When I teach about the Association of International Petroleum Negotiator’s (AIPN) Model International Farmout Agreement at AIPN’s courses, I tell the attendees that farmouts (and the model form) are a lot like the “Choose Your Own Adventure” books that I fondly remember reading as a child. For those of you who are not familiar with this literary genre, “Choose Your Own Adventure” books are a style of children’s literature (particularly popular in the 1980s) written in the second person (i.e., from your viewpoint) that allows the reader to make decisions throughout the story for the protagonist and at each decision point the reader is directed to a different page (and a different outcome) depending on their answer.
Unlike other types of international oil & gas agreements, where there is more or less a standard scheme that one could study and apply best practices to in order to map out a reasonably straight line approach, farmouts are for the imaginative and brave. They are a puzzle that can be put together in a hundred different ways, depending on country of operation, governing law of the agreement, terms of consideration, allocations of liability, timing of Transfer(s), etc.
A farmout agreement (also referred to as a farm-in agreement or a participation agreement) is an agreement for a transfer of a portion of the seller’s (often referred to as the “farmor” ) ownership interest in an upstream oil and gas granting instrument (such as an oil & gas concession, license or production sharing agreement) (the Granting Instrument). A farmout agreement will usually provide for consideration consisting of a combination of cash payments and the performance of work obligations. It is the work performance aspect of the consideration that makes this type of agreement unique and clearly differentiates it from a standard sale and purchase agreement, where the price is entirely cash based. In addition, the farmout usually has the challenges of historic cost valuation, governmental consents for transfers and assignments, reassignment risks resulting from a default of the purchaser/farmee, and wide-open range of terms and timings only limited by the imagination and creativity of the parties’ negotiation teams.
AIPN’s 2019 Model International Farmout Agreement
AIPN, through the volunteered efforts of its membership (individuals who span the workstreams of the oil & gas industry and the globe), has developed a library of 19 model contracts for use in the international oil & gas business. These model contracts, such as the model farmout agreement, the model joint operating agreement and the model confidentiality agreement, are regularly used as a starting place for negotiations and drafting, giving the oil & gas negotiation teams a head start in developing their agreements and a common basis and vocabulary from which to negotiate. AIPN’s model contracts are drafted in committee, receiving input from members with diverse backgrounds and experience. Each model contract is drafted with additional options and alternatives that the user can select from in order to help tailor the model contract to his or her project-specific needs.
In June 2019 AIPN published the 2019 Model International Farmout Agreement (the 2019 Model FOA). The 2019 Model FOA is a substantial revision of AIPN’s 2004 Model International Farmout Agreement. I was honoured to have a front row seat to its development as the co-chair of the revision committee for the 2019 Model FOA, together with Frank Cascio (Barnes & Cascio, retired). Leading the work of a committee-drafted model contract is not for the faint of heart, from start to finish the revision took approximately nine years to complete. The committee’s perseverance, I believe, has resulted in a much improved starting place for negotiators working a farmout arrangement.
Prior to commencing the revision, the AIPN membership was surveyed with respect to how they used the 2004 Model FOA and what they wanted to see in the revised model. Based on the membership response, the revision committee elected to draft the 2019 Model FOA primarily from an English law governance perspective given that the membership indicated that English law was the more prevalently (but not only) selected governing law for their international farmout agreements. The governing law is crucial because it influences the legal interpretation of several key value levers of the farmout agreement, including warranties and indemnities. At the same time, certain options and alternatives have been included in the 2019 Model FOA to allow the model form to be adjusted for other jurisdictions. For example, there is an option which the parties could select that would grant the warranties on an indemnity basis, an approach more commonly found in US practice.
The 2019 Model FOA presents a user-friendly format that has been improved to work in tandem with AIPN’s 2012 model joint operating agreement (AIPN Model JOA). The new version includes more form and substance to the provisions dealing with warranty, indemnity and termination and provides new options and alternatives to better customize the user’s experience.
Nevertheless, the 2019 Model FOA is only a model - a starting point from which the parties can begin to develop their agreement. The model forms must be customized commercially and legally for each project and jurisdiction in which the form will be used.
