Oil & Gas: Joint venture issues in a low oil price scenario 

In the current low oil price environment with added complications triggered by the COVID-19 crisis, oil and gas joint venture participants will doubtless be considering co-venturer risk. Previous oil price lows have resulted in co-venturer issues concerning: (i) defaults on invoices/cash calls; (ii) insolvency; (iii) failure to agree work programmes and budgets; and (iv) disputes concerning payments under decommissioning security deeds.

Below we consider some of the key issues.

Joint Venture Default

Typically, under a joint operating agreement (“JOA”), failure to pay invoices or cash calls by the due date will give rise to a default. The non-defaulting parties are traditionally granted remedies against the party in default.

In the event of a default, the Operator is often obliged to issue a default notice. The requirements for service of the notice will be prescribed under the JOA. The Operator must then advise (by way of the default notice or otherwise) the non-defaulting parties of the default, and those parties are then required to fund their share of the amounts in default. The defaulting party may cure the breach through payment of the amount due plus interest. If the Operator is the defaulting party, differing alternatives in JOAs may allow: (i) the joint venture partner with the most equity to issue a default notice; or (ii) any participant to issue a default notice.

The consequences of a default will usually be that the defaulting party’s voting rights, and entitlement to data and information, will be suspended during the default period. If the default is not remedied within a specified period, the defaulting party will be subject to a series of consequences of increasing severity. At a specified point in time, the defaulting party’s production entitlement will be allocated to the non-defaulting partners.

If the defaulting party fails to remedy the default within a further period specified in the JOA and the notice of default, the non-defaulting parties may acquire a right to acquire (by option, forced sale (perhaps with a discount) or forfeiture depending upon the terms of the JOA) the defaulting party’s participating interest. In addition, the non-defaulting parties may be granted a security interest over the defaulting party’s participating interest.

Below we consider the key issues at English law of:

1. whether a forfeiture amounts to an unenforceable penalty at English law or whether a forfeiture can be subject to equitable relief;
2. whether the anti-deprivation rule under insolvency law voids any forfeiture, option or sale provisions in JOAs; and
3. whether any security granted by a JOA will be enforceable.

It is noteworthy that the party in default under a JOA may have failed to meet liabilities under the JOA precisely because it is in financial difficulty. It is for this reason that all three areas may be relevant on the facts.

1. Forfeiture

The AIPN Model Form Operating Agreement and the OGUK Model Form JOA contain forfeiture provisions for default. The non-defaulting parties have the right (but not an obligation) to acquire the defaulting partner’s interest for zero consideration. The drawbacks of forfeiture are that enforcement can be difficult as the defaulting partner may not be willing to sign the required novation agreements. To overcome this, an irrevocable power of attorney exercised by the Operator on behalf of the defaulting party is often prescribed under the JOA. (Note that in order for this power of attorney to be valid the JOA must have been executed as a deed.)

The challenges with enforcing a forfeiture provision under English law are that a defaulting party (or its administrator) may argue that the forfeiture clause is subject to: (i) the rule against penalties; and/or (ii) the granting of equitable relief from forfeiture. These issues are analysed in detail in a more fulsome article by some of the authors (see Aldersey-Williams et. al, “Default Clauses in Joint Operating Agreements: Recent Guidance from the English Courts” [2016] (2) IELR 36).

Key arguments in favour of enforceability are:

