This article considers the efficacy of the withering interest forfeiture remedy under a joint operating agreement (“JOA”) as a reaction to a party’s unremedied default and whether the interest sale option is a preferable remedy.
This article references the model form JOAs issued by the AIPN (2012), the AMPLA (2011) and OGUK (2009).
Remedies for default
The default remedies under a JOA apply principally to the failure of a party to pay when due its proportionate share of a cash call or invoice request (depending on how the JOA deals with demands by the operator for funding the costs of joint operations).
The two essential components of the default remedies under the JOA are that the default is made good by the non-defaulting parties (so that the continuation of joint operations is not jeopardised) and that the defaulting party will be required to make good the default amount. Ultimately, this second component could result in the loss by the defaulting party of its interests in the concession and the JOA.
In the first instance the JOA will typically prescribe a series of steps which disenfranchise the defaulting party: that party will be excluded from voting under the JOA and will be denied the ability to transfer or withdraw from its interests under the JOA. Thereafter the JOA’s default remedies focus their attention on attaching the economic interests of the defaulting party, in the interest of recouping the payments made by the non-defaulting parties to make good the defaulting party’s default. If the project is producing petroleum, then the defaulting party’s entitlements will be sequestered by the non-defaulting parties.
The ultimate intended purpose of the JOA’s default remedies is to ensure that the non-defaulting parties are fully recompensed for the amounts which they have had to expend in order to make good the default amount. The ostensible purpose of the JOA’s default remedies is not to punish the defaulting party for its default (although this could of course be an inevitable consequence).
The most accurate way of achieving the intended purpose of the default remedy is to see the amount to be recompensed being repaid in cash by the defaulting party to the non-defaulting parties. Cash compensation, paid on a full indemnity basis, should give a perfect reconciliation and no room for argument as to whether the non-defaulting parties have been over-compensated or under-compensated. In recognition of this, the JOA typically reflects that the default amount constitutes a debt which is due and owing from the defaulting party to the non-defaulting parties.
This sounds simple enough but the reality is that if the defaulting party lacked the necessary cash resources to pay its share of the cash call or invoice request then, in all probability, that defaulting party will also lack the cash resources necessary to repay the resultant debt. Thus it becomes necessary for the non-defaulting parties to look to any other assets or interests of the defaulting party in order to recover the default amount.
The last level of recourse for the non-defaulting parties is to take over the interests of the defaulting party in the petroleum project itself. Those project interests are represented by the presence of the defaulting party in the concession and the JOA.
At this point two options present themselves for consideration: (i) the forfeiture remedy, whereby the defaulting party’s entitlements as party to the concession and the JOA will be transferred to the non-defaulting parties in satisfaction of the default amount; and (ii) the sale of the defaulting party’s project interests to the non-defaulting parties (or to third parties) in consideration of the payment of a price which is set at a fair market value (with any surplus beyond the default amount being returned to the defaulting party).
Historically the principal concern regarding the operation of the forfeiture remedy has revolved around whether the remedy might be determined by a court to be a penalty and so potentially unenforceable by the non-defaulting parties against the defaulting party. This is based on the principle that under the rules of equity a provision will be unenforceable if it is imposed in terrorem (i.e. where it is intended to enforce the performance of a contract by a defaulting party rather than to compensate the non-defaulting party for a breach of contract).
Applicable English law has suggested that a penalty might be inferred where a sum stipulated for payment (which, in the context of a JOA, could be read as the interest to be surrendered by the defaulting party) is “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach.” Following on from this, where a defaulting party is at risk of forfeiting its interests because of a default in respect of a monetary amount which is comparatively much smaller than the value of those interests, the defaulting party might argue that the forfeiture remedy constitutes a penalty and so is unenforceable because the gravity of the remedy applies irrespective of the size of the default.
Since the principal purpose of the forfeiture remedy is to recompense the non-defaulting parties for the amounts they have had to pay in order to make good the defaulting party’s default then there must be some careful consideration around proportionality - the loss of the defaulting party’s interests in the concession and the JOA should be effected only to such extent as is necessary to give full recompense to the non-defaulting parties.
