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Does the Supreme Court’s ruling in Cavendish increase the likelihood of JOA forfeiture provisions being enforceable?

In November 2015, the Supreme Court took the opportunity to review and recast the English law on penalties, in Cavendish Square Holding BV v Talal El Makdessi [2015] UKSC 67.  The decision has been of particular interest to the oil and gas community, where the enforceability of JOA forfeiture provisions has long been the subject of debate.

The Cavendish ruling was welcomed by English lawyers, coming as it did some 100 years after the previous leading authority, Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79.  In the intervening period, English case law had sought to refine the penalties test, with results that were sometimes helpful and at other times confusing.  The result was, according to the Supreme Court, “an ancient, haphazardly constructed edifice which has not weathered well“.

Before Cavendish, any analysis of whether a clause was a penalty would likely have started with Lord Dunedin’s four “tests” from the Dunlop case and his focus on whether the sums payable amounted to a genuine pre-estimate of loss or a deterrent.  Post-Cavendish, the test is now clearer.  The key question is whether the relevant clause is a secondary obligation and, if it is, whether it is out of all proportion to any legitimate interest of the innocent party in its enforcement.

So, the first task is to establish if the obligation is a primary obligation or a secondary obligation.  A primary obligation would, for example, be an obligation to pay for services (even if a part of that payment is contingent on future behaviour, as it was in Cavendish) provided under a contract; a secondary obligation would be an obligation to pay liquidated damages on breach.  Only if the clause is a secondary obligation can it be a penalty, as the English courts will not interfere in the parties’ original commercial bargain.

The second task is then to investigate the legitimate interest of the innocent party in the enforcement of the clause.  In Cavendish, for example, this focused on the interest of the buyer in ensuring that the seller adhered to certain restrictive covenants to ensure that the goodwill in the value of the company’s shares was preserved.

JOA forfeiture provisions take many forms.  However, most operate on the basis of certain key principles.  First, they apply to circumstances where a contractor has failed to pay its share of costs when due.  Second, they require the other contractors to pay the defaulting contractor’s share of costs, pro rata to their participating interests.  Third, where the default remains unremedied, the defaulting contractor is required to assign (or “forfeit”) some or all of its participating interest to the non-defaulting contractors.

Whether such provisions amount to primary obligations under the JOA will be determined by the wording used.  Generally, those we have seen more naturally fall within the category of secondary obligations.  However, the legitimate interest of the non-defaulting contractors will be similar across most JOAs; the continuity of the operations and compliance with their obligations to the Government that has granted them rights in the given contract area.  The non-defaulting parties will argue with some force that these legitimate interests justify the partial or complete exclusion of a party that is unwilling to bear its share of costs, particularly where the innocent contractors have had to bear those costs themselves.

Whether the forfeiture provisions are proportionate to these legitimate interests will depend on their precise terms and, importantly, the commercial context.  Some commentators have suggested that it may be easier to argue that forfeiture is proportionate where costs incurred are relatively low and the prospects for the contract area uncertain, for instance during the exploration phase of operations.  This is one reason for the range of remedies often to be found in JOAs, where mandatory assignment and withdrawal provisions may be accompanied by buy-out and withering interest options.

It remains to be seen to what extent Cavendish has affected the enforceability of JOA forfeiture provisions.  Whilst the Supreme Court’s focus on legitimate interests over genuine pre-estimate of loss or deterrence is undoubtedly helpful for parties seeking to enforce such provisions, it may be argued that English case law had already been moving in that direction.  More recent case law had, for example, tended to focus on the commercial justification for the sums payable; the legitimate interests test is arguably an extension of this.  Non-defaulting contractors would likely have deployed the same (persuasive) arguments in support of a commercial justification test as they now would in support of their legitimate interests.

Further, two English law principles that are key to analysing JOA forfeiture provisions were established long before Cavendish.  The first is that, where a contract has been negotiated by properly advised parties of comparable bargaining power, there is a strong presumption that they are the best judges of what is legitimate and that the court should therefore not interfere (Philips Hong Kong Ltd v Attorney General of Hong Kong (1993) 61 BLR).  In the sophisticated world of oil and gas exploration and production, the vast majority of contracts will meet this description.

Second, Lord Dunedin made clear in Dunlop that the analysis of whether or not a clause is a penalty must be carried out at the time the contract was entered into, not at the time of breach.  In addition, he emphasised that the fact that it may be difficult to estimate what the true loss would be is no obstacle to enforceability (and may, indeed, be a reason to uphold the parties’ original bargain).  In JOAs, the loss suffered by the non-defaulting contractors as against the value of the interests to be forfeited by the defaulting party may well be difficult (if not impossible) to estimate at the time the JOA is entered into, which may help persuade a court to uphold the terms agreed.

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Does the Supreme Court’s ruling in Cavendish increase the likelihood of JOA forfeiture provisions being enforceable?

Know your JOA: top 10 tips for anxious partners in upstream oil and gas joint ventures

A year dominated by the story of low oil prices is drawing to a close amid predictions that the pressures on upstream oil and gas companies’ financial positions may well intensify through 2016.  For those who may be concerned about the financial health of their joint venture partners, we offer below a quick guide to taking stock of where you stand under your Joint Operating Agreements (JOAs) to put you in the best position to deal with any emerging problems.

Know what the JOA says about default

Most JOAs contain an unqualified and absolute obligation on a party to pay all cash calls, pre-funding and invoice requests.  But check if a partner is in trouble, it may try to dispute the validity of payment obligations – most JOAs depend on a ‘pay now argue later’ formulation – but it’s worth checking.

If the operator is in trouble

Check that the JOA allows a non-operator to issue a default notice and ask for all joint account statements. The JOA should require the operator to provide periodic information on funding the joint account to evidence that non-operators and the operator are funding their participating shares.

The operator is not responsible for a shortfall

Do not suppose the operator’s functions extend to funding any default – they will almost certainly not.  The non-defaulting parties will be liable for the defaulting party’s share in proportion to their respective shares and non-payment of the additional share will be a default event itself.  The operator may be able to borrow funds instead – this may be a more attractive means of funding any immediate work commitments, so talk to the operator.

Know the short-term remedies

The defaulting party will cease to have voting rights – and a non-defaulting party’s rights at OPCOM will increase proportionately.  Other entitlements will be lost as well: the right to information, the right to transfer an interest or withdraw.  Again, check the JOA.  The prohibition on transfer should be at the non-defaulting party’s discretion – there may be a willing buyer and the advantage of a quick sale.

What happens to the petroleum?

Rights over petroleum entitlements will be lost as well. Check what the operator’s obligations are – usually to sell the defaulting party’s petroleum on the best terms available to offset against the shortfall.  Non-defaulting parties will want transparency on this and no sweetheart deals with the operator’s affiliates.

What happens next?

Here’s where JOAs differ in approach, so it’s important to know the process. Options include compulsory withdrawal, interest sales, mortgage security enforcement and forfeiture. The process for enforcing additional remedies will be spelt out in the JOA.  Timing, and the role and exposure of the non-defaulting parties will differ depending on the form of the sequestration sanction.

Mortgage security enforcement

This avoids the uncertainties with forfeiture and is potentially attractive.  The non-defaulting parties have a secured interest – and can rank ahead of unsecured creditors.  But it can be problematic in some respects, multiple charges need to be registered and commercial lenders to the defaulting party may have some priority.

Interest sales … what needs to be passed over

Know what deductions can be made from the sale price beyond the amount in default. It is easy to justify all associated costs of the sale, marketing, legal and so on.  However, any deduction that cannot be easily justified (such as fixed percentage deduction) may look like a penalty – and that can be problematic.

A slippery slope

Forfeiture – i.e. distribution of the defaulting party’s interest to the others.  Fine in principle, but it only works if all the non-defaulting parties are willing to assume an additional burden.  If others won’t do this, the situation can rapidly worsen – with other parties withdrawing and the handback or surrender of the concession.  This can be off-putting to buyers – have the sellers got good title?

The ultimate sanction … perhaps not

Forfeiture comes with baggage – how effective is it?  Not commercially justifiable – so perhaps a penalty?  Or an unfair preference over unsecured creditors, such that a private contract defeats the law of insolvency?  Not straightforward and plenty of scope for mischief by those in default.

If you would like to discuss any of the issues raised above, please do not hesitate to get in touch with the author or any of your other regular contacts in the Dentons oil and gas team.

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Know your JOA: top 10 tips for anxious partners in upstream oil and gas joint ventures