Uncertainty in the energy sector understandably has oil and gas companies that are engaged in joint operations and joint venture projects on edge. Oil and gas producers are under tremendous economic stress and some are teetering on the brink of insolvency. Many companies are likely to see partners in joint operations and joint ventures enter formal insolvency proceedings, resulting in uncertainty in the ability to collect amounts owed by the insolvent partner. This is true whether the insolvent partner is the operator or a non-operator. It is therefore important for energy companies to prepare themselves to respond effectively to the insolvency of partners in joint ventures or joint operations.
This update identifies some of the risks to which participants in joint oil and gas exploration and production operations and joint ventures are exposed when a partner becomes insolvent; it also considers possible strategies to mitigate these risks, both in the negotiation of new joint venture and joint operating agreements and in instances where such an agreement already exists.
Both operating and non-operating partners can take a variety of measures to protect themselves from the consequences of having an insolvent partner. On the insolvency of a partner there will likely be many competing claims for the same pool of assets, and unravelling the competing priorities of the various secured and unsecured claims on the insolvent partner's assets can be complex. If insolvency proceedings are commenced against the operator, the other partners will risk losing funds that the operator was holding on their behalf. Further, non-operating partners will potentially be exposed to liability to third parties for contractual obligations undertaken by the operator that have not been fully satisfied. Imposing as many protections as possible into the relevant joint operating or joint venture agreement at the outset – and exercising these protections as soon as possible – can mitigate these exposures significantly.
From a security perspective, if each partner has granted an operator's lien on its working interest in the jointly operated lands (or on its participating interest in the joint venture) to secure its respective joint venture obligations, and that lien ranks first in priority to other security against such interest, the other partners can access the interest of the insolvent partner to remedy defaults with much greater ease. Of course, there may be restrictions on the parties' abilities to grant such security, including under their loan and security documents with other lenders.
If there is no operator's or joint venture lien, or if there is one but it ranks below the security of other lenders, the ability to recoup losses out of proceeds of enforcement is much reduced. In such cases, the ability to enforce other effective remedies in the face of a default becomes even more important; further, the partners will want to be able to access these remedies before any insolvency proceedings are commenced, in order to avoid having those remedies stayed under the insolvency proceedings. In addition to provisions granting security or trust interests to protect amounts owing, it may also be possible at the time of negotiating the joint venture agreement to include additional remedies, such as a buy-out right or seize-and-sell remedy.
In practical terms, it is also important to consider the extent of the credit risk against the anticipated capital expenditure profile for the relevant project or assets. For example, if the assets are conventional producing assets and the partners are not expected to fund significant capital projects to bring the assets into production, there will be less insolvency risk. These risks can be further mitigated by:
- imposing tight controls over the cash-call process;
- over-funding cash calls; or
- in more extreme cases, having partners with undesirable credit ratings provide letters of credit supporting their payment obligations relating to operations.
In negotiating joint venture agreements, it is important to consider potential risks that can arise if a partner becomes insolvent and include provisions in the agreement that are appropriate to the nature of the joint venture. The following provisions should be considered.
Approval of expenditures
To protect against operator insolvency, the agreement must ensure that the non-operating partners have adequate control over proposed operations and expenditures. In projects involving significant capital expenditures, it must ensure that non-operator approval is required for annual work plans and budgets and include provisions strictly limiting the operator's overspending allowances, both in the aggregate and for individual line items. Where no annual work plan or budget exists, it may be possible to require the approval of individual authorities for expenditure and include provisions limiting the operator's authority to spend more than the amount specified in the authority for expenditure without additional partner approval.
Careful consideration should be given to funding provisions. A balance must be struck between requiring sufficient funding to provide the operator with the funds required to conduct approved operations as and when required (thus ensuring that all partners can fund their respective share of expenditures), and avoiding funding provisions that will leave surplus joint venture funds in the operator's account for long periods (thereby exposing such funds to the risk of operator insolvency). The timing of funding obligations (eg, monthly, quarterly or at irregular intervals as needed) should be matched to the timing of expenditures by the operator. The operator should be required to return unspent funds over a specified amount to the funding partner if they are not spent on approved operations within a specified period. Further, the agreement should require the provision of adequate security (eg, a stand-by letter of credit from partners with a credit rating below a pre-defined acceptable level) to secure funding by such partner of its respective share of such costs – particularly where the nature of the joint venture project requires significant financial commitments.
Trust and commingling of funds
A trust in favour of the non-operating partners should be established for joint venture funds held by the operator. This should cover funds received by the operator from the partners as well as joint venture revenues received by the operator. The operator should be expressly prohibited from commingling joint venture funds with the operator's own funds and a separate bank account should be established to hold joint venture funds. Adequate monitoring to ensure that the operator is following these steps may also be required. Many operators balk at taking on the additional administrative burden of holding joint venture funds in separate accounts and prefer the administrative efficiency of commingling funds. However, this commingling may make it impossible to identify the funds held for the joint account, thereby possibly defeating the partners' trust claim to those funds.
