LESSONS LEARNED FROM RECENT JOA DISPUTES. Jana Grauberger Liskow & Lewis. Greg Mathews Chevron. The more I know, the less I understand.

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1 I. INTRODUCTION LESSONS LEARNED FROM RECENT JOA DISPUTES Jana Grauberger Liskow & Lewis Greg Mathews Chevron The more I know, the less I understand. 1 Many an oil and gas lawyer dealing with a JOA dispute may experience a moment or two like this. Even though the JOAs that often serve as the basis for joint operations are model form agreements, the types of problems that arise and the meaning given to model form JOA provisions continue to evolve. And, sometimes the results are unexpected. This presentation examines recent judicial decisions involving JOA issues and is intended to include a heavy dose of practice tips and lessons learned in an effort to better prepare all of us to be able to avoid, anticipate, and adeptly handle JOA issues and disputes. II. LIABILITY UNDER THE JOA AFTER ASSIGNMENT A. Seagull Energy E&P, Inc. v. Eland Energy Inc. Seagull Energy, 2 is a much-discussed Texas case allowing an operator to recover current joint account expenses related to plugging and abandonment of two wells from the predecessor of one of the current non-operating working interest owners. 3 In Seagull Energy, the operator and lessee of two federal offshore Gulf of Mexico leases, Seagull Energy, brought a breach of contract suit against its co-lessee, Nor-Tex Gas Corporation for failure to pay its share of the lease operating costs as required by the two operating agreements between the parties. Nor-Tex had purchased its interest in the leases from Eland Energy, and Seagull also named Eland as a defendant in the lawsuit. On cross motions for summary judgment, the trial court held both Nor-Tex and Eland jointly and severally liable to Seagull for the unpaid operating expenses. 4 The court found that Eland remained liable for the expenses even though it no longer owned an interest in the leases. 5 The court of appeals reversed, in part, concluding that Eland had no continuing liability 1 Don Henley, Heart of the Matter, The End of the Innocence, S.W.3d 342 (Tex. 2006). 3 For an in-depth consideration of the Seagull Energy decision, see David Patton, Bad Moon Rising The Continuing Liability of an Assignee After Assignment, 53 ROCKY MTN. MIN. L. INST (2007)

2 under the operating agreements after it assigned its working interest to Nor-Tex because the agreements had no express provision imposing an obligation of continuing liability. 6 On review before the Texas Supreme Court, Eland argued that its responsibility for reimbursement of operating expenses terminated on the date it assigned its interest to Nor-Tex. Eland based its position on several provisions in the operating agreements that tied its obligation for payment of expenses to its participating interest, which was based on its ownership in the leases. For example, the contract provision concerning expenditures stated that the Operator shall pay all costs and each Party shall reimburse Operator in proportion to its Participating Interest. 7 The Texas Supreme Court rejected Eland s arguments finding it significant that none of the provisions relied upon relating to sharing of costs and participating interests dealt with the subject of release or the consequences which are to follow the assignment of a working interest. 8 Instead, the court found nothing in the contracts expressly releasing the assignor upon assignment of its working interest, and, as a result, the general rule that a party cannot escape its obligation under a contract merely by assigning the contract to a third party was applied: Because the operating agreement did not expressly provide that Eland s obligations under the operating agreement should terminate upon assignment and Seagull did not expressly release Eland following the assignment of its working interest, we reverse the court of appeals judgment and render judgment for Seagull as the trial court did. 9 Significant to the Seagull Energy decision are several facts not mentioned in the Texas Supreme Court s opinion, namely, that Nor-Tex was bankrupt, and that it had acquired Eland s interests for $500 each at an auction with no minimum bid, which raised a significant policy issue of the propriety of allowing a party to assign away its interests in a lease once production waned to a financially insolvent party for minimal consideration in order to avoid plugging and abandonment obligations under the lease. 10 It is also significant that the leases involved were federal OCS leases, which allow the federal government s MMS to look to present owners, as well as any prior interest owners, in relation to plugging and abandonment responsibilities. 11 The result under the particular facts may not be undesired, but the purchase and sale agreement whereby Nor- Tex was assigned Eland s interests like virtually every other PSA stated that all 6 at at at at The form of the operating agreement at issue was not identified by the Texas Supreme Court or the court of appeals. The operating agreement provisions cited by both courts do not appear to be A.A.P.L. model form JOA provisions. 10 Eland Energy, Inc. v. Seagull Energy E&P, Inc., 135 S.W.3d 122, 129 (Tex. App. Houston [14th Dist.] 2004), rev d, 207 S.W.3d 342 (Tex. 2006). 11 See, e.g., 30 C.F.R , ,