Proportionality of the forfeiture remedy could be realised by a mechanism in the JOA whereby the extent of the defaulting party’s interests which are forfeited to the non-defaulting parties is directly commensurate with the default amount. This will result in the defaulting party remaining party to the concession but enjoying a reduced level of interest in the petroleum project as expressed through the JOA. This structure leads to a consideration of what is popularly called the ’withering interest’ formulation in the JOA.
The AIPN JOA is the only model form JOA which conceives of the withering interest formulation. In contrast, the OGUK JOA’s forfeiture provision applies to the full value of the defaulting party’s interests. The AMPLA JOA does not prescribe forfeiture as a remedy (relying instead on options for the sale of sequestered petroleum entitlements, the sale of the defaulting party’s interest and the exercise of cross-security rights).
The proper purpose of a withering interest formulation is to fix an equation between the amounts paid by the non-defaulting parties in making good the default and the defaulting party’s interests in the concession and the JOA, such that only a corresponding portion of those interests are sequestered by the non-defaulting parties in satisfaction of what they had to pay out to cover the default. Few withering interest provisions actually achieve this goal however. Most withering interest formulations simply end up with the defaulting party losing something less than 100% of its project interests in the vague hope that any partial project interest loss would somehow be defensible.
The JOA might apply a simple narrative to the effect that the forfeiture remedy will apply to whatever proportion of the defaulting party’s project interests correspond to the extent of that party’s default. The parties will then be left to work it out for themselves, and a formal dispute between them as to the accuracy of the resultant calculation is unlikely to be far away.
The alternative to this purposefully deflective approach is to prescribe a particular algorithm in the JOA, which will be applied mechanistically in order to quantify the extent of the interest to be forfeited. This approach is preferable, but only if it is done properly.
The AIPN JOA applies a suggested form of withering interest provision based around such an algorithm. With all due credit for the intention, the execution is somewhat lacking. The AIPN’s withering interest provision is, in its standard form of drafting and without modification, difficult to apply.
Under the AIPN provision the interest of the defaulting party which is to pass to the non-defaulting parties is defined by the following formula:
The Withering Interest shall be determined based on the following formula:
Click here to view formula.
“Withering Interest” means the lesser of: (i) the Defaulting Party’s entire Participating Interest, in the applicable Exploitation Area to be assigned to the Acquiring Parties (expressed as a percentage); or (ii) the part out of the Defaulting Party’s Participating Interest, in the applicable Exploitation Area to be assigned to the Acquiring Parties (expressed as a percentage).
“Withering Price” means the amount equal to DPETC less DPACP.
“Estimated Total Costs” means the estimated total costs to be expended to complete the approved Development Plan for the applicable Exploitation Area, including any contingent amounts, amendments and approved cost over-runs arising before the due date of the Cash Call giving rise to the default.
“DPETC” means the Defaulting Party’s Participating Interest share of the Estimated Total Costs.
“DPACP” means the aggregate costs paid by the Defaulting Party regarding the applicable Development Plan before the date of the Cash Call giving rise to the default.
“Default Factor” means:
1.25, if less than twenty-five percent (25%) of the Estimated Total Costs have been expended by the Parties;
1.20, if at least twenty-five percent (25%) but less than fifty percent (50%) of the Estimated Total Costs have been expended by the Parties;
1.15, if at least fifty percent (50%) but less than seventy-five percent (75%) of the Estimated Total Costs have been expended by the Parties; or
1.10, if at least seventy-five percent (75%) of the Estimated Total Costs have been expended by the Parties.
“DPPI” means the Defaulting Party’s Participating Interest as of the due date of the Cash Call giving rise to the default (expressed as a percentage).