Joint venture lien
Each partner should grant to the other partners a lien, ranking in priority to all other encumbrances on the partner's working interest and production from the joint lands or joint venture interest (as applicable), to secure the partner's proportionate share of joint venture costs, expenses and liabilities. Where practical, this joint venture lien should be registered as a security interest. The joint venture agreement should mandate that each partner grants to each other partner a power of attorney, authorising it to exercise the lien and any other remedies set out in the joint venture agreement in the event of default by the granting partner.
Take in kind
Agreements relating to production should grant to the partners the right to take their proportionate share of production in kind; where the operator appears to be at imminent risk of insolvency, partners should exercise their right to take in kind as soon as possible. If partners permit the operator to sell production on their behalf and the operator enters into a formal insolvency proceeding, the ability of partners to take their production in kind following the commencement of insolvency proceedings may be prevented by the stay that arises by virtue of proceedings.
Where the operator can market product on behalf of the joint venture, the non-operating partners should be entitled to approve the contractual terms (eg, price, contract term, renewal rights and credit provisions applicable to the buyer).
Events of default and cure periods
The agreement should include a detailed list of breaches and financial events that entitle the other partners to issue of a notice of default and, if unresolved, exercise remedies. Events of default should include all the standard defaults (eg, breach of the agreement, failure to pay amounts as and when due and the creation of a lien over joint venture interests). Further, parties should consider including cross-defaults under other agreements (eg, credit facilities and other material agreements), insolvency events and a drop in credit rating (unless acceptable security is provided within a specific time period). For specific financial defaults (eg, insolvency events, failure to pay material amounts or failure to provide required security), remedies should be exercisable either immediately or very quickly. Partners should include short notice and cure periods for financial defaults and specify that remedies are exercisable immediately on the occurrence of events of insolvency.
Remedies on financial default or insolvency
The agreement should provide for a suite of remedies, any or all of which may be invoked by the non-defaulting partners on financial default or insolvency of a partner, including:
- the rights to:
- set-off the defaulting partner's share of proceeds of production or joint venture revenue against amounts owed by the defaulting partner;
- charge interest on outstanding amounts owed by the defaulting partner; and
- institute claims against the defaulting partner for amounts owing and the costs of enforcement;
- if the defaulting partner is the operator, permission to remove and replace it as the operator immediately;
- suspension of the defaulting partner's right to vote on joint venture matters until the default is cured;
- provision for an optional 'buy-out' remedy whereby non-defaulting partners can buy out the defaulting or insolvent partner's interest free and clear of all encumbrances for an amount equal to the fair market value of its interest, discounted by an appropriate percentage, with proceeds of such sale first going to satisfy amounts due and owing by the defaulting partner to the joint venture;
- permission for the operator (or, where the operator is in default, any other partner) to take possession of the defaulting partner's interest, with the right to sell any or all of the interest to offset amounts owed by the defaulting partner; and
- placing responsibility on the defaulting partner for any and all reasonable costs and expenses incurred by the non-defaulting partners in exercising their rights and enforcing their remedies as a result of the default or insolvency of the defaulting partner.
It should also be specifically provided that all remedies may be exercised by a non-operator if the operator is the partner that is insolvent or in default.
It should be established that each partner's responsibility for any third-party credit support is limited to its respective joint venture interest; if guarantees must be provided to a third party, a letter of credit in lieu of a guarantee should be required from any party whose credit rating drops below a specified acceptable level.
Reporting and approval requirements are perhaps the most important means for non-operators to mitigate the risks attendant on operator insolvency. In addition to the budget and expenditure approvals discussed above, the agreement should limit the scope of the commitments being made by the operator for the joint account by requiring partner approval for contractual commitments over specified amounts or terms and for non-arm's-length contracts. Periodic reporting requirements should be included, covering results of operations, financial reporting (including information on delinquent accounts receivable and accounts payable), regulatory matters and other issues material to the partners. For large joint venture projects, non-operating partners should consider including provisions in the agreement granting them the right to second employees to the operator. Seconded employees often have greater visibility into operational and financial matters affecting the operator and the joint venture.
Sometimes platitudes should be heeded: in today's economy, it really is better to be safe than sorry. Risk awareness, coupled with protection strategies, are vital. In addition to ensuring that these various protections are included in the joint operating agreement, it is equally important to invoke them as soon as possible to ensure that their benefit is not lost as a result of contractual rights being stayed by an insolvency filing. Armed with the strategies identified above, parties to joint venture agreements can enter fruitful partnerships while simultaneously being adequately prepared for a worst-case scenario.
For further information on this topic please contact Aditya M Badami, KayLynn G Litton or Randal S Van der Mosselaer at Norton Rose Fulbright by telephone (+1 403 355 3550) or email (firstname.lastname@example.org, email@example.com or firstname.lastname@example.org). The Norton Rose Fulbright website can be accessed at www.nortonrosefulbright.com.
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