3 obligations related to the interests passed to Nor-Tex as of the assignment date. 12 Accordingly, post-seagull Energy, assignors of oil and gas interests need to pay close attention to their operating agreements and negotiate for the inclusion of language providing for an express release upon assignment or achieve the same result through an addendum or side agreement at the time the assignment is made. B. GOM Shelf, LLC v. Sun Operating Ltd. Partnership In the recent GOM Shelf 13 decision, a Texas federal district court relied upon Seagull Energy to again allow an operator to recover plugging and abandonment costs incurred in connection with a federal offshore Gulf of Mexico lease from assignors under circumstances where the current working interest owner and its predecessor-in-interest were in bankruptcy. Sun Operating Limited Partnership acquired a 50% interest in the lease in It conveyed the interest to TDC in TDC assigned 12.5% of the interest to Online Resources, Inc. also in In 1998, TDC assigned its remaining 37.5% interest to Cronus Offshore, Inc., and Online Resources also assigned its 12.5% interest to Cronus Offshore, which resulted in Cronus having a 50% interest in the lease. GOM Shelf, LLC acquired the remaining 50% interest in the lease in 2000, and was designated operator. Shortly thereafter, between 2002 and 2006, GOM Shelf paid 100% of the plugging and abandonment costs for the lease. Because Cronus had filed for bankruptcy, GOM Shelf was unable to collect from Cronus its proportionate share of these costs. GOM Shelf filed suit against Cronus predecessors-in-interest, Sun and Online Resources. GOM Shelf did not sue TDC as TDC had also filed for bankruptcy. On cross-motions for summary judgment, GOM Shelf argued that the 1965 JOA, under which lease operations were conducted, unambiguously imposed a continuing obligation on Sun and Online Resources to pay their share of plugging and abandonment cost, and that no valid release of those obligations existed. Sun and Online Resources countered that no liability could be imposed on them as they were no longer parties to the JOA at the time that the plugging and abandonment obligations were incurred by GOM Shelf, and also that the express terms of the JOA released them from payment for obligations accruing subsequent to the date of assignment of their respective interests in the lease. The JOA included provisions dealing both with obligations accruing prior to and subsequent to assignment: The assignment... shall not relieve the assignor... of any responsibility or liability hereunder accruing on or prior to the execution, delivery and approval by lessor, if required, of such assignment unless consented to in writing by all of the parties then owning and holding interests in said lease[] Eland Energy, Inc, 135 S.W.3d at No. 4:06-cv-3444, 2008 WL (S.D. Tex. Mar. 31, 2008). -3-

4 ... Should any party hereto sell its entire interest... then the party so disposing of its interest shall be relieved of all obligations hereunder which accrue subsequent to the date of the delivery to the purchaser of written assignment or conveyance of such interest, approved by lessor, if such approval is required In ruling, the court focused first on federal regulations promulgated and enforced by the Department of Interior concerning federal offshore leases. Those regulations provide that (1) decommissioning obligations accrue when a party becomes a lessee not at a later end-of-production date; (2) assignors are liable for all obligations that accrue on a lease before the date that an assignment is approved by the federal government; and (3) assignors can be held liable by the federal government for satisfaction of obligations that accrued prior to assignment if the subsequent interest holder fails to perform any of those obligations. 15 The court recognized that the applicable federal regulations do not give a private entity, such as GOM Shelf, a private cause of action, but only apply to the federal government: The regulations govern the parties joint and several liabilities vis-à-vis the Government, not amongst themselves. 16 Yet, the court still relied, to a large extent, on the federal regulations in determining that Sun and Online Resources plugging and abandonment obligations accrued as soon as each became a lessee, which clearly was before each had assigned away its interest in the lease. Their assignment, therefore, would not relieve them of these liabilities and responsibilities. 17 Alternatively, the court stated that, if it were to determine that the plugging and abandonment obligations accrued between 2002 and 2006 when GOM Shelf incurred such expenses, Seagull Energy would apply, and Sun and Online Resources would still be liable since there was no valid release of their liabilities under the JOA, and the simple act of assigning the contract to a third party did not relieve them of their contract obligations. 18 The JOA language relieving assigning parties of all obligations accruing subsequent to the date of assignment was deemed analogous to the JOA language in Seagull Energy, and the court held that it did not constitute an express release of Sun and Online Resources plugging and abandonment obligations at *3-*4. 15 at *6-*7. 16 at *7 (quoting Fruge ex rel. Fruge v. Parker Drilling Co., 337 F.3d 558, 563 (5th Cir. 2003)). 17 at * at *11. The form of the operating agreement at issue was not identified in the Southern District of Texas Court s opinion. The operating agreement provisions cited by the court do not appear to be A.A.P.L. model form JOA provisions. -4-