• Primary obligation: It might be arguable that some forfeiture provisions operate as primary obligations (i.e. obligations to perform the terms of the contract), such that the rule against penalties does not apply.
• Commercial rational and proportionality: Assuming that forfeiture provisions are secondary obligations (i.e. remedies for a failure to perform a primary obligation), in ascertaining whether the clause should be unenforceable the law will ask “whether the [forfeiture] provision… imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance.” (Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67). There are good arguments that the purpose of the forfeiture clause is to allow the joint venture to continue to operate, such that its purpose is not to “simply punish” but to pursue a “legitimate interest” concerning the primary performance obligations.
• Freedom of contract: English law is reluctant to interfere in contractual arrangements. The Supreme Court has confirmed that: “[i]n a negotiated contract between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach” (Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67). Oil and gas companies enter into contracts as sophisticated commercial parties and are typically legally represented. They are often (but not always) of a similar bargaining power. English law is thus likely to take a “strong initial presumption” that a JOA party must be held to its bargain.
• Equitable Relief: While the timing for the assessment of a penalty provision is as at the date the contract was entered into, equitable relief is assessed as at the time the relief is sought (in this connection, the ‘life stage’ of the asset may be important). The case law demonstrates that an application for equitable relief may be made in respect of primary or secondary obligations. In relation to any application for equitable relief from forfeiture: (i) the defaulting party would need to show that such relief was available concerning a JOA interest (for which there is no existing authority); (ii) the remedy is at the discretion of the court of tribunal and does not exist as a right; (iii) the remedy, if granted, may only result in additional time to make payment before forfeiture (not prevent the clause from operating forever, or allow a scaling down of the interest forfeited); (iv) the remedy will likely not be available where the JOA requires that, as concerns payment, ‘time is of the essence’; and (v) as the JOA is a commercial, ‘mercantile’, agreement the law will likely be sympathetic to an argument that the requirement of timeous payment was the intention of the parties such that no relief should be granted.

2. Insolvency

Parties cannot contract out of insolvency legislation. In this context, there was a concern that a forfeiture clause may offend:

1. The anti-deprivation rule which operates to invalidate any arrangement that attempts to withdraw an asset on liquidation or administration thereby reducing the value of the insolvent estate to the detriment of creditors; and
2. the pari passu rule which reflects the principle that the statutory provisions for pro rata distribution may not be excluded by a contract which gives one creditor more than its share (calculated in proportion to the debts due to each creditor).

The Guidance Notes to the OGUK Model Form JOA refer to the anti-deprivation rule and suggest that there is “significant risk that the forfeiture provision would offend against the rule”.

However, since the Guidance Notes were published some clarification has been provided in the Supreme Court in Belmont Park Investments PTY Limited v BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc [2011] UKSC 38. The Supreme Court clarified that the law should not give effect to contractual terms agreed between the parties which amount to a blatant attempt to deprive a party of property in the event of liquidation.[1] However, to the extent that a JOA could be said to be a “complex commercial transaction entered into in good faith”, with default provisions operating (as they typically do) in circumstances other than insolvency, there are arguments that, following the Supreme Court’s decision, such default provisions will not offend against the anti-deprivation rule.

In many cases, although the JOA may be governed by English law, the parties to the JOA may be incorporated outside of the UK and/or the asset situated outside the UK. There is tension as to whether the anti-deprivation rule is a matter of English contract law or a matter of insolvency law that applies only to United Kingdom companies. This more complex issue and the pari passu rule are considered in greater detail in Aldersey-Williams et. al, “Default Clauses in Joint Operating Agreements: Recent Guidance from the English Courts” [2016] (2) IELR 36.

In the event of prospective or actual insolvency, parties should carefully consider the applicable insolvency law(s) and the impact on the enforceability of the remedy of forfeiture.

3. Security in AIPN JOA

The AIPN Model Form JOA (2014) provides that each party “grants to each of the other Parties, in pro rata shares based on their relative Participating Interests, a mortgage and security interest on its Participating Interest” as security for sums and other security due under the JOA. In the event of an unremedied default, each non-defaulting Party has the option to foreclose. The interest may then be sold, including to the non-defaulting party in possession of the security.

Such provisions are doubtless useful to non-defaulting participants, as they provide a potential route to a remedy other than forfeiture. However, it will be necessary to consider whether the validity of such mortgage and/or security is subject to proper registration at the time the mortgage and/or security is purportedly given. Further, it will also be necessary to consider any other limiting factors – such as legal restrictions governing how the security must be exercised and the proceeds of any sale.

Agreeing a work programme and budget

In the current economic and financial climate, there is a heightened risk that co-venturers will develop differing views on appropriate work programmes and budgets for the forthcoming period. This is a particular risk where capex intensive operations are envisaged in the near future. These differences may simply result from co-venturers prioritising different assets. However, they may also result from difficulties in financing projected expenditure under work programmes and budgets favoured by other co-venturers.

When considering the approval of work programmes and budgets, companies with immediate financial constrains will need to consider (i) directors’ duties in approving future spending commitments that may not be within the financial ability of the company to fund and (ii) the risk that a work programme and budget may be setting the company up for a default and resulting forfeiture.

Most JOAs provide that if the Operating Committee is deadlocked on the agreement of a work programme and budget, and there are minimum work obligations to be met under the production sharing contract, the Operator must determine the work programme and budget to meet the minimum work commitment. In the absence of minimum work commitments, many JOAs simply create a contractual deadlock.

In fact, the Guidance Notes to the OGUK Model Form JOA state that the working group could not agree on a solution to resolve a deadlock – even though it potentially left the Operator in the difficult position of owing obligations to the Government to continue operations under the terms of the licence without the benefit of co-venturer approval for expenditure. The risk of deadlock, therefore, creates specific risks for the Operator. The OGUK Model Form JOA does contain an optional provision enabling the operator, if a production programme and budget cannot be agreed by a specified date, to continue to operate the asset under certain conditions for an additional 90 days, but this is clearly only a stopgap.

On the UKCS, the co-venturers will need to consider their obligations under MER UK if a deadlock is reached. However, it seems likely that these MER UK obligations are owed to the OGA and do not create additional obligations between co-venturers (see Taqa Bratani Ltd & Ors v Rockrose UKCS8 LLC [2020] EWHC 58 (Comm)).

Security Decommissioning

Under UK and international law, any infrastructure installed offshore in relation to the production of oil and gas from the UKCS must, with limited exceptions, be removed (or decommissioned) at the end of its life. The United Kingdom standard Decommissioning Security Agreement (“DSA”) requires the joint venture parties to provide security for the cost of decommissioning.

The DSA sets out the concept of a ‘trigger date’. This allows a DSA to be entered into between the co-venturers at an early point in the life of the relevant field without the need to provide security at that stage. The ‘trigger date’ requirement to post security would arise at a point when the remaining “Net Value” is equal to a percentage of the “Net Cost”.

If the oil price declines, all other things being equal, the net value of any field will decline. For the purposes of a DSA this reduces the “Net Value”, meaning the point at which the ‘trigger date’ will occur will be accelerated. If the oil price falls dramatically, the acceleration may be significant. Further, any acceleration of the ‘trigger date’ will occur at the time that the co-venturers are least well placed to post security – as they will also be managing the fallout from the declining oil price on other aspects of their business.

As a consequence, co-venturers (or second tier participants) may take differing positions as to the operation of the DSA and posting security – resulting in disputes concerning the correct ‘trigger date’ and the dates for the posting of security.

In the context of a default under the DSA being a default under the JOA there is also the possibility for wider issues of cross-default.

In many cases, these issues will tend to come to the fore when DSA security comes up for annual renewal and the Net Cost/Net Value calculation is refreshed, often in October or November of each year but some DSAs also provide for a reference to an Expert and if necessary for the amount of security topped up if there is a significant change in Net Cost or Net Value. These provisions have rarely been applied in practice and they may lead to disputes. In all calculations of security, the risk of disputes arising will depend on a range of factors including the degree of alignment among co-venturers and their respective financial positions, and the degree of detail and clarity in which the DSA sets out the assumptions to be applied in carrying out the calculation.

[1] Belmont Park Investments PTY Limited v BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc [2011] UKSC 38.