The recent further dip in oil price has placed even more pressure on the costs paid by Operators to Contractors, and also how much reliance Contractors can place on an Operator's promise to pay.
From opposing ends of the market, therefore, there are important issues to consider: for instance, whether an Operator is able to continue if one of its Contractors fails (ie their service or supply is business critical), and whether a Contractor is obliged to continue supplying when the Operator is of doubtful solvency. Although all service and supply contracts are tailored for the relevant asset, certain standard clauses are prevalent throughout the market; we consider some examples of these below by reference to the insolvency of a Contractor and an Operator.
Can the Operator terminate the contract?
It is perhaps unsurprising given the lack of distress in this sector in recent decades, but most of the insolvency 'trigger' events contained in standard form documents that we have seen refer to old and incomplete lists of insolvency processes. There is also a difficulty when English law documents use American insolvency terms ("bankruptcy", for instance, in England only refers to real people and not companies). Recent case law has also been restrictive in the interpretation of insolvency triggers, such that a right based on an "administration order" being made, was not triggered when the company was placed into administration using the out-of-court process (which is most common, and is how Afren Plc, for example, entered administration). It is therefore necessary to check the insolvency event description in the agreement, but on the assumption it is wide enough, the Operator usually has the ability to terminate the contract on the Contractor's entry into an insolvency process.
Recently, we have also seen Operators seeking to terminate agreements for other reasons, such as a failure to perform to the required standard or health and safety breaches. Whilst a number of these will be valid, there is also concern amongst Contractors that some of these terminations are a fiction, created to enable Operators to extricate themselves from agreements that are no longer commercially attractive. There is likely to be a large amount of litigation on this topic in the near future.
Can the Operator exercise step-in rights?
If the Contractor's supply of services is critical to the operation of a producing well, any well advised Operator would want to ensure it has the ability to step-in and use the Contractor's assets to continue the provision of the service until a replacement can be found. Whether or not this will work is dependent on both legal and practical issues. As part of the legal test, the Operator would need to ensure the event necessary to trigger the right has occurred (see above). It would also be necessary to ensure any administrator or liquidator could not defeat the right (usually, the Operator would want to ensure it had some sort of proprietary entitlement to the assets to rank in priority to other creditors, as discussed below).
Practically, there can be a number of difficulties. For instance, the Operator could be entitled to use the Contractor's computers or systems, but not have a licence for the software or passwords to access the information. There may also be difficulties if the Contractor's employees hold important information or know how. If the use of step-in rights is part of an Operator's contingency plans, an Operator's in-house team should walk through the steps they would take on day one etc, to think through the practical and legal issues that may arise and think through now (whilst they have some time) how any difficulties may be overcome.
Who owns the half-built product?
On any insolvency, there will be a conflict between simple unsecured creditors with, for instance, breach of contract claims (who rank very near the bottom of the list of priorities) and those creditors with proprietary or in rem claims to particular assets in the possession of the Contractor (who are entitled to the entirety of that asset with little dilution). Many contracts we have seen seek to pass ownership of part-built product to the Operator, thus giving the Operator a proprietary claim, and therefore a claim to that asset in priority to other creditors. A number of standard form contracts also seek to prevent the creation of a lien in favour of the Contractor for its unpaid fees, which again protects the recovery an Operator could make. However, there are also the practical difficulties of the saleability of half-finished product and the cost of taking possession of it (or storing it). A further hurdle in cross-border cases is whether the local law of the jurisdiction in which the asset is located would recognise a distinction between physical possession and legal ownership. It is likely, therefore, that the efficacy of such a clause would depend on the circumstances.
Can a Contractor terminate the contract?
The standard form contracts we have seen are very heavily weighted in favour of the Operator. In fact, whilst the Operator is given a long list of reasons for which it can terminate (including "for convenience"), Contractors are not even given a right on the liquidation of the Operator. This comes into stark focus when, for instance, the Contractor is already owed significant sums, and is obliged to outlay further cost, with a doubtful promise to pay from a distressed Operator.
What can the Contractor do to protect its position?
As with all insolvency processes, to protect its position the goal of the Contractor would be to raise its position over that of the other creditors. It can achieve this most readily by having a proprietary right to assets of a value equal to or greater than the debt due to the Contractor. This could be achieved by taking security or a lien over the Operator's assets (which we appreciate is unlikely to be given), by the Operator agreeing to hold certain assets on trust for the Contractor (again unlikely), the Contractor providing assets on retention of title terms (which mean they belong to the Contractor until paid for – the efficacy of these clauses is an article itself, see for instance Retention of Title Clauses), or that the Contractor receives a promise to pay from third parties with a stronger covenant (eg, other participants or letters of credit). However, an Operator's legal ability to provide some of these protections is likely to be limited, and its desire to provide them equally low. Most of the standard form contracts we have seen expressly exclude, for instance, the creation of a lien or the ability to retain title.
If the Contractor cannot terminate the contract, what can it do?
If the Contractor does not have a contractual entitlement to terminate the agreement on the Operator's insolvency, it will have to rely on common law rights to bring the contract to a conclusion. This would usually involve the Contractor arguing that the Operator, in failing to pay, had performed a repudiatory breach, ie a failure of performance which goes to the root of the contract or which deprives the innocent party of a substantial part of the benefit to which he was entitled, enabling the innocent party to treat the contract as at an end. If the Operator was not yet obliged to pay, but the Contractor believed the Operator would not pay, it could try to argue that there was an anticipatory breach. Given this area of law is based on case reports and not statute, it is very much fact specific. As each case must be considered on its own facts there is an inherent risk in taking this approach, and the possibility of a damages claim against the Contractor for failing to perform.
Please click here for our Insolvency glossary defining the italicised words above.
This update is the twelfth in our series on the impact of oil price volatility. To read the previous updates please click here.