5 Notwithstanding the fact that the JOA release language in GOM Shelf did not specifically state that plugging and abandonment obligations would be deemed to accrue when those expenses were incurred by the operator, and that any and all plugging and abandonment obligations not accrued were released upon assignment, it is difficult to understand just how the JOA release language did not amount to an express release of assignors from all post-assignment obligations. This decision underscores the necessity of careful drafting of JOA release language on the front end including thinking through how issues such as plugging and abandonment will be handled and drafting specific language to accomplish the parties intent and again the need on assignment to obtain express release of existing JOA obligations by addendum or side agreement. The frustration (and nightmare for drafters of agreements) is that no one can predict all possible situations that might occur in the future, and what appears to be perfectly suitable general release language may be held insufficient by the courts. III. PREFERENTIAL RIGHTS ISSUES A. Navasota Resources, L.P. v. First Source Texas, Inc. In Navasota Resources, 20 the issue presented was whether the preferential right to purchase provision in a 1989 A.A.P.L. model form JOA was triggered when working interests subject to the JOA were to be sold along with other interests not subject to the agreement as part of a package deal. First Source, a working interest owner under the JOA, sought to sell to Chesapeake Energy 33.3% of its working interest in an oil and gas leasehold covering First Source s Hilltop Prospect in Leon and Robertson Counties, Texas, along with 19.9% of the outstanding shares of stock of First Source s parent company, Gastar Exploration, Ltd. As part of the transaction, Chesapeake was to pay First Source $700 per net acre for the leasehold, pay a promoted share of the cost to drill the first six wells on the prospect, and enter into an area of mutual interest ( AMI ) with First Source covering 13 counties in East Texas. First Source notified Navasota, the other working interest owner under the JOA, of its intent to sell a portion of its working interest, and Navasota opted to exercise its preferential right to purchase. Later on the same day that Navasota elected in a facsimile transmission to exercise its preferential rights, First Source sent notice that its notice had been in error and was rescinded. First Source then sent a new notice indicating that Navasota must comply with every aspect of the Gastar/Chesapeake agreement, i.e., purchase of the working interest, payment of the promoted well costs, purchase of Gastar stock, and entering into the AMI agreement, if it intended to exercise its preferential rights under the JOA. Navasota refused to accept the modified offer and notified First Source that the parties had a binding contract based on its initial election. First Source insisted that it had the right to rescind the first notice, and it closed its deal with Chesapeake. Navasota sued claiming, inter alia, breach of contract and requesting specific performance. 20 No CV, 2008 WL (Tex. App. Waco Jan. 9, 2008, pet. filed May 13, 2008). -5-

6 The trial court granted Chesapeake s and Gastar s motions for summary judgment, but provided no reasons for its decision. The appellate court reversed in favor of Navasota, holding: (1) Navasota s preferential right to purchase First Source s working interest was triggered even though the interest was to be sold along with interests not subject to the JOA; (2) Navasota was required only to comply with the terms of the cash sale relating to the working interest being conveyed, and not the additional terms of the sale relating to the stock purchase or the agreement to pay promoted well costs or join in the AMI; (3) a binding contract for sale between Navasota and First Source was created when Navasota notified First Source that is was exercising its preferential right to purchase the working interest under the terms of the sale as offered to Chesapeake; (4) the preferential right provision of the JOA did not place an unreasonable restraint on alienation; and (5) that Navasota had established its right to specific performance of the contract for sale of First Source s working interest under the terms offered to Chesapeake. In ruling that Navasota s preferential rights were triggered, even though First Source s deal with Chesapeake included more than just a portion of First Source s working interest under the JOA, the court of appeals recognized that courts have differed on this issue in package sale situations. Some courts have held that [a]n attempt to sell the whole may not be taken as a manifestation of an intention or desire on the part of the owner to sell the smaller optioned part so as to give the optionee the right to purchase the same. 21 Others have held that a preferential right is invoked by a package sale. Those courts have found that [t]o conclude otherwise would permit an owner and prospective purchaser to, in effect, destroy a bargained-for purchase preemption before the expiration of the term for which such preemption was obtained. 22 The Navasota court noted that Texas courts, with little exception, have followed the rule that a sale of something greater than whatever is covered by the preferential rights does cause the rights to come into play. First Source argued that Navasota was not entitled to specific performance because a genuine issue of material fact existed as to the true value of the 33.3% working interest that Navasota was to obtain. First Source contended that the value was substantially higher than what was reflected in the letter of intent with Chesapeake. According to First Source, the letter of intent reflected a lower value for the working interest acquisition because of the other terms of the sale the stock purchase and the AMI. The appellate court again recognized that some courts have agreed that allocation of prices in a package sale can be artificial, and that evidence as to the true market value should be used. However, [o]ther courts have held that the seller should be held to the allocated price absent affirmative evidence of bad faith or of some other improper basis for the allocated price. 23 The court followed the latter approach and rejected as immaterial First Source s argument that Navasota was being allowed to exercise its preferential rights by paying less than the true value of First Sources 33.3% working 21 at 533 (quoting Guaclides v. Kruse, 170 A.2d 488, 493 (N.J. Super. Ct. App. Div. 1961)). 22 at 534 (quoting Berry-Iverson Co. v. Johnson, 242 N.W.2d 126, 134 (N.D. 1976)). 23 at

