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Joint Operating Agreements: Providing Assurance in Uncertain Times

Author: Melinda Frazier

Contributing Editor: Ashley Glassman

Springtime in the Rocky Mountain Region generally signals the commencement of an increase in upstream oil and gas activities here in the DJ-Niobrara Basin. However, in light of the recent COVID-19 pandemic, the oil and gas industry now finds itself navigating uncharted waters rife with unprecedented demand destruction and market volatility.[1] Accordingly, entities otherwise engaged in exploration and development have opted to drastically reduce drilling schedules and overall capital spending in the short-term.[2] And while veterans of upstream operations have survived previous downturns, this one in particular is unlike any most have experienced.

As operators reposition development strategies and consider the challenges of meeting contractual obligations while preserving value long-term, additional complexities arise for leaseholds that are being jointly developed by multiple parties. It is likely that development of these interests are being conducted under a Joint Operating Agreement (“JOA”). By providing the framework and a mechanism for upstream operations, the JOA has served to facilitate development of these interests by allocating the cost and risk among multiple parties.[3] Yet just how effective is the JOA in those situations where a party ceases to perform certain obligations, such as covering its portion of operating costs and related overhead for existing wells? Should a party ultimately default, the JOA, if properly drafted, executed and filed, may provide some assurance by protecting the interests of the other, non-defaulting parties.

Noting there are a variety of JOA’s and an endless possibility of the terms contained therein, this article will briefly examine how an operator can utilize the basics of a JOA to protect certain interests prior to and in the event of default by a non-operator. In the event of default, certain non-judicial and judicial remedies are available that will be discussed herein. Finally, should the non-operator file for bankruptcy, there are some key pointers that will be discussed in order to ensure the operator optimizes its status as a secured creditor.

The JOA is a contractual agreement between two or more parties with shared interests in a tract or leasehold that outlines coordinated exploration, development and production activities in a designated contract area.[4] By providing the framework and structure for drilling operations as well as a process by which the parties share in the costs related thereto, the JOA facilitates development by allocating risk and liability among the parties. Typically the JOA designates an operator (usually the party with the largest working interest) that is subsequently vested with the exclusive right to develop the contract area on behalf of the other, non-operator parties.[5] The operator accounts for all costs and expenses incurred, of which non-operators contribute a share proportionate to their ownership.[6] In addition to establishing rights and obligations among the parties, the JOA secures performance of these obligations by granting a reciprocal lien and security interest on certain property.[7] This not only ensures the parties’ performance to one another, but provides the operator with some assurance of recovery of costs and expenses in the event a party is in default.[8]

In an abundance of caution and in an effort to optimize one’s position against other potential creditors, operators should be taking this opportunity to review all JOA’s to ensure they are complete and have been properly executed by all parties. The JOA should specify what ancillary documents and/or exhibits are part of the JOA, which of these documents are or are not incorporated, and which will control in the event of conflict. Common errors include missing attachments and exhibits as well as the lack of signatures of all parties. In addition, parties should ensure that a memorandum of the JOA including any ancillary documents are recorded in the county in which the contract area is located.[9] A complete, properly executed and recorded JOA and related documents will provide the operator with additional assurance that its interests under the JOA are protected.

In the event a non-operator fails to fulfill its obligations, the operator can turn to the Default and Remedies provisions in the JOA to seek non-judicial or judicial remedies.[10] It is important to note that although the JOA may use language that expressly states the lien and security interest created therein has priority, this does not necessarily act as an absolute guarantee against other claimants.[11] There may be other lien and security interests that have priority, and/or there may be a prior perfected security interest in the same collateral. Therefore, while the language of the JOA states otherwise, the lien and security interest created under the JOA may actually be junior (subordinate) in priority.

Although the lien and security interest may be subordinate, this provision still provides security and value. In considering non-judicial remedies, the operator (as well as the other, non-defaulting parties) may choose to collect from the purchaser any proceeds from the sale of the defaulting party’s share until the amount owed by the party in default has been received (known as “clawing back”).[12] In addition, the operator may choose to suspend the non-operator’s rights under the JOA.[13] This prohibits the defaulting party from participating in continuing operations, the right to receive proceeds therefrom, and includes a suspension on the right to elect to participate in a subsequent operation until the default is cured.[14] Finally, the operator may choose to deem the defaulting party is a non-consent owner.[15] Once notice requirements have been satisfied and the defaulting party has failed to cure (usually within 30 days), the party in default shall be deemed to have elected not to participate thereby relinquishing its interests to the other, non-defaulting parties.[16] The non-defaulting parties electing to participate in this interest will be required to pay a proportionate share of the payments owed by the party in default.[17] It is important to note that although there is a separate provision that allows for an additional remedy of a suit for damages,[18] by seeking remedy under the non-consent provision the operator cannot subsequently sue for any unpaid amounts.[19]

In the alternative, the operator may prefer to pursue judicial remedies such as an action for damages or a foreclosure to a lien. In an action for damages, the operator may collect any unpaid amounts due plus interest, including any expenses associated with the suit.[20] Should the wells or leases under the JOA continue to have value, the operator may prefer to recoup costs and expenses through a lien foreclosure. Depending upon the terms of the JOA, the operator can foreclose the contractual lien or pursue any available statutory lien. It should be noted, that failing to properly execute, acknowledge and record a lien as required by state law is void as to a creditor or subsequent purchaser without notice of a lien.[21] In addition, while the principle of perfecting a lien on real property is similar, each state’s procedural requirements for successfully doing so may differ.[22] Therefore, in order to maximize the operator’s remedies under the lien and security interest provisions, it is strongly advised that parties in this position seek immediate legal counsel in order to ensure its opportunity to subsequently recoup costs and expenses is optimized.

