Category Archives: Lawsuit Issues in Due Diligence

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

August, 2018

-Installment 2 of 3-

With the price of natural gas being close to historically low, it hardly seems worthwhile to hit on the subject of gas imbalances at the closing of a PSA.  But, in this lawsuit tale, there are several lessons to be learned, to avoid getting into a lawsuit. After being in the business 38 years, I have seen too many lawsuits that could have been avoided had both the parties, the seller and the purchaser, performed correct due diligence prior to the closing of the sale. This is the second step to follow if you want to get into a lawsuit (and possibly commit professional suicide).

Step Two: Ignore the Discomfort of Gas.  https://youtu.be/VPIP9KXdmO0

Background:
In July, 2001, Wapiti Energy, L.L.C. (“Wapiti”) entered into a purchase and sale agreement (“PSA”) with Petro-Hunt, L.L.C. (“Petro”) for the sale of Petro’s interest in a producing oil and gas property located in the Conroe Field, Montgomery County, Texas.  In that PSA, Petro represented and warranted that none of Petro’s interests being sold were “overproduced” relative to the other interests in the property. Overproduction is a liability on a working interest and represents an “imbalance” where a party’s interest is not produced according to that party’s share of ownership in the well.* The PSA required Wapiti to assume all liabilities associated with Petro’s interest.  As is common with many PSA’s, a “Final Settlement” takes place after the closing date of the PSA, to reconcile monetary issues related to production revenues and imbalance valuations.

After the closing date of the PSA, ExxonMobil (“Exxon”), the Operator of the property in question, informed Petro that Petro’s interest was overproduced by an “undetermined” amount. Petro informed Wapiti of this fact on October, 2001, before the Final Settlement date. Both parties acknowledged that the overproduction was a breach of Petro’s warranty under the PSA and that it lessened the value of Petro’s interest being sold to Wapiti.  Because of the looming deadline of the Settlement Date and the knowledge that Exxon could not arrive at an overproduced amount before then, the parties agreed to an additional agreement (“Extended Settlement”) that allowed for one more adjustment that would address gas imbalances to be reconciled once the overproduction amount was known.  In the Extended Settlement, both parties agreed that $3.70/MMBTU was the price any overproduced amount would be valued at.

In November, 2002, Exxon delivered its report on the overproduction amount to the parties indicating the overproduced amount was 115,518 MMBTU’s.  A few months later, Wapiti contacted Petro to reconcile the imbalance with an adjustment and close the books on the sale.  Because there was some disagreement on the amount of overproduction that Exxon reported, Petro refused to pay Wapiti for the imbalance.

On October 14, 2005, Wapiti filed suit against Petro to recover payment for the overproduced gas.  In the months leading up to the lawsuit, Wapiti had acquired other interests in this field, including the interest of Exxon. In the Exxon transaction, the Exxon interest was underproduced, to which Wapiti paid an additional amount for.

In 2009, Wapiti sold all of its interest in the Conroe Field to Denbury Resources, Inc. Wapiti claimed that it received less in the way of consideration for this sale because of the overproduced interest.  Petro disputed that claim, saying Wapiti, because of its prior acquisitions, had a net underproduced interest during the time of the sale.

Through years of legal maneuvers by both parties the trial court eventually found Petro had beached the Settlement Extension and awarded Wapiti $424,811.80 in damages for the overproduced position as well as prejudgment interest, taxable costs of court, and post-judgment interest, with the final judgement being entered on August 26, 2010.  The judgement was upheld in 2012 through subsequent appeals by Petro.

*Note: Overproduction is where a party does not take gas attributable to its share of production and instead, that gas production is allocated to another working interest owner in the well, where it is sold. In that instance, the interest attributable to the party not taking the gas is “underproduced”.  The interest of the party that did take the gas is thus “overproduced”.  An overproduced interest represents a liability on that party’s interest, because that party must either pay the underproduced party back in gas, or in cash.  Usually, a Gas Balancing Agreement, attached as an exhibit to a Joint Operating Agreement, governs the taking of production and the method of balancing that production imbalance between the parties.  Many times, reconciling of the imbalances can occur at the depletion of the well, where upon a cash amount, attributable to the imbalance, is given to the underproduced party.