7 interest: While this may be correct, the preferential right provision agreed to by the parties does not require the preferential right holder to pay true value or fair market value. Rather, the preferential right provision requires only that the holder match the third-party offer. 24 The court of appeals further found that Navasota could obtain specific performance from Chesapeake because Chesapeake stood in the shoes of First Source as a purchase with notice of Navasota s preferential right. To prevent such a result, a practitioner should consider deleting the preferential right to purchase provision in the JOA, or the including of a provision that provides, in the event of a package sale which includes assets or corollary agreements not covered by the preferential right to purchase provision, the potential purchaser must submit a purchase price allocable to the specific property being purchased, and the methodology of how the purchase price is calculated. Potential conflicts may be avoided down the road if the parties clearly articulate and understand the value of the property being sold. B. Subissi Holdings, L.P. v. Hilcorp Energy I, L.P. Subissi Holdings 25 serves as a reminder of the importance of understanding precisely what action is required under the terms of a JOA to successfully exercise preferential rights. SubISSI and Hilcorp s JOA included an Area of Mutual Interest provision that required a party acquiring a mineral interest in the AMI to offer the other party the opportunity to participate in it. The receiving party had thirty days to make the election by delivering written notice of its decision to participate to the offering party. If the receiving party elected to participate, then the Offering Party shall execute, acknowledge, and deliver to [the receiving party] an assignment thereof..., and [the receiving party] shall pay... the Offering Party the associated purchase price. 26 Hilcorp acquired land in the AMI, notified SubISSI, and SubISSI elected to participate. Hilcorp then sent SubISSI a letter dated December 4, It included the initial closing settlement statement, executable assignment, conveyance, and bill of sale documents, and wire transfer instructions for SubISSI s payment. SubISSI did not execute the documents or send payment within the required thirty days. On January 22, 2004, the principals of SubISSI and Hilcorp met for lunch. At lunch, SubISSI offered a check, dated December 26, 2003 to Hilcorp in payment for its participating interest in the AMI. However, Hilcorp refused to accept the check and informed SubISSI that it had forfeited its rights because it had missed the January 3, 2004 deadline for payment. The parties JOA also included a provision concerning a party s election to not participate in a newly acquired interest in the AMI: If any Party fails to elect to acquire its Participating Interest in a given Offered Interest within such thirty (30) day 24 at No CV, 2008 WL (Tex. App. San Antonio June 25, 2008, no pet. h.). 26 at *1 (quoting the parties JOA). -7-

8 period, or elects to acquire but fails to pay its Purchase Price on or before the thirtieth day following the date that the Offering Party tenders the assignment thereof (a Rejecting Party ), then such Rejecting Party shall have no further rights with respect to such Offered Interest, and the other Parties shall have no obligation to the Rejecting Party with respect to such Offered Interest Hilcorp argued that SubISSI s failure to deliver payment within 30 days of the letter with an enclosed unexecuted assignment resulted in SubISSI s loss of rights as to the acquired interest. SubISSI contended that payment was not due until after Hilcorp delivered a fully executed assignment. The trial court rendered judgment in favor of Hilcorp and SubISSI appealed. The court of appeals examined whether the JOA preferential rights provisions contained a condition precedent that required Hilcorp to execute, acknowledge, and deliver the assignment before SubISSI was obligated to make payment. The appellate court found that once SubISSI exercised its preferential right (the condition precedent), the JOA imposed mutual, concurrent obligations on the parties Hilcorp had to tender the assignment and SubISSI had to pay for the interest within 30 days. The court determined that SubISSI s concurrent obligation to pay was not constrained to the thirtyday period following Hilcorp s tender of the [] assignment, but was merely limited to a period no later than the thirtieth day following the tender. 28 SubISSI, for example, could have paid for the interest to be acquired following its exercise of the preferential right, but before Hilcorp sent it the unexecuted assignment. The court further determined that Hilcorp s delivery of the December 4, 2003 letter and unexecuted assignment met the requirement that it tender the assignment sufficiently to trigger SubISSI s 30-day period. In doing so, the appellate court relied upon a Texas Supreme Court decision, Perry v. Little, 29 concerning the meaning of tender and the applicable rules under circumstances of tendering performance versus a tender of money. While a tender of money must be an unconditional offer to pay consisting of actual production of funds and relinquishment of possession of such funds for sufficient time to allow the receiving party to acquire possession, a tender of performance is not subject to strict rules: [W]hat is essential is that it shall appear to the court and shall have been made clear to the other party to the contract that the exchange agreed upon would be carried out immediately if the latter would do his part. This requirement involves both ability on the part of the [party] to perform and an indication of that ability to the other at * S.W.2d 198, (Tex. 1967). -8-