Overview of Four Key Components
Below we will take a look, from the legal perspective, at a few of the more challenging aspects of a farmout agreement and the 2019 Model FOA – transfer, valuation, consideration, and termination / reassignment. These issues will highlight the pull and tug nature of the farmout between the objective of the seller/farmor to get paid to the objective of the purchaser/farmee to receive the assignment of the interest in the Granting Instrument (the Farmout Interests).
Simple Farmout Timeline
In many farmouts the timing of the transfer (assignment) of the Farmout Interests from the seller/farmor to the purchaser/farmee (the Transfer) is a topic of hot discussion. However, the parties may not have much optionality with respect to the timing as the overwhelming tendency is for host governments (i.e., the government that has issued the Granting Instrument under which the Farmout Interests are being transferred) to require, by law or by the terms of the Granting Instrument itself, the prior approval of the government or one of its authorities to the Transfer of the Farmout Interest. Therefore, the host government approval is a key determinate and restriction for the timing of the Transfer.
Failure to receive such approval prior to the Transfer of the Farmout Interests will typically cause the Transfer to be void and in many cases will also be a cause for termination of the Granting Instrument. The obligations to obtain government approval for a Transfer should be carefully reviewed by the parties. In some jurisdiction, such as Nigeria, even the conditional agreement to Transfer under a farmout scheme could be viewed as a violation of the government’s right to grant the approval and could put the Granting Instrument at risk.
The 2019 Model FOA provides that the Transfer of the Farmout Interests will be made after the satisfaction or waiver of the conditions precedent and that “Completion” shall occur five Business Days after all of the conditions precedent are satisfied or waived. One of the Conditions Precedent of the 2019 Model FOA is “obtaining the Approval of the Government of [●] [as required under Article [●] of the Contract]”  – Article 2.3.2(a). Consequently the timing for applying for governmental approval should be carefully considered. If the seller/farmor applies for government approval prior to the satisfaction of the other conditions precedent, there is a risk in certain jurisdictions that the government could grant its approval for the assignment and thereby affect the Transfer from the government’s perspective prior to the other conditions precedent having been met; however, in many jurisdictions the amount of time required for a government to approve a Transfer can be quite long, so waiting for all of the other conditions precedent to have been satisfied may not be practical.
A cut-off period or long-stop date has been included in the 2019 Model FOA which provides that all of the conditions precedent must be either satisfied or waived by the parties by such date and after which, if any condition precedent is not satisfied or waived, then either party has the right to terminate the agreement. The parties may want to limit this right to terminate to the extent that the party whose acts or omissions caused the failure to satisfy a condition precedent does not have the right to terminate the agreement for failure to satisfy such condition precedent.
Given that a farmout arrangement envisages that the purchaser/farmee enters into a project that has already incurred costs for, at a minimum, acquisition of the Granting Instrument and the conduct of exploration operations, the valuation needs to address the parties’ agreement on the historic costs accrued by the seller/farmor to the date of the agreement to bring the two parties into parity, as well as the costs that will be incurred from the signing date of the farmout agreement until the actual Transfer.
The 2019 Model FOA includes the concept of an “Accounting Date”, which is the date agreed by the parties from which time the purchaser/farmee will assume the Benefits (being “all income, receipts, revenues, insurance proceeds, payments, and rebates of whatever nature accrued on an Accruals Basis attributable to the Farmout Interests”) and the Costs (being “all costs, charges, expenses (including [reasonable] legal fees and professional charges), obligations, and liabilities of whatever nature, attributable to the Farmout Interests whether incurred pursuant to the Joint Operating Agreement or otherwise”) attributable to the Farmout Interests.