Discussion:
There are several lessons here:

  1. If you are a Seller, never represent and warranty something you are not completely sure about. The way to be certain about a representation one is considering making is to perform proper due diligence to confirm that representation before you make it.
  2. If you are a Buyer, never rely on a warranty or representation: in fact, good due diligence researches all representations and warranties, sometimes even before a PSA is executed.
  3. When reconciling with a post settlement after the closing of a PSA, its important to get everything reconciled, even in the case of imbalances that might not be known with any certainty. Imbalances are not rocket science and can be estimated using revenue stubs and production runs with pretty close certainty.  In the era of depressed gas prices, the cost of any error is low (compared to the cost of possible litigation to collect).
  4. The longer you wait to reconcile any amounts under a PSA (whether its defect amounts, gas imbalances or other issues), the higher the chance one party will breach a settlement agreement. I make this last statement based on experience.

All of these issues point to failures in the due diligence process.  Presumably there was a period to conduct due diligence before the closing of the sale (if not, then that would more adequately explain this mess).  In that due diligence period, Wapiti could have requested pay stub information from Petro and could have easily calculated an approximate amount of the imbalance burdening Petro’s interest.  Yes, I know there are issues with processing costs, settlements and net backs that need to be taken into account, but even still, you can estimate those.  The judgment awarded Wapiti was a little over $424K and that included attorneys’ fees, damages and interest.  If you were to calculate the actual dollar amount of the overproduced gas, based on the gas price agreed to in the Extended Settlement and the overproduced volume Exxon reported, that comes to $427K, which is greater than the judgment.  So it would appear that Petro had legitimate concerns about the amount of overproduction that Exxon reported, or that as Petro asserted, Wapiti’s acquisitions in this field diminished the amount of the overproduced interest, issues that apparently the court took into consideration in its monetary award. It is unknown if any attempt to agree to an overproduced amount was made by the parties before the final settlement date, but it would appear that someone came up with the idea of having a side agreement to have another settlement when the final overproduced amount was arrived at by Exxon.  On the surface, that would seem a practical approach, to have another settlement when the final amount is known. The reality is this: if parties don’t settle monetary issues within the confines of the PSA and either a deadline of a closing date or a settlement date, instead delaying the day of reckoning, the chances increase someone is going to breach the agreement.  Even if Wapiti had to take a “haircut” on the amount of overproduction, I would assert that given the time from 2001 to 2012, when the final judgment was rendered, if Wapiti and Petro had agreed on an overproduced volume based on estimates, Wapiti would have had that money in hand and could have earned interest on it in the 11 years it took to collect (plus not have expended attorney’s fees and litigation costs), coming out ahead of the game.

From Petro’s side, how hard would it have been to run some preliminary due diligence on their gas sales and discover even a hint that their interest was overproduced?  Just a hint would have kept them from warranting that there was no overproduction and put in place a way to value and deal with any imbalance in the PSA.  This is a lesson that applies to not just gas balancing, but land issues, too.

Representations and warranties are always a red flag for me when I perform due diligence.  In one transaction I ran a due diligence team on, a mineral transaction, the Seller made representations as to what minerals were leased and unleased.  That opened the door for us: because how many chains of title are riddled with unreleased oil and gas leases, whose status is unclear?  Needless to say, such a claim created nothing but multitudes of clouds of title.  In fact, there were many interests that were claimed to be unleased, that were indeed under an in-force oil and gas lease and vice versa. 

I like takeaways.  The takeaway on this tale: run your diligence seriously, as a Seller and as a Buyer.

 

DISAGREE OR AGREE?  PLEASE TELL US YOUR OPINION.

 

 

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

By: Russ Darbyshire, Mesilla Energy Acquisition LLC
www.mesillaenergy.com
May, 2018
-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
Background:
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.

Discussion: 

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.

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