9 party. The actual production of the... thing which the [party] is to give is... unnecessary. 30 The court noted that Hilcorp s letter, accompanying the unexecuted tender, stated that the documents enclosed were for your review and execution, and that upon execution and return, Hilcorp will return one fully executed original to your attention. 31 The court found that Hilcorp indicated it would comply with its concurrent obligation to execute, acknowledge, and deliver [the assignment to SubISSI] not based upon SubISSI s payment of the purchase price, but based upon SubISSI s return of three executed assignment originals, thereby giving meaning to [this] provision in the agreement. 32 And, the court found no basis to excuse SubISSI from performance within the 30-day period as time is of the essence to adequately exercise a preferential right of purchase. The court also noted that the parties should have used the term deliver instead of tender if they meant for SubISSI s payment limitation period to commence upon Hilcorp s conveyance of the interest to SubISSI. C. Coral Production Corp. v. Central Resources, Inc. Coral Production Corp. 33 involves the interpretation of a preferential rights provision with a market exit exclusion. In Coral Production, two oil and gas companies entered into a JOA containing a preferential right to purchase clause. Texas law governed disputes arising from the JOA. As part of a sale of all of its oil and gas assets, the operator under the terms of the JOA, Central Resources, sold 70% of its Nebraska assets to EXCO Resources without providing Coral, the non-operator, the opportunity to purchase. EXCO later transferred overriding royalty interests in the Nebraska assets to Paul Zecchi, Central s CEO. The remainder of Central s assets had been sold more than two weeks earlier to another company. Coral and KJJ held fractional working interests in the assets covered by the JOA; Coral and KJJ sued Central, EXCO, and Zecchi to quiet title, alleging breach of contract, fraud, and tortious interference. The parties JOA was the 1977 A.A.P.L. Model Form 610, which contains a preferential right to purchase clause providing an option to purchase on the same terms as offered to the other parties to the contract under circumstances where one party decides to sell its interests. However, the parties had added a typewritten interlineation to the model form providing that there was no preferential right to purchase when all or substantially all of the assets were sold to a third party. Coral argued that Central breached the preferential right to purchase clause of the JOA by its failure to offer the Nebraska assets to it, and also that EXCO breached the clause after the sale by transferring the overriding royalty interests to Zecchi without offering the interest to Coral. 30 Subissi Holdings, L.P., 2008 WL at *4. 31 at * N.W.2d 357 (Neb. 2007). -9-

10 The Nebraska Supreme Court affirmed the district court finding that the JOA was unambiguous and that the term party in the preferential right to purchase provision did not mean a single third party; thus, the sale of all assets to two companies unaffiliated with the JOA, fell within the interlineated exception. 34 The court held that Central did not breach the JOA because the parties clearly intended that the preferential right to purchase clause not be triggered when a party to the JOA sought to exit the oil and gas industry by selling all of its assets. 35 However, the court reversed the district court s finding that the preferential right to purchase does not apply to overriding royalty interests transferred by EXCO to Zecchi. 36 The court noted that the JOA was binding on the parties successors and assigns, which bound EXCO to the preferential right to purchase provision. EXCO and Zecchi argued that because overriding royalties are nonoperating interests carved out of working interests, they are not subject to the JOA. The court disagreed, finding that neither the JOA nor Texas law limits the opportunity to purchase valuable rights in the subject property to operating rights. Instead, the preferential rights provision in the JOA broadly applies to a party s sale of its rights and interest in the Contract Area. 37 The court held that, under Texas law, overriding royalty interests are interests in the contract area and that a preferential right to purchase applies to the sale of those interests. 38 The court remanded this single issue to the lower court to determine whether a sale of the overriding royalty interests occurred finding that Texas courts require an arm s-length transaction between a willing seller and buyer in order to trigger a preferential right to purchase an issue the district court left undetermined based upon its finding that the preferential rights did not apply to the overriding royalty interests. 39 D. Fordoche, Inc. v. Texaco In Fordoche, 40 the Fifth Circuit addressed issues relating to what it takes to make an offer sufficient to satisfy a JOA preferential rights provision. Plaintiffs and defendants were parties to four different JOAs covering production units in Fordoche Field in Point Coupee Parish, Louisiana. The JOAs required the parties, before selling any interest covered by the JOA to a third party, to offer the interest on the same terms to the other parties to the JOA. The right of first refusal ( ROFR ) clause in the 1962 JOA applied to the sale of an interest, in whole or in part, in the properties affected by this agreement. The ROFR in the other three JOAs provided that the ROFR extended to the sale of any part of a party s interest in unitized substances. 34 at at F.3d 388 (5th Cir. 2006). -10-

