NOT PERFORMING DUE DILIGENCE ON OIL AND GAS ACQUISITIONS: A GUIDE TO GETTING INTO A LAWSUIT

By Russ Darbyshire
Mesilla Energy Acquisition LLC
www.mesillaenergy.com
July 2019
-Installment 3 of 3-

I used to have a Land Manager boss who would tell me, “The Maintenance of Uniform Interest clause in the Joint Operating Agreement (‘JOA’) is never enforced.  Don’t worry about it.” He was right, at that time, no one paid much attention to the Maintenance of Uniform Interest (“MUI”) clause in JOA’s.  Historically speaking in this business, it was never enforced. As is always the case, things change.

As this lawsuit tale shows, MUI’s, as well as other clauses in the JOA concerning transfers of interest, deserve attention in a due diligence effort, especially if they have been modified.  This is the third step to follow if you want to get into a lawsuit (and possibly commit professional suicide):

Step Three: Don’t Worry About it, Because it’s Never Enforced!

Background:

On August 15, 1983, ExxonMobil Corporation (“Exxon”), as Operator,
and Getty Oil Company, et al, entered into a JOA. The JOA covers a
contract area known as the Gladewater Gas Unit #16 (“GGU”) in Montgomery County, Texas. Later, Valence Operating Company (“Valence”)
succeeded Getty Oil Company under the JOA, with Exxon remaining the Operator. As Operator under the GGU, Exxon owned an 81.8% working interest.  Valence owned an 18.2% working interest.  Prior to Valence succeeding Getty, the working interests under the JOA had drilled three producing gas wells to the Lower Cotton Valley formation, the production of which was holding and maintaining the GGU.

The original parties to the JOA modified the MUI clause as shown below:

“E. Maintenance of Uniform Interest:

For the purpose of maintaining uniformity of ownership in the oil and gas leasehold interests covered by this agreement, and Notwithstanding any other provisions to the contrary, no party shall sell, encumber, transfer or make other disposition of its interest in the leases embraced within the Contract Area and in wells, equipment and production unless such disposition covers either:

1. the entire interest of the party in all leases and equipment and production; or

2. an equal undivided interest in all leases and equipment and production in the Contract Area.

Every such sale encumbrance, transfer or other disposition made by any party shall be made expressly subject to this agreement, and shall be made without prejudice to the rights of the other parties.” (Note: the rest of the MUI clause is not recited here, because it is irrelevant to our discussion.)

In 1996, Exxon entered into a farmout agreement (“Farmout”) with Wagner & Brown Ltd and C. W. Resources (collectively “the Farmees”), which gave the Farmees the right to drill in the GGU to test the Upper Cotton Valley formation, a non-producing formation whose depth was shallower than the already producing Lower Cotton Valley formation.  That Farmout gave the Farmees the right to earn a portion of Exxon’s leasehold interest, upon completion of a producing well in the Upper Cotton Valley formation. It was known by all the working interests in the GGU that there were reserves behind pipe in the existing producing gas wells (specifically in the Upper Cotton Valley), meaning there was untapped potential production in formations up-the-hole from the producing formation in the producing wells.

After execution of the Farmout, the Farmees gave notice to Valence of their intent to drill two wells. Not knowing the Farmees had any relationship with the GGU and knowing that the Farmees were not a party to the JOA, Valence made a written inquiry to Exxon about the well proposals sent by the Farmees.  Exxon at that point informed Valence of the existing Farmout. Valence did not respond to the first two well proposals sent to them by the Farmees and had their interests deemed non-consent under the JOA (non-consent meaning Valence’s interests in the well were taken over by parties participating in the drilling of the well, with Valence being able to come back into the wells’ revenue stream at a certain point in the future).

The Farmees proposed three more wells to Valence.  Valence participated in those three wells, “under protest”.