The Accounting Date will often correlate with a date of finalisation of the purchaser’s/farmee’s due diligence or the audited operation accounts. The purchaser/farmee will be obliged to pay for the Farmout Interests’ share of all Costs arising from the Accounting Date and, subject to Completion, will also receive the Benefits arising from the Accounting Date. The Parties will need to agree to the timing of the purchaser’s/farmee’s payment of these Costs keeping in mind that part of the Costs arose prior to the date that the farmout agreement is signed (and thus are often agreed to be paid as a lump sum at signing or at Completion) and the other part of the Costs arise after signing of the farmout agreement and, while typically based on an agreed work program and budget, may not be entirely predictable (therefore, the parties may agree that the purchaser/farmee will pay such Costs in cash calls as they arise prior to the Completion date, partially in advance at signing or as a lump sum at the Completion date).
In addition, to the Costs arising after the Accounting Date, the parties may agree that the purchaser/farmee will also pay for certain past or historical costs that arose prior to the Accounting Date, usually as an agreed amount in a lump sum payment.
The 2019 Model FOA provides optional provisions for audit rights and a post-Accounting Date adjustment. The reference in optional Article 3.7 to audit of the Joint Account refers to audit provision in a joint operating agreement assuming that the AIPN Model JOA audit provisions would apply. If a joint operating agreement has not been executed or the respective joint operating agreement does not reflect the same terms of Joint Account audit as the AIPN Model JOA, then the parties will need to consider what audit provisions are appropriate.
The optional adjustment provision has been kept brief in the 2019 Model FOA. While Article 3.8 provides for the preparation of the interim costs statement and acknowledges the potential for a post-Completion adjustment, the article does not provide the details of how such adjustment should be prepared, calculated, paid or resolved if disputed, as this will depend on the particulars of the commercial agreement.
The 2019 Model FOA contains multiple options in the Consideration sections which are in addition to the Accounting Date/Cost discussion from the above Valuation section. In practice Consideration can be structured in almost any combination of ways, so Article 3 of the 2019 Model FOA only provides a starting point for the parties to build upon. The two main optional components of Consideration in the 2019 Model FOA are a cash payment (Article 3.1.1) and a Work Obligation (Article 3.1.2).
If there is a cash payment component of consideration, then the parties have multiple options that they will need to agree with respect to the structure of the cash payment, including the timing of the payment (which will be linked to the parties’ position as to the timing of the Transfer of the Farmout Interests, e.g., at signing of the agreement or at the time that the Farmout Interests are Transferred to the purchaser/farmor) and to whom it will be paid and on what basis (i.e., to the seller/farmor as a reimbursement of the past or historic costs or as a premium or to the operator under the joint operating agreement for cash calls as a promote or carry).
It is the Work Obligation that makes a farmout agreement uniquely different from a standard purchase agreement. Under the Article 3.1.2 of the 2019 Model FOA the purchaser/farmee will commit to “perform” certain work. This work could be a Seismic Commitment, a Well Commitment or any other work that the parties agree will be performed in connection with the Transfer of the Farmout Interests.
In some jurisdictions the parties may agree that the purchaser/farmee will actually conduct the work using its resources and employees/contractors; however, this is relatively rare in the international practice for a variety of reasons including the operational liability, prohibitions in the Granting Instrument, permits and consents required for operations being linked to the operator under the Granting Instrument, etc. Therefore, in most cases the purchaser/farmee will make cash payments to the seller/farmor or to the operator under the existing joint operating agreement on behalf of the seller/farmor for express work to be conducted or for an agreed percentage of work costs.
The benefit of a Work Obligation, instead of or in addition to a cash payment, is that it may create a considerable tax benefit for the parties by having the payment linked to deductible project operations costs as opposed to a straight cash payment for acquisition of the Farmout Interests. However, the parties need to carefully analyse the tax legislation of the applicable jurisdictions – i.e., the jurisdiction of the operations and the respective jurisdictions of the parties, to ensure that the deductions will be applicable and that additional tax will not be applied to the payment. Some jurisdictions have revised their tax legislation to discourage the ‘zero tax’ tax structuring of a farmout.
As the AIPN Guidance Note for the 2019 Model FOA mentions, the performance of the Work Obligations could also be structured as a tiered earn-in by which the purchaser/farmee would “earn” the interest in percentages as the purchaser/farmee reaches agreed milestones in performance/payment. The 2019 Model FOA does not include an earn-in as an alternative to the one-time Transfer provision. While an earn-in may reduce the Transfer/payment risk for the parties, allowing them to break the obligation into pieces and Transfer promptly upon performance, in most jurisdictions a Transfer of the Farmout Interests requires governmental approvals for each assignment and therefore, this method could create logistical difficulties.
Termination / Reassignment
Under the 2019 Model FOA, the agreement can only be terminated prior to Completion (Article 11.1.5). Termination prior to Completion is permitted by mutual written agreement of the parties or upon notice (by the party not at default) if Completion does not occur before the Long Stop Date or upon receiving a “final, unappealable written notice from the Government that it will not grant Approval for the Assignment of the Granting Instrument”. In addition there are a number of pre-Completion termination rights that have been included as options for the parties to consider.
As mentioned above, the parties need to carefully consider the expected timing of the government approval to the assignment of the Granting Instrument and the legal effect of such approval. If the assignment of the Granting Instrument will be approved before the Completion and such approval de facto assigns the Granting Instrument without any further action of the seller/farmor, then when using the 2019 Model FOA, the parties should modify Article 11 so that the termination right ends and the reassignment provisions become applicable not on Completion but upon the governmental approval of the assignment of the Granting Instrument.
Article 11.4.1 of the 2019 Model FOA provides that if the agreement is terminated then the seller/farmor is to reimburse the purchaser/farmee for any of the consideration payments (Articles 3.1.1 and 3.1.2) made by the purchaser/farmee prior to termination; however, if the agreement is terminated for any other reason, then “Farmor shall not be obligated to reimburse, and Farmee shall not be entitled to reimbursement of, the payments made by Farmee pursuant to Articles 3.1.1 and 3.1.2, and Farmor shall be entitled to retain such payments”. The parties should consider whether there are any other times in which the purchaser/farmee should have the right to repayment if the agreement is terminated prior to Completion.
After Completion if there is a purchaser/farmee default (meaning the purchaser/farmee has failed to pay an amount due under the agreement or to complete a Work Obligation), then subject to the Default terms, the reassignment provisions of Article 11.5 will apply.
Reassignment was the most difficult issue for the revision committee to address. The core problem with reassignment is that once the assignment of the Farmout Interests has been made, if the purchaser/farmee defaults on a payment, then the seller/farmor may be limited, in practice, as to what recourse it has to unwind the transaction and receive some or all of the Farmout Interests back. In addition to the risk of potentially having a non-cooperative purchaser/farmee, the seller/farmor is likely to be required to obtain governmental approval for the re-assignment of the Farmout Interests back to the seller/farmor which may take a considerable amount of time or may not be achievable subject to the interest of the government.
Reassignment, as a concept, is also challenging to draft in a manner that will be enforceable under the legal regime of the country in which the Granting Instrument is issued and under the law governing the farmout agreement (if different). Numerous legal issues including, among others, the equitability of the reassignment, the enforceability of a trust arrangement, and the requirements and timing for governmental approval of the reassignment and the potential liability for additional assignment bonuses or other payments for such reassignment need to be taken into consideration.
While reassignment has been discussed and drafted in various ways over the years, including through the use of reassignment of withering interests, trust arrangements and/or a break fee, liquidated damages or penalty, the revision committee for 2019 Model FOA elected, for the purposes of the model form, to only include a full reassignment provisions, which seemed to be the more standard approach based on the AIPN member survey and further discussions at AIPN’s Model Granting Instrument Workshops and revision committee meetings.
Just like the “Choose You Own Adventure” books, any given farmout can have a very different ending. If you are not careful in selecting and negotiating your set of options and alternatives, the ending may not always be a happy one. However, with some careful consideration and attention to the details without losing sight of the big picture by understanding how each option and alternative option will affect the outcome of the other provisions, your story can have a happy ending for both parties, which is the ultimate goal of a farmout -- to pave the way for future mutual cooperation in the project’s joint operations.
The 2019 Model FOA and the Guidance Note for the 2019 Model FOA, along with all of AIPN’s other model forms, can be downloaded on AIPN’s website (https://www.aipn.org/model-contracts/).