11 Texaco decided to sell its working interest in 16 fields to the highest bidder; Texaco called the transaction the Gulf Coast Package. EnerVest won the bid and paid $78.7 million, allocating $1,998,811 as the value of the property covered by the ROFR. Texaco offered plaintiffs the right to exercise the ROFR as to its undefined interests in the property at a purchase price of $1,998,811. Plaintiffs responded, asking about the property offered and requesting information concerning how the price was determined. Texaco sent another offer letter to plaintiffs a month later in an effort to clarify the property interests offered and stating an increased allocated purchase price of $2,014,861. Plaintiffs requested time to investigate the property interests and the price. Seven months later, Texaco sold the interests covered by the ROFR to EnerVest. Plaintiffs brought suit on grounds that Texaco had failed to properly give them the opportunity to exercise their preferential rights under the JOAs. The district court granted summary judgment in favor of Texaco. The JOA provision at issue required the Operating Party to give the other Operating Parties the preferred right to purchase at the best price offered in good faith by a third party. The ROFR had to be exercised within 30 days after receipt of written notice of the third party s offer. On appeal, the Fifth Circuit held that under the 1962 JOA, the ROFR extended to Texaco s entire working interest including assets such as facilities, rights of way, pipeline rights of way, and surface leases affected by the JOA. Texaco argued that, under the remaining three JOAs, plaintiffs did not have a ROFR because the tangible assets were not subject to the ROFR. The Fifth Circuit interpreted these three JOAs to mean that unitized substances as stated in the ROFR clause means that each party participates in the acquisition of ownership of any tangible property associated with unit drilling and production operations by the same percentage as it enjoys in the minerals produced. 41 The court held that Texaco was not authorized to sell even under these three JOAs because all of the working interest owners held an indivisible interest in those tangible assets. 42 If Texaco was permitted to exclude the tangible assets from its offer to plaintiffs, then its sale to EnerVest would be unequal to the offer it made to plaintiffs, which violated preferential rights provisions of the JOAs. 43 The Fifth Circuit reversed and remanded the case to the district court, finding that genuine issues of material fact existed. 44 For example, Texaco did not specify the property interest being offered in its offer letter, excluded tangible facilities from the offer made to plaintiffs, and the record was replete with evidence that the plaintiffs were uncertain as to the property interests offered for sale. 45 Additionally, the court determined that Texaco offered plaintiffs less than its entire interest for $2,014,861 and offered EnerVest its full interest in the same property for that same price. 46 The court 41 at at at at

12 also examined whether Texaco had violated the Louisiana Civil Code s duty of good faith with respect to the performance of contracts and obligations in general, and found a genuine issue of material fact based upon Texaco s representations as to the purchase price and other matters. 47 E. El Paso Production Co. v. Geomet, Inc. El Paso Production, Co. v. Geomet, 48 concerns whether preferential rights to purchase extend to overriding royalty interests an issue also addressed in Coral Production, supra. El Paso and GeoMet signed a JOA containing a preferential right to purchase, providing that a party selling its rights and interests in the Contract Area must first offer the rights and interests to the other parties to the JOA on the same terms as the offer to the third party. The JOA was governed by Alabama law. GeoMet offered CDX, a third party, its interests, including overriding royalty interests in the property covered by the JOA. El Paso then notified GeoMet that it would exercise its preferential right to purchase. GeoMet agreed to sell all but the overriding royalty interest to El Paso. El Paso sued, arguing that the preferential right to purchase also applied to overriding royalty interests. In examining the issue, the Texas appellate court noted that overriding royalty interests are interests in real estate. 49 The parties JOA was a 1982 A.A.P.L. Form 610 with a standard preferential right to purchase clause. The JOA defined Contract Area as all of the lands, oil and gas leasehold interests and oil and gas interests intended to be developed and operated for oil and gas purposes under this agreement. 50 Because the overriding royalties were from production from leases governed by the JOA, the court held that GeoMet s overriding royalty was a right and interest in the Contract Area. 51 Thus, the overriding royalty was subject to the preferential right to purchase. 52 The court rejected GeoMet s argument that the overriding royalty interest was not subject to the preferential right because the overriding royalty interest itself is not part of the Contract Area: The issue is not whether the overriding royalty interest is part of the Contract Area; the issue is whether the overriding royalty interest constitutes rights and interests in the Contract Area[,] [and] [t]he overriding royalty interest, as a right to payment from production in the land and leases constituting the Contract Area, is clearly rights and interests in that land and those leases. 53 To prevent such a result, the parties to a JOA should consider adding a phrase 47 at S.W.3d 178 (Tex. App. Dallas 2007, pet. denied). 49 at at Interestingly, the court did not cite Imco Oil & Gas Co. v. Mitchell Energy Corp., 911 S.W.2d 916, 921 (Tex.App. Ft. Worth, no writ), where the Fort Worth Court of Appeals held, in 1995, that an overriding royalty interest, created by a party to a JOA, is subject to the JOA s preferential right to purchase provision

13 to the preferential right to purchase provision which expressly excludes overrides, net profit interests, production payments and any other like interests which are nonpossessory and non-cost bearing. IV. THE EXCULPATORY CLAUSE The standard language of model form JOAs requires the operator to act as a reasonably prudent operator and limits operator liability to non-operators to situations of gross negligence or willful misconduct. 54 In Stine v. Marathon Oil Co., 55 the Fifth Circuit held that the JOA exculpatory clause applied to all good faith actions undertaken by the operator pursuant to the JOA, including performance of its contractual duties. Pursuant to Stine, operators could expect to enjoy broad protection from claims by nonoperators. However, a number of courts since Stine including Texas appellate courts have taken a different approach and interpreted the scope of the JOA exculpatory clause more narrowly. For example, in Abraxas Petroleum Corp. v. Hornburg, 56 a Texas court of appeals concluded that the exculpatory clause requirement that there be a showing of gross negligence or willful misconduct on the part of the operator, was limited to claims involving the operator s physical activities and did not apply to performance of contractual obligations or administrative actions. And, in Cone v. Fagadau Energy Corp., 57 a different Texas appellate court rejected the notion that a showing of operator gross negligence or willful misconduct was required in order to prevail on claims based upon breach of contract and accounting issues. A third Texas appellate court addressed the scope of applicability of the JOA exculpatory clause in IP Petroleum Co., Inc. v. Wevanco Energy, L.L.C. 58 IP Petroleum Co. involved operational activities a claim against an operator for allegedly failing to drill deeply enough to test a specific formation and the court of appeals did require a showing of gross negligence or willful misconduct in order to hold the operator liable. The court emphasized that the nonoperators claims for damages involved physical activity, and not claims based upon breach of contract. Several recent cases have adopted or expanded upon the Abraxas Petroleum Corp. rationale in situations involving joint interest account disputes between operators and non-operators. Shell Rocky Mountain Production, L.L.C. v. Ultra Resources, Inc. 59 is an example of an operator claim spurring counterclaims involving joint interest account issues by the non-operator. In Shell Rocky Mountain Production, L.L.C., Shell brought a declaratory judgment action against Ultra Resources regarding who was entitled to 54 See, e.g., A.A.P.L. Form Model Form Operating Agreement, Article V.A F.2d 254, 261 (5th Cir. 1992) S.W.3d 741 (Tex. App. El Paso 2000, no pet.) S.W.3d 147, 155 (Tex. App. Eastland 2001, pet. denied) S.W.3d 888 (Tex. App. Houston [1st Dist.] 2003, pet. denied) F.3d 1158 (10th Cir. 2005). -13-

14 operate a well on jointly leased lands. Ultra Resources counterclaimed against Shell asserting that Shell breached the JOAs by imposing excessive drilling and operations costs as to wells that Shell was already operating. The trial court granted summary judgment in favor of Shell holding that, absent a showing of gross negligence or willful misconduct, the exculpatory clause barred Ultra Resources excessive costs claims against Shell. The Tenth Circuit reversed. In doing so, the court first noted the existence of specific duties in the JOA that the operator incur costs that are similar to those incurred by other operators in the contract area to drill and complete wells, and that the operator drill and complete wells at generally prevailing rates. Ultra Resources alleged that Shell charged in excess of generally prevailing rates and, thus, breached the JOA. Shell argued that the exculpatory clause of the JOA protected it from liability absent a showing of gross negligence or willful misconduct. However, the Tenth Circuit rejected the argument that the exculpatory clause applied to the breach of express terms of the JOA. The court determined that (1) parties would not include such explicit directions on administrative matters if they did not intend the operator to be liable for breach of them; (2) the types of duties at issue did not involve extraordinary risk like drilling operations, etc.; and (3) an expansive reading of the exculpatory clause might encourage operators to take advantage of non-operators: While a higher standard for breach might apply to drilling, extraction, and other risky operations because most operators have the same incentive as non-operators to do well in physical operations, it is nonsensical to apply such a standard to administrative and accounting duties where the operator can profit by cheating, or simply overcharging, its working interest owners. 60 In Tri-Star Petroleum Co. v. Tipperary Corp., 61 a Texas appellate court affirmed a temporary restraining order removing the designated operator of a large natural gas project located in Queensland, Australia. The JOA provided for removal of the operator upon a showing of its failing or refusing to carry out its duties under the agreement. The operator argued that the trial court should have applied the gross negligence standard of the JOA exculpatory clause, or, alternatively, that its removal was improper absent a showing of complete abdication of all activity and responsibility by abandonment or by allowing another party to conduct operations on the contract area. 62 The court of appeals found no evidence that the trial court had abused its discretion in finding that the non-operators had cause to remove the operator by virtue of evidence that the operator: (1) improperly assessed charges to the joint account; (2) failed to supply reasonable information requested by the non-operators; (3) commingled funds that did not belong to the joint account; (4) inexplicably classified and reclassified amounts billed to the joint account; (5) failed to provide timely and proper adjustments to the joint account for surpluses in a foreign exchange account; (6) double-charged the non-operators on cash calls and other billings; (7) allowed the premature loss of acreage; 60 at S.W.3d 583, 589 (Tex. App. El Paso 2003, pet. denied). 62 at