In March, 1998, Valence filed suit in the Harris County 198th District Court of Texas, against Exxon for breach of contract, alleging that Exxon’s Farmout to the Farmees breached the modified MUI of the JOA. Valence alleged that the modified MUI only allowed Exxon to either convey an undivided interest in its entire leasehold in the GGU, or 100% of Exxon’s entire interest in the GGU, but that Exxon could not convey a partial depth limited interest in the GGU.  Valence further contended that the reserves in the Upper Cotton Valley formation could be accessed in the current producing wellbores and that drilling new wells subjected Valence to non-consent penalties under the JOA, as well as causing Valence to spend more money to drill new wells to the Upper Cotton Valley than Valence otherwise would have had to spend re-completing the existing wells in the Upper Cotton Valley formation. Valence sought to recover the non-consent penalties it had incurred, as well as the difference between the cost of drilling new wells to the Upper Cotton Valley and the cost of recompleting the existing wells in the Upper Cotton Valley. Additionally, Valence sought not only attorney’s fees, but pre-trial interest and penalties on the damages in question.

The Farmees fulfilled the terms of the Farmout and on October 8, 1998, received an assignment of leasehold (“Assignment”) from Exxon, which conveyed all of Exxon’s right, title and interest in only Exxon’s leasehold, down to the base of the Upper Cotton Valley, reserving any formations below the Upper Cotton Valley to Exxon, with Exxon retaining an overriding royalty interest (“ORRI”) on all production. In the Assignment an option was given to Exxon to either increase the ORRI to a larger amount, or convert the ORRI to a working interest at a defined payout of each well drilled by the Farmees, to be exercised on a well-by-well basis. The date of the Assignment is important because Valence filed suit against Exxon before any conveyance by Exxon to the Farmees.

A trial was initially scheduled for February 18, 2000 but was postponed by the parties.  In that postponement process a “Rule 11” agreement was reached, an agreement that had stipulations and deadlines for amended pleadings and discovery leading up to the trial.  There was later on, contention and disagreement about this Rule 11 agreement when Valence amended its initial pleadings in the case, to which Exxon objected. Since this disagreement has no bearing on the issues being discussed, no attention will be given it in this writing, except to say the court ruled in Valence’s favor on these issues.

Exxon’s defense was that it did not violate the modified MUI of the JOA because no conveyance had been given to the Farmees at the time the suit was filed by Valence and even if there had been a conveyance, there was no violation of the MUI because Exxon only conveyed an interest in Exxon’s leasehold and not in wells, production and equipment.  Exxon’s contention was that by modifying the MUI as was done, the intent of the original parties to the JOA was not to maintain a “uniform” interest. Exxon further contended that the modified plain language of the MUI only applied to the sale of a party’s interest in leases AND in wells, production and equipment; and since Exxon’s Farmout and Assignment to the Assignees only covered Exxon’s interest in leasehold (and not wells, production and equipment), there had been no violation of the MUI.

Valence counters that Exxon’s interpretation of the modified MUI corrupts the true meaning of the modified MUI. While Exxon had not yet delivered an Assignment when the lawsuit was filed, Valence maintained that the Farmout was adequate proof of a coming conveyance of interest by Exxon. Valence alleges that the original parties’ modification of the MUI that struck references to “maintenances of uniform interest” were only because the parties did not have uniform interests to maintain.  Valence indicated that the altered MUI was intended to maintain the interests the parties contributed when the JOA was executed.  Further, Valence argued that the modified MUI required a party to transfer either an undivided or 100% interest in the leasehold, wells, equipment and production and if that is not adhered to, there is no way to maintain any party’s entire interest in the leases and the provision is essentially meaningless if a party can convey an entire interest in only a portion of a lease, as Exxon did. Valence pointed out that Exxon’s claim it only conveyed an interest in Exxon’s leasehold is false, that with that conveyance of leasehold came the right in wells, production and equipment.

In addition, Valence offered these arguments during the trial process:

1.  Pertaining to the damages regarding the modified MUI, the paragraph preceding the modified MUI in the JOA, Article VIII, entitled, “Acquisition, Maintenance or Transfer of Interest” states in part: “The leases covered by this agreement, insofar as they embrace acreage in the Contract Area, shall not be surrendered in whole or in part unless all parties consent thereto…. However, should any party desire to surrender its interest in any lease or in any portion thereof, and other parties do not agree or consent thereto, the party desiring to surrender shall assign, without express or implied warranty of title, all of its interest in such lease, or portion thereof, and any well, material and equipment which may be located thereon and any rights in production thereafter secured, to the parties not desiring to surrender it.” Exxon never gave Valence the chance to consent to Exxon’s ultimate Assignment, nor the opportunity to surrender Exxon’s interest to Valence if Valence did not agree to Exxon’s Assignment to the Farmees.

2.  Pertaining to the damages concerning non-consent, Valence argued that the JOA requires any party that intends to drill a well to give notice to the other parties, stating the particulars of that proposed wells (cost, objective depth, etc).  Once notice is received, the parties have 30 days to make an election.  Clearly, Exxon did not do that, with the two parties that were not part of the JOA attempting to provide notice.

There were other arguments and pleadings on other legal points, but the above is a concise summary of the main arguments.

After a bench trial on March 5, 2002, the court found for Valence on all points, awarding Valence $310,867.28 in damages for the cost of having to drill new wells, $523,432.00 for damages incurred in going non-consent in the first two wells, pre-trial interest and attorney’s fees. 

Exxon appealed this decision to the 1st District Court of Appeals in Houston in 2005, but the appeals court upheld the lower court decision on all counts.

Discussion

The point here is: During a due diligence project, never overlook the Maintenance of Uniform Interest, or any other clause dealing with transfers of interest, that are in a JOA that covers an interest a company is buying, or selling.  Always check the conveyance history of an interest that is being sold to see if it matches with the original interest that was contributed to the JOA when executed. Also, if a MUI clause is altered, don’t assume a meaning, as in this case, when interests have been conveyed out by a working interest owner.  One may argue that the statute of limitations will cover any transgression committed by a party under a MUI clause if that transgression was in the distant past, but that is not always the case.  All trial lawyers have a ready argument about why a statute of limitations can be tolled.

If you are a Seller, selling your working interest in production and if in the history of your ownership you have violated the MUI in a JOA, that is a potential lawsuit waiting to happen.  From the standpoint of Seller’s due diligence, this should be an item to remedy before a sale and before a possible suit is filed by an aggrieved party.

On the buying side of a working interest, one may also ask, “In this instance how would this type of violation of the MUI that Exxon committed affect due diligence and create a title defect?  Valence received monetary damages and usually a PSA would confine liability derived from after sale litigation to the Seller.  If you are a Buyer, this would not affect you.”

Let’s look at this suit a little closer.  Valence received monetary damages from the court based on their calculations of being subjected to a 200% payout on 2 producing wells. That 200% figure is the 300% non-consent penalty minus 100% at well payout. The court awarded Valence those damages based on that calculation, erasing the payout penalty. It can be assumed that Valence got back its working interest (and with that its revenue interest) in those two producing wells at 100% payout. That’s the practical effect of this award. So even though the Seller would be responsible for the monetary liability incurred with this type of lawsuit post-closing on a sale, the interest purchased by the Buyer is suddenly reduced after the fact. A potential reduction of interest from what a Seller has represented in a sale is usually a pretty standard defect under any PSA.

As I look back on my history of running due diligence projects when I was consulting, I never was instructed by my client to check the conveyance history of the interest under the JOA to verify if there was a violation of the MUI clause or for that matter, any other clause in the JOA that a conveyance of an interest could affect.  That was because at the time, the belief in the industry was that these were issues that hardly ever came up and if they did, these clauses were never enforced.  As this case proves, these types of issues can come up and prudent due diligence dictates that MUI and transfer of interest clauses must be checked for compliance. 

error: Content is protected !!