The difficulty of application of the AIPN’s withering interest provision can be illustrated by a simple example which starts with the following base data:
A concession is held by three companies, with the following participating interests:
A Co - 40%
B Co - 40%
C Co - 20%
The operator issues a cash call for US$100m gross. B Co defaults on its share of the cash call and the deficit is made good by A Co and C Co as non-defaulting parties as follows:
A Co - US$40m (40%) + US$26.67m (US$66.67m)
C Co - US$20m (20%) + US$13.33m (US$33.33m)
(B Co - US$0m)
Historically (and prior to the current cash call) the total amount of US$800m had been cash called and paid in respect of the current development plan, split as follows:
A Co - US$320m (US$800m x 40%)
B Co - US$320m (US$800m x 40%)
C Co - US$160m (US$800m x 20%)
Under the AIPN’s withering interest provision the following outcome ensues:
Estimated total cost of completion of the current development plan = US$1bn (with US$800m already paid)
Withering Interest = [US$400m - US$320m] x 1.10 x 40%
It is anybody’s guess as to how the resultant figure of US$0.088m is supposed to fit within the definition of ’Withering Interest’ and to result in a reallocation of a proportion of the defaulting party’s participating interest to the non-defaulting parties. The AIPN’s withering interest provision simply does not work, as drafted.
As an alternative solution, the JOA might apply the following algorithm within the following provision:
1. In this clause [•] the following terms have the following meanings:
DC = Default cash call, being the cash call to which this clause [•] applies.
DI = Defaulted Interest, being that part of the DPPI to which this clause [•] applies, which is the product of:
DPRP/TA x 100 (expressed as a percentage) minus DPAP/TA x 100 (expressed as a percentage).
DPAP = Defaulting Party’s Actual Payment, being the total amount which the Defaulting Party has paid in respect of the Development Plan as at the first day of the Default Period.
DPPI = Defaulting Party’s Participating Interest, being the Participating Interest of the Defaulting Party as at the first day of the Default Period.
DPRP = Defaulting Party’s Required Payment, being the total amount which the Defaulting Party would have paid in respect of the Development Plan if the Unremedied Default had not occurred.
TA = Total Amount, being: (i) the total amount paid by the Parties in respect of the Development Plan as at the first day of the Default Period and (ii) the gross amount of the DC (notwithstanding the Unremedied Default).
Unremedied Default means a Default to which this clause [•] applies.
2. In the event of an Unremedied Default:
- the DPPI will be reduced by the DI through subtraction of the DI figure from the DPPI figure (provided that the DPPI will never be less than zero).
- the DI which is subtracted from the DPPI will be allocated between the Non-Defaulting Parties, so as to increase their respective Participating Interests, in the proportions which their respective Participating Interests bear to the aggregate of their Participating Interests.
3. Upon completion of the transaction contemplated by this clause [•] the Operator will promptly issue a schedule to the Parties which will demonstrate the consequent revisions to their respective Participating Interests and clause [•] will be deemed to be amended accordingly.
Applying the same base data to this formulation results in the following outcome:
DPRP x 100% - DPAP x 100%
= 360 x 100% - 320 x 100%
= 40% - 35.5%
A Co - 40%
B Co - 40%
C Co - 20%
Post - Default PIs:
A Co - 43.0% (40% + 3.0%)
B Co - 35.5% (40% - 4.5%)
C Co - 21.5% (20% + 1.5%)
This formulation at least reconciles what the parties have (or have not) paid by way of cash calls with the aggregate value of the project which is represented by the development plan. Thus if the default relates to the very first cash call under the JOA, then the defaulting party loses the entirety of its project interests. There is an element of proportionality to this because the defaulting party has not actually invested any other cash call contributions into the project. If the default occurs later in the history of the project, when the defaulting party has invested in through cash calls, then the defaulting party loses a proportionally smaller percentage of its project interests.
On the other hand, if the default occurs much later in the history of the project, when significant payments have been made by the defaulting party, then the amount of the defaulting party’s interest which is forfeited will be relatively marginal. There could be a concern that this renders the forfeiture remedy somewhat toothless and as a reaction to this there could be a suggestion that the algorithm should apply a multiplier in the later stages of its existence, so that the defaulting party has more to lose. This suggestion, however, takes the forfeiture remedy away from being compensatory and makes it more penal in nature which is not a healthy move.
The forfeiture remedy also has to deal with issues relating to the application of grounds for relief from forfeiture and potential offence of the anti-deprivation rule. They are stories for another day; suffice to say for now that these issues give further grounds for disenchantment with the forfeiture remedy.