15 and (8) was unable to sustain deliverable quantities of gas under existing contracts. The appellate court s decision was based upon its review of the evidence and an examination of the JOA provisions to determine whether the non-operator had demonstrated a probable right to recovery the applicable injunction standard. The court concluded that the trial court could have determined that the JOA provisions were unambiguous and should be interpreted in accordance with their plain, ordinary, and generally accepted meaning. In R & R Resources Corp. v. Echelon Oil & Gas, L.L.C., 63 another Texas appellate court affirmed a temporary restraining order which approved the non-operators removal of the defendant-operator and enjoined the defendant-operator from refusing to turn over operations. The JOAs at issue, both A.A.P.L. Form , provided for removal of the operator for good cause, which the agreement defined as gross negligence, willful misconduct, or the material breach of or inability to perform its obligations under the agreement. In support of their claim for removal, the non-operators presented evidence of improper operational and accounting practices, including: excessive operational charges, late payment of lease expenses, loss or delay in production, and damage to the lease equipment. The operator argued that removal was improper given that the wells at issue had produced oil and gas in paying quantities under its operatorship, that it had made proportional distributions of this income each month, and an audit of its financial records by non-operators revealed no unpaid invoices, pollution, loss of acreage, liens, or claims against the wells. However, testimony and evidence from the non-operators demonstrated that the operator had an I m going to do it the way I m going to do it and you can like it or dislike it attitude. There was also testimony that continued late payments to vendors one of the complaints against this operator could cause vendors to refuse to extend credit, charge higher prices, or refuse to provide services. 64 Additionally, the nonoperators presented evidence that the newly elected operator could do a better job, had more experience, more personnel, and a better location. 65 In light of this evidence, the court affirmed the trial court s decision that R & R Resources improper accounting and operation practices which were a material breach of the standards of operation and/or inability to meet the standards of operation and a material failure or inability to perform obligations under the joint operating agreements constituted good cause for its removal as operator. 66 Forest Oil Corp. v. Union Oil Co. 67 is an example of a court focusing on the detailed nature of the JOA the COPAS Accounting Procedure attachment, in particular and holding an operator to the accounting standards and methods contained therein. In 63 No CV, 2006 WL (Tex. App. Austin Jan. 10, 2006, no pet.). 64 at * at *9. 67 No. 3:05-CV-0078-RRB, 2006 WL (D. Alaska Apr. 7, 2006). -15-

16 Forest Oil Corp., the non-operator asserted claims against the operator for breach of the parties JOAs by charging inflated fees for the disposal of naturally occurring radioactive material or NORM. The operator, Unocal, charged the joint interest account $275/barrel for disposal of NORM generated from the offshore oil and gas leases in which both Unocal and Forest Oil own working interests in Alaska s Cook Inlet. At the outset, the court noted that the JOAs between Unocal and Forest expressly incorporated documents titled Accounting Procedure Offshore Joint Operations, which were developed by COPAS. The COPAS Procedures identified two methods of calculating charges to the joint account for this type of expense: (1) rates commensurate with costs of ownership and operation, which includes labor, maintenance, repairs, insurance, taxes, depreciation, and the like; or (2) average commercial rates prevailing in the area less 20%. However, Unocal did not base the $275/barrel charge on either of these methods and, instead, appeared to have focused more on getting the waste disposed and getting a fair cost recovery. Based upon this evidence, the court determined that the operator failed to follow the express terms of the contract in calculating appropriate NORM disposal charges for the joint interest account: Unocal did not follow the procedures specified in... the COPAS Procedures. 68 In evaluating whether a breach of contract had occurred, the court first had to determine the scope of the exculpatory clause in the applicable operating agreement. It provided that the [operator] shall conduct all Unit operations in a good and workmanlike manner, and that the [operator] shall not be liable to the [parties to the agreement] for damages, unless such damages result from [operator s] gross negligence or willful misconduct. 69 Unocal argued that the exculpatory clause included both operational and accounting activity, while Forest argued that the exculpatory clause applied only to operational activity. After noting the differing results reached by the Fifth Circuit in Stine and the Tenth Circuit in Shell Rocky Mountain Production, L.L.C., the court chose to follow the Tenth Circuit s Shell Rocky Mountain Production, L.L.C. decision and held that Unocal had breached its duty to charge for NORM disposal in accord with the parties JOAs: This Court agrees with the holding and reasoning of the Tenth Circuit. A broader reading of the clause would allow a party to act negligently (just not grossly) in following its express contractual administrative and accounting duties. 70 Interestingly, Unocal s testimony was to the effect that the $275/barrel NORM disposal charge likely was a significant undercharge for NORM disposal. PYR Energy Corp. v. Samson Resources Co. 71 largely concerns the pooling of interests and the authority to do so. Yet, it also addresses the scope of a JOA exculpatory clause, although it does so in a hypothetical environment. The plaintiff non-operator in PYR Energy Corp. claimed that Samson breached its duty to perform the JOA in a good and workmanlike manner when it allegedly formed a unit in order to maintain leases and 68 at * F. Supp. 2d 709 (E.D. Tex. 2007). -16-

17 by forming a unit that it knew or should have known included non-productive acreage. 72 Samson argued for summary judgment in its favor based upon the fact that the JOA exculpatory clause required a showing of gross negligence or willful misconduct for it to be held liable, and there was no such showing in the record. The court deferred ruling on the scope of the exculpatory clause and on the merits of whether the non-operator s argument could support a finding of failure to act as a reasonably prudent operator. However, the federal district court performed a thorough examination of Stine, Abraxas Petroleum Corp., and related cases, and found that it would be bound to follow the circuit precedent set forth in Stine: Although the Texas Supreme Court has not ruled on this issue, Stine may not accurately forecast Texas law. First, no Texas court has followed or even cited Stine s substantive holding in the almost fifteen years since the Fifth Circuit made its Erie guess. Second, subsequent holdings and statements by three separate Texas courts of appeals suggest that Stine may no longer correctly state Texas law....[yet], [t]his trial court surely is as bound to follow prior circuit precedent as are subