Joint Operating Agreements:Default and Bankruptcy

Presented by:Melissa Munson

&

Blake Jones

Texas and Oklahoma Series

These materials are public information and have beenprepared solely for educational purposes. These materialsreflect only the personal views of the authors and are notindividualized legal advice. It is understood that each caseis fact-specific, and that the appropriate solution in anycase will vary. Therefore, these materials may or may notbe relevant to any particular situation. Thus, the authorsand Steptoe & Johnson PLLC cannot be bound eitherphilosophically or as representatives of their variouspresent and future clients to the comments expressed inthese materials. The presentation of these materials doesnot establish any form of attorney-client relationship withthe authors or Steptoe & Johnson PLLC. While everyattempt was made to ensure that these materials areaccurate, errors or omissions may be contained therein,for which any liability is disclaimed.

Road Map

I. DEFAULT

a) Liability of the Parties

b) Express JOA Remedies

c) Enforcement of Default Remedies

II. BANKRUPTCY

a) Effect of Bankruptcy

b) Assumption/Rejection of the JOA

c) Risk Mitigation

Liability of the Parties• ART. VII(A)

• Each party is responsible only for its shares of costs.

• No party is liable to a third party to pay the debts of a co-party to the JOA.

• The parties do not intend to create a partnership.

• The parties do not have a fiduciary relationship.

• But the parties have the obligation to act in good faith in their dealings with each other.

Liens and Security Interests• ART VII(B) – scope of collateral and obligations

• Each party grants a lien on its now-owned and after-acquired Leases and Interests.

• Each party grants a security interest in now-owned and after-acquired personal property.

• To secure performance, including:• Payment of expenses.• Proper disbursement of all monies paid.• Assignment or relinquishment of interest in Oil and Gas Leases.• Proper performance of operations.

• Liens cover: • Leasehold, WIs, operating rights, RIs and ORRIs, now owned or after-

acquired.• As-extracted hydrocarbons.• Accounts, contract rights, inventory, intangibles.• Proceeds and products of the above.

Liens and Security Interests• ART VII(B) – perfecting the lien

• Each party is required to execute and acknowledge the recording supplement.

• Either party is authorized to file the JOA or recording supplement as a lien or financing statement.

• Perfecting the lien on real property:

• Under the JOA:

• Laws of the state where the Contract Area is located dictate how liens are perfected.

• Recording the JOA versus the Recording Supplement.

• Perfecting the lien on personal property:

• The nature of the collateral determines the method of filing and perfection.

• Generally the UCC requires filing financing statement with Secretary of State.

• But consider as-extracted collateral.

Liens and Security Interests• ART VII(B) – reps and warranties

• Each party represents and warrants to the others that the lien and security interests granted are first and prior liens.

• This does not guarantee the priority of the liens.

• To determine whether there are secured creditors, conduct due diligence in applicable counties and Secretary of State recording offices.

• What if there is a higher priority perfected lien?

• Determine scope of collateral.

• Determine whether creation agreement permits JOA liens to take priority.

• Negotiate a subordination agreement.

• Determine whether additional collateral will be required.

Liens and Security Interests• ART VII(B) – enforcing the security interest

• Parties with security interests are entitled to exercise rights as a secured party under the UCC.

• Filing a lawsuit and obtaining a judgment is not an election of remedy and does not otherwise affect a party’s lien rights.

• Non-defaulting parties may collect from the purchaser of the oil or gas the proceeds the defaulting party would have been entitled to.

• If defaulting party fails to pay its share of expenses, interests or fees.

• 2015 Form: the improper use of funds by any party.

• If Operator improperly uses funds.

• 2015 Form: or other financial obligations under the JOA.

Liens and Security Interests• ART VII(B) – non-operator obligation

• If a party fails to pay its share within 120 days after statement issued:• Operator can request• Non-defaulting parties, including Operator• To pay the unpaid amount• In proportion to their respective interests

• Prevents the Operator from acting as the banker for all Non-operators.

• The amount paid by a non-defaulting party is secured by the liens and security rights previously granted.

• Each paying, non-defaulting party may independently pursue any available remedy.

• Each paying, non-defaulting party is entitled to recover interest under Exhibit C - COPAS.

Liens and Security Interests• ART VII(B) – non-performance and waiver

• Non-performing parties subject to foreclosure or execution proceedings waive:

• Right of redemption.• Right of valuation or appraisement before sale.• Right to stay execution• Right to any required bond when receiver is appointed.

• Each party grants to the others a power of sale as to any property subject to the lien.

• Sale must be exercised in manner provided by applicable law.

• Sale must be exercised in commercially reasonable manner.

• Sale must be conducted with reasonable notice.

Advances• ART VII(C)

• Operator can elect to require parties to pay their shares of estimated expenses in advance.

• Requires submission of itemized statement and invoice.

• Statement and invoice must be submitted on or before 20th

day of month preceding advance request month.

• Each party must pay its share within 15 days after estimate is received.

• 2015 Form: each party gets 30 days to pay.

• If a party fails to pay its share of the estimate, the amount due bears interest.

• Adjustments are made monthly between advances and actual expenses.

Advances• ART VII(C)

• Advances are secured by Operator’s liens and security interests.

• What kind of security could satisfy the advance payment requirement?

• Letter of credit• Cash deposits• Surety bonds• Guarantees

• Non-operator considerations• Use of funds and separate accounts• Return of unused funds and time limits• Interest• Limits on operations

Default and Remedies

• 1. Suspension of Rights

• 2. Suit for Damages

• 3. Deemed Non-Consent

• 4. Advance Payment

• 5. Costs and Attorneys’ Fees

Suspension of Rights• ART VII(D)(1)

• Deliver Notice of Default, which shall specify:• The default.• The action to be taken to cure the default.• That failure to take action will result in exercise of one or more

remedies.

• If default is not cured within 30 days of delivery of notice:• All rights of defaulting party may be suspended until the default is

cured.• If Operator is in default, the Non-operators can appoint a new Operator.

• Rights to be suspended include:• The right to receive information.• The right to elect to participate in subsequent operations.• The right to participate in current operations.• The right to receive proceeds of production from any well subject

to the JOA.

Suit for Damages• ART VII(D)(2)

• Suit for damages.• Any non-defaulting party can bring a lawsuit to

collect amounts in default + interest.• The expenses for that lawsuit are a joint account

expense.• Non-defaulting parties can seek consequential

damages.

Deemed Non-Consent

• ART VII(D)(3)

• Deemed non-consent.• After the 30-day notice and cure period, non-defaulting party can

deliver a written Notice of Non-Consent Election.• The defaulting party is deemed to have elected not to participate

in any operation, to the extent of costs unpaid by such party.• The interest subject to this election is then offered to non-

defaulting parties who can elect to acquire their proportionate share of the defaulted interest.

• If a non-defaulting party goes this route, it cannot then sue for unpaid amounts.

Advance Payment• ART VII(D)(4)

• Advance payment.• After the 30-day notice and cure period, Operator (or

Non-ops, if Operator is in default) can require advance payment from the defaulting party of anticipated expenses, whether or not the expense was the subject of the previous default.

• This includes the right to require advance payment of:

• Estimated costs of drilling a well.• Completion of a well as to which election to

participate has been made.

Costs and Attorneys’ Fees

• ART VII(D)(5)

• Costs and attorneys’ fees.• Non-defaulting parties are entitled to recover court

costs, collection costs, and a reasonable attorneys’ fee, which is secured by the lien provided for under the JOA.

Other Remedies

• Removal of Operator

• Preferential Right to Purchase

• Force Majeure

Removal of Operator

• ART V(B)(1)

• Operator may be removed only for good cause.

• By an affirmative vote of Non-Operators owning a majority interest.

• What is “good cause”?

• Gross negligence or willful misconduct.

• Material breach of or inability to meet the standards of operation contained in Article V. A.

• Material failure or inability to perform its obligations under this agreement.

• When does removal take effect?

Preferential Right to Purchase

• ART VIII(F)

• In the event of a sale by a party to the JOA, the other parties have an optional prior right to purchase.

• Caveat – but consider bankruptcy.

• No pref. right in some specified cases.

• This provision is commonly deleted and re-written in Article XVI.

Force Majeure

• ART XI

• If a party cannot carry out its obligation due to force majeure

• Other than the obligation to indemnify or make money payments or furnish security

• Upon written notice, its obligations will be suspended during the force majeure event

• What constitutes “force majeure” under the JOA?• Hint: does not specifically say “pandemics”

• Affected party is required to use all reasonable diligence to remove the force majeure situation

Bankruptcy• Effect of Bankruptcy:

– If Operator becomes insolvent, bankrupt or is placed in receivership, it shall be deemedto have resigned without any action by Non-Operators, except the selection of asuccessor. If a petition for relief under the federal bankruptcy laws is filed by or againstOperator, and the removal of Operator is prevented by the federal bankruptcy court, allNon-Operators and Operator shall comprise an interim operating committee to serveuntil Operator has elected to reject or assume this agreement pursuant to the BankruptcyCode, and an election to reject this agreement by Operator as a debtor in possession, orby a trustee in bankruptcy, shall be deemed a resignation as Operator without any actionby Non-Operators, except the selection of a successor During the period of time theoperating committee controls operations, all actions shall require the approval of two (2)or more parties owning a majority interest based on ownership as shown on Exhibit "A."In the event there are only two (2) parties to this agreement, during the period of timethe operating committee controls operations, a third party acceptable to Operator, Non-Operator and the federal bankruptcy court shall be selected as a member of theoperating committee, and all actions shall require the approval of two (2) members ofthe operating committee without regard for their interest in the Contract Area based onExhibit "A "

– ART. V(B)(3)

Effect of Bankruptcy - ART. V(B)(3)

• Operator bankrupt Deemed to have resigned

• Non-Operators Select successor

• Removal rejected by Court Interim operating committee (Op. & all Non-Ops.) until Op. assume or rejects the JOA

– Reject Resignation by Operator. Non-Op. selects successor.

Operating Committee

• Actions require approval of 2 or moreparties owning a majority interest; or

• If there are only 2 parties, a 3rd partyacceptable to operator, non-operator, andCourt is selected as a committee member.

– Action requires approval of 2 parties.

– No requirement that they own majorityinterest

JOA as an Executory Contract

• A contract wherein there are ongoing orunperformed obligations on both sides

• Unduly Burdensome

• Business Judgment Rule

Assumption/Rejection • Prior to Assumption The JOA is

enforceable by the debtor, not against thedebtor

• Timing Debtor can assume or rejectany time before confirmation of a plan ofreorganization.

• Court Ordered Assumption/Rejection

Rejection

• Creates tenancy in common

• Non-operators receive a general unsecured claim for damages.

Assumption and Assignment

• Debtor can assume and seek to assign the JOA to a third party.

Severability of the JOA• Severability:

“For purposes of assuming or rejecting thisagreement as an executory contract pursuantto federal bankruptcy laws, this agreementshall not be severable, but rather must beassumed or rejected in its entirety, and failureof any party to this agreement to comply withall of its financial obligations provided hereinshall be in material default.”– ART. XV(D)

Risk Mitigation

• Expressly state the JOA is an ExecutoryContract

• Record JOA or Memo of JOA

• Negotiate Setoff and Recoupment rights

• Protect JOA rights as covenants runningwith the land

• Define Adequate Assurance

• Limit Successor Liability

Recording the JOA

• Record the JOA, or a memorandum thereof, to provide notice of the Operator’s lien rights

Setoff (pre-bankruptcy)

• A creditor’s right to offset mutual debts of the creditor and debtor, provided that the debts:

1) Arose before commencement of the bankruptcy; and

2) Are mutual – each party owes a debt to the other

Setoff Limitations1) Right must exist

under State law

2) Applies to pre-bankruptcy debts only

3) Automatically Stayed

– Creditors must first obtain relief from the automatic stay.

Recoupment

• Permits a creditor to withhold funds tooffset debts arising from the sametransaction.

• Same Transaction Both debts arise outof a single, integrated contract or similartransaction, such as a joint operatingagreement.

Covenant Running with the Land

• Cannot be assumed or rejected in bankruptcy

• Draft the JOA to:

– Recognize rights as covenants running with the land; and

– Bind the parties and their successors and assigns

Covenant Running with the Land

• Elements under Texas Law:

– The right touches and concerns the land;

– It relates to a thing in existence or specifically binds the parties and their assigns;

– It is intended by the original parties to run with the land; and

– The successor to the burden has notice

Adequate Assurance

• Require advance payments

• Deposit the Debtor’s share of expenses into escrow

Bankruptcy and Successor LiabilitySeagull v. Eland, 207 S.W.3d 342 (Tex. 2006)

• Court imposed liability on the prior non-operator WI owner that assigned its interest to a non-operator that subsequently went bankrupt.

Preferential Rights• The U.S. Bankruptcy Court for S.D. Texas

held that a preferential right to purchaseclause in a JOA (executory contract) wasunenforceable in a sale of all orsubstantially all of a debtor’s assets underSection 365(f)(1) of the Bankruptcy Code.– In Re Cobalt International Energy, Inc. U.S. Bankruptcy Court,

S.D. Texas (Case No. 17-36709).

Questions?

melissa.munson@steptoe-johnson.com

281-203-5765

blake.jones@steptoe-johnson.com

281-203-5730