The interest sale option remedy
As an alternative to forfeiture, in order to apply a remedy for default which has some bite but which also has a fair element of proportionality (and also one where there is considerable experience of successful enforcement in an analogue context), the JOA could provide that the project interests of the defaulting party are forcibly sold (whether to the non-defaulting parties or to third parties) at an established fair market value (with recourse to a valuation expert in the event of a dispute) and the balance of the sales proceeds (after deduction of the default amount and associated enforcement costs) are returned to the defaulting party.
The interest sale option remedy applies a measure of proportionality between the default amount and the net loss of interest which the defaulting party is exposed to, which will be helpful in reducing the prospects of the remedy being impugned as a penalty. An assessment of the prospects of success of the interest sale option can borrow heavily from the world of enforcement of secured lending, where the rights of a lender to sell a borrower’s secured property interests (subject to accounting to the borrower for any balance of the resultant sales proceeds beyond the default amount) are better known.
The interest sale option also results in the complete removal of the defaulting party from its standing as a party to the JOA and the concession, and this could be preferable to the withering interest formulation (where, despite all the aggravation, the defaulting party remains a party).
The interest sale option is recited as a possible option for default in the AIPN JOA, the AMPLA JOA and also in the OGUK JOA. In the OGUK JOA this is done in simple narrative terms. The AIPN JOA tries to be more formulaic about this, using the following algorithm:
Buy-Out Price shall be deemed to be equal to the fair market value of the Defaulting Party’s entire Participating Interest, less the following:
- The Total Amount in Default
- All costs, including the costs of the expert, to obtain such valuation; and
- _ percent (_%) of the fair market value of the Defaulting Party’s Participating Interest
A notable feature of this algorithm is the provision for the extra deduction from the sales proceeds in favour of the non-defaulting parties in limb (c). This deduction has the capacity to be problematic. It has the appearance of introducing an additional element of penalty into the equation, and this will particularly be so if the amount of the deduction cannot be justified. The costs of the non-defaulting parties are covered by the interest sale option, as is the default amount, and so what is the deduction intended to provide for? If the answer to that question is anything like ’an additional amount to penalise the defaulting party by not giving it a full recovery of the surplus’, then it places the interest sale option remedy on dangerous ground.
The position improves if the amount of the deduction can be justified. One argument which could be made in its favour is that it represents some fair measure of compensation to the non-defaulting parties for the additional risk that they have had to accommodate through having their participating interests increased because of the default, but there is still no obvious correlation between the amount of the deduction and that risk. After all, that risk is just a perception, and it is a risk which would still have applied if it was undertaken under the forfeiture remedy.
The OGUK JOA also imports the notion of a defined percentage deduction which is to be applied to the value of the Defaulting Party’s interests. In the guidance notes to the OGUK JOA this is described as an option for “discounting the agreed or determined price to reflect the default”, with the warning that “this option might be challenged as a penalty.” The AMPLA JOA applies no such deduction.
The potential loss of a defaulting party’s interests remains an essential protective provision for non-defaulting parties (particularly where no other forms of recovery exist in practical terms in respect of a default). A loss of interest provision which applies a proportionate (rather than an absolute) degree of sequestration stands a better chance of not being impugned as a penalty. And a provision which applies a clear and reasoned algorithm for defining what interest is to be lost will be preferable to relying on a vague narrative as to what sort of outcome is required.
The withering interest formulation is a device which is intended to afford a practical commercial remedy for a default (although as seen above, the value of the remedy becomes questionable where it is applied later in a project’s life) and which is also intended to mitigate (to the greatest possible extent, since absolute and guaranteed mitigation is never assured) the possibility of a successful legal challenge to its existence. Yet actual incidences of complete forfeiture are almost nonexistent in reality and there is no concrete jurisprudence on the legal efficacy of the remedy. Thus despite all the effort which could be devoted to getting it right, whether the withering interest formulation actually works, both commercially and legally, is still a great unknown.
In contrast to forfeiture, the interest sale option remedy offers a solution to default which is arguably is easier to structure and to implement, and which offers a clearer degree of proportionality between default and remedy. When it comes to structuring an effective default remedy in a JOA, this could be the better way to go.