An additional point to consider is that the non-operator may ultimately file for bankruptcy. Prior to filing, the operator should already be well aware that the non-operator is experiencing financial distress. Accordingly, operators should take advantage of this opportunity to review any previously filed memoranda of JOA’s as well as related financing statements for accuracy and sufficiency. Properly executed and filed financing statements and their perfection may ultimately ensure the operator has priority as a secured creditor against other parties.[23] However, once the party in default files for bankruptcy, an automatic stay is issued that may suspend rights normally held under the JOA as well as prevent any further perfection of security interests.[24] Thus, it is strongly advised that operators review these statements well in advance of any bankruptcy proceedings, foreseeable or otherwise.

Finally, the majority of oil and gas contracts, including JOA’s, are considered to be executory contracts under Section 365 of the Bankruptcy Code.[25] Under Section 365(a), subject to the court’s approval, the debtor can either reject, assume, or assume and assign its rights under the JOA.[26] Importantly, the executory contract is not enforceable against a debtor, but it is enforceable by the debtor. Should the debtor choose to assume the executory contract, it is required to perform all of the obligations covered thereby including those that are otherwise unfulfilled. In the alternative, should the debtor choose to reject the executory contract, the other parties to the JOA are responsible for continuing to perform, ultimately bearing the entire risk of the JOA. Therefore, although one of the primary purposes of the JOA is to allocate risk among the parties, under certain circumstances the operator may soon find itself going alone.

As those engaged in upstream operations under the JOA continue to move forward through these uncertain times, there are a few key points to consider. First, the benefit of the JOA is that it allocates costs, risk and liability among parties and serves to facilitate coordinated operations. By defining rights and obligations and securing liens on interests, the JOA provides the operator a mechanism by which obligations are enforced and remedies may be pursued against defaulting parties. In order for the lien created under the JOA to be enforceable, it is strongly advised that the JOA is complete and properly executed by all parties. A memorandum of the JOA as well as any ancillary documents should be timely recorded in the county in which the contract area is described as well as the appropriate state office. In the event of default, the operator may pursue certain non-judicial and judicial remedies against the defaulting party under the JOA. However, should the non-operator file for bankruptcy, certain remedies under the JOA may be limited. Therefore, it is imperative that operators ensure their status is optimized as a secured creditor prior to this event.

Kearney, McWilliams & Davis, PLLC is dedicated to the oil and gas industry and is particularly adept at assisting clients engaged in upstream oil and gas. Our team of oil and gas attorneys have the experience and knowledge to assist in drafting and negotiating effective JOA’s that provide assurance and protect a client’s interests.

(Ms. Frazier, J.D., M.A., is an associate attorney based in Denver, Colorado, licensed in Wyoming, and has over a decade of experience negotiating and implementing a variety of contracts for multiple parties engaged in upstream operations.)

 

[1] Y Charts, Average Crude Oil Spot Price, https://ycharts.com/indicators/average_crude_oil_spot_price (last visited May 5, 2020). Last year’s average crude oil spot price in April 2019 was $68.58 USD/bbl compared to April 2020’s average price of $21.04/USD/bbl., down 69.31%.

[2] Baker Hughes North America Rig Count, US Rig Count by Basin, https://rigcount.bakerhughes.com/na-rig-count (last visited May 9, 2020). The DJ-Niobrara rig count is at 7, down from 29 last year at this same time.

[3] American Association of Professional Landmen (AAPL) Contract Center and AAPL Model Forms, https://www.landman.org/resources/contract-center-and-forms, (last visited May 11, 2020).

[4] Patrick H. Martin and Bruce M. Kramer, Williams & Meyers, Oil and Gas Law, §503 (LexisNexis Matthew Bender 2019).

[5] Model Form Operating Agreement, AAPL Form 610-1989, Article V.

[6] See id. at Article V.D.

[7] See id. atArticle VII.B. The collateral defined therein may include but is not limited to, leasehold interests, working interests, operating rights, equipment, accounts, contract rights and proceeds.

[8] Id.

[9] Id. The terms require that each party to the JOA execute and acknowledge a recording supplement and/or a financing statement in order to perfect the liens under state law and in accordance with the Uniform Commercial Code.

[10] See id. at Article VII.D.

[11] See id. at Article VII.B. (“Each party represents and warrants to the other parties hereto that the lien and security interested granted by such party to the other parties shall be a first and prior lien…taken subject to the lien and security interest granted by this Article VII.B.”).

[12] Id.

[13] See id. at Article VII.D.1.

[14] Id.

[15] See id. at Article VII.D.3.

[16] Id.

[17] Id.

[18] See id. at Article VII.D.2.

[19] See id. at Article VII.D.3.

[20] See id. at Article VII.D.2.

[21] See Colo. Rev. Stat. § 38-35-109 (2019); Wyo. Stat. Ann. § 34-1-121 (2020).

[22] Wyo. Stat. Ann. §§ 29-3-103 – 29-3-111 (2020).

[23] C.R.S. § 4-9-301 (2019); Wyo. Stat. Ann. §§ 34.1-9-301 – 34.1.9-307 (2020).

[24] 11 U.S.C. § 362(a) (2020).

[25] 11 U.S.C. § 365 (2020). While the term “executory contract” is not defined in the Bankruptcy Code, the general definition is that a contract is considered to be executory if the obligations of both parties are so far unperformed that the failure of either party to perform would be a material breach. See Vern Countryman, Executory Contracts and Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973).

[26] Id. at 11. U.S.C. § 365(a).

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