By: Russ Darbyshire, Mesilla Energy Acquisition LLC
-Installment 1 of 3-
There appears to be a new breed of Landmen and Attorneys in the oil and gas industry that either view due diligence as unnecessary, not worthy as an in-depth endeavor, or rationalize that due diligence before an acquisition is not needed because of a title warranty. Over my 38 years in the oil and gas business, I am familiar with either legal action or financial disasters resulting from very lax divestment-acquisition practices, all involving either a herd mentality, financial considerations that create pressures and time lines to expedite deals or funding that is so easily obtainable as to create sloppiness. The step-by-step guide below explains how to get into a lawsuit (and possibly commit professional suicide) is based on true fact scenarios.
Step One: The AMI “Comb Over”. https://youtu.be/Oyf7dUbK7VE
In early 1990, three parties, The Wiser Oil Company (“Wiser”), Roger Chapman (“Chapman”) and J. Charles Hollimon (“Hollimon”), along with other contributing parties, entered into a Joint Operating Agreement (“JOA”) to govern the acreage acquisition and subsequent drilling of the Donie Prospect in Freestone County, Texas. The JOA contained a common provision used to develop oil and gas prospects when several partners are involved: an Area of Mutual Interest (“AMI”) provision. The AMI provision offered a way for all the parties to share in an acreage acquisition by paying their proportionate share of the acreage cost to the party that acquired the acreage. Usually, it is the Operator of the JOA that acquires acreage, but any party to the JOA can acquire acreage, with the obligation to offer the other partners their share of that acreage acquisition. The transaction is consummated when that partner pays its share of the acquisition costs, as dictated by the terms in the AMI provision. As is common in the industry, the AMI provision contained a map of the Donie prospect area, with a red line around the prospect area, to define the area where the AMI provision applied. By letter agreement dated April 17, 1991, Wiser, Chapman and Hollimon further modified and clarified the AMI provision.
On May 25, 1999, Finley Resources Inc., along with another party (collectively “Finley”), purchased the interests of Wiser in the Donie Prospect, thus binding Finley to the terms of the JOA. Subsequently, Finley purchased other interests from the original parties in Donie. On February 12, 2001, XTO Energy, Inc. (“XTO”) purchased certain formation intervals in Donie from Miller Energy, Inc., who derived its interest from Chapman and Hollimon. XTO was aware of the JOA and understood that is was bound by its terms, including the AMI provision.
However, XTO had a different interpretation of the AMI provision in the JOA. XTO interpreted the AMI provision to apply to only the acquisition of new oil and gas interests from third parties not a party to the JOA, that is interests not originally dedicated to the JOA and AMI. Finley took issue with that interpretation, taking the position that interests previously acquired that had expired, that were renewed or reacquired by XTO should be treated as “new” interests and offered to the parties under the AMI provision. XTO, before becoming subject to the JOA, had acquired interests in the area that were not bound by the JOA. Obviously, this disagreement between Finley and XTO occurred when XTO acquired interests that had expired that were previously owned by the other parties to the JOA and acquired other interests in the area before being bound by the JOA, then subsequently refused to offer these interests to the other parties under the AMI provision. Finley filed suit against XTO to enforce the provisions of the AMI provision.
XTO’s defense in the lawsuit, for the most part, was built around these arguments: 1) that the description of the AMI, that is the map with the red outline, was inadequate and failed to meet the Statute of Frauds and thus rendered the AMI provision unenforceable; 2) that the AMI provision only applied to new interests, not interests previously committed to the AMI that had expired or interests acquired before XTO was bound by the JOA; 3) that there was disagreement and ambiguity among the original parties to the AMI as to who was bound by the AMI provisions and that there was an attempt to terminate the AMI by some parties; and 4) the Statute of Limitations bars some or all of the claims made by Finley.
In motions for summary judgements by both parties, the judge in the case made some pre-trial rulings that in summary said: the AMI provision was enforceable and though the Statute of Limitations was applicable, the defense of estoppel/waiver/unclean hands/Laches was denied. The judge did allow that the claims of Finley concerned him, but only as to the ownership percentages being asserted and would have to be settled during the damages phase of the trial.
On March 1, 2007, this suit was dropped, because the litigants reached an out-of-court settlement.
Disclosure: I was a consultant for The Wiser Oil Company during the mid-1990’s and actually did work on the Donie Prospect. The above described case was well after my tenure there and the facts recited above were taken from court filings and pleadings. I do not have a copy of the JOA in question and therefore can offer no comment on the clarity of the wording of the AMI provision.
By now, if you have read this far, you are wondering what this case has to do with performing divestment and acquisition due diligence. You can always tell, with a high probability, that a company did not perform due diligence on an acquisition, by the defense their lawyers are using, probably forced on them by the circumstances. The defense by XTO in this case was suspicious and one could reasonably conclude that XTO was just buying up interests left and right in this area and not running due diligence. Though XTO claimed they were aware of the JOA and AMI, but they could have not been given their behavior. Also, the JOA in question must have been mentioned in the records (probably in an assignment). If it had not, XTO could use the defense they did not have constructive notice, but they did not. XTO tried to create doubt about the AMI wording in the JOA, which ultimately the judge did not buy. So, if XTO had performed due diligence, they would have identified any issues with the AMI upfront, and in any PSA process, declared that a defect to be cured by the Seller. In all probability, XTO could have avoided this lawsuit by performing due diligence on their acquisitions in this area and addressing the problems their defense of this lawsuit raised, before a closing. It’s not good practice to perform your due diligence after you have been sued!
But this type of mess-up is not uncommon. I am aware of a recent case where an oil and gas company (“Acquiring Party”) purchased a substantial interest in a prospect from the Operator and other partners. This prospect had an existing JOA with an AMI provision. The management of this AMI was such that an original partner (“Partner”) was making claims of not being offered its option to purchase acreage acquisitions under the AMI, as well as being denied the opportunity to participate in the drilling of wells and had in fact, filed suit against the Operator. In a succession of acquisitions from the Operator over time, the Acquiring Party apparently failed to investigate how the Operator had complied with the provisions of this AMI (which is the only logical conclusion, because the Acquiring Party consummated all the acquisitions). The Partner making the claims of being denied rights under the AMI filed suit against the Acquiring Party after the final acquisition, seeking compensation and damages for its interest in wells and acreage it should have had under the AMI, an interest that had been sold to the Acquiring Party. The AMI provision in the JOA only had a map describing the AMI, but this did not appear to be a determining factor in the litigation. The Partner’s claims were eventually validated and a settlement was agreed to by both parties out of court.
Here’s the takeaway from all of this: AMI’s, if not worded near perfectly and if not administered near perfectly, are more than likely going to be, if not an immediate problem, a “sleeper” problem. In fact, If you are an Operator selling prospects that have an AMI, and you have investors and stockholders, you have a fiduciary responsibility to them to run divestment due diligence on your properties to catch these types of issues up-front (as well as other potential deal blowing issues) before putting these properties on the market. If you are a buyer of properties, unless you want a lawsuit, its sheer negligence not to run acquisition due diligence on potential properties to be acquired that have AMI’s.
So what about the defense of XTO that the map in the AMI provision did not meet the Statute of Frauds? This actually is a legitimate defense, or at least it’s a defense that worked in other cases. While in this case the judge did not allow, or at least discounted that defense, someone else has apparently used it successfully. Subsequent legal rulings after this case do support that the Statute of Frauds requires that the property in question be unambiguously described and that standard requires that a legal description of the acreage in the AMI be used and NOT a map. AMI’s are a common litigation target. The description of the AMI is just one of 5 common issues with AMI’s that are targets for litigation. For more detail on this issue, please refer to this commentary: https://castaneda-firm.com/wp-content/uploads/2017/09/Litigation-Issues-in-Area-of-Mutual-Interest-Agreements-final.pdf .
WE WOULD LIKE TO KNOW YOUR EXPERIENCE WITH AMI’S PURCHASED IN AN ACQUISITION.