is returned to the defaulting party. An example of this sort of this provision is found in part VIIB of the AAPL JOA (the American Association of Petroleum Landmen Form 610 model form operating agreement 1989).[17] This sort of clause may be controversial as the non-defaulting parties may wish to have a say with regard to who buys the defaulting party’s interest. Some provisions grant cross-charges over each JOA party’s interest in favour of each party. This will permit the non-defaulting parties to exercise rights as secured creditors against the defaulter’s interests.[18] While there is still a forced transfer of PI, it is not unconscionable because the proceeds are only used to satisfy the amount in default. This is unlike forfeiture where the entire PI may be forfeited irrespective of the amount in default 

NUTSHELL:

According to Nkaepe, under a JOA, default occurs when a party breaches its financial obligations and fails to make a payment due following a cash call. She states that there are usually provisions in the JOA which aim to discourage default. Forfeiture is one of such provisions. In subsequent articles, her analysis will examine the enforceability of forfeiture provisions in light of relief from forfeiture. She will then discuss enforceability of forfeiture clauses. The scope of analysis will be limited to enforceability in relation to relief from forfeiture. In the final analysis her report will then analyze the impact of the case law on forfeiture provisions in JOAs. This is a good read, especially for Lawyers who know little or nothing about JOA's.  For more information on this article and to view Kunaba's professional profile, click here.-->

[1] ETTEH, N. 2010. Joint Operating Agreements: Which issues are likely to be the most sensitive to the parties and how can a good contract design limit the damage from such disputes? : CEPMLP. 

[2] GORDON, G. & PATERSON, J. (eds.) 2007. Oil and Gas Law - Current practice and emerging trends, Dundee: Dundee University Press Ltd. at 289 

[3] DAINTITH, T. C. & WILLOUGHBY, G. D. M. 1984. Manual of United Kingdom Oil and Gas Law.at 103 

[4] GUDERNSEN, B. N. Year. Default by a fellow Joint Venturer Are you adequately protected? In: New Zealand Petroleum Conference, 2004 New Zealand. 

[5] Ibid 

[6] ROBERTS, P. 2008. Fault lines in Joint Operating Agreements,. International Energy Law Review, 290. 

[7] AIPN JOA 8.4(D) Alternative 1 

[8] Dunlop Pneumatic Tyre Co., Ltd. v. New Garage and Motor, Ltd., [1915] A.C. 79 

[9] Section 10 and 11 Insolvency Act 1986 

[10] Supra Note 1 

[11] See GORDON G. et al Supra note 2 at 294 

[12] BOIGON, H. L. 1987/88. Joint operating agreement part 2 Oil and Gas Law and Tax Review, 11 at 30 

[13] AIPN JOA 8.2 

[14] AIPN JOA 8.4(D) Alternative 2 

[15] CAPL JOA 5.05B(g) 

[16] See ROBERTS P Supra note 6 at 3 

[17] AAPL JOA VIIB 

[18] GUNDERSEN, B. N. Year. Default by a fellow Joint Venturer Are you adequately protected? In: New Zealand Petroleum Conference, 2004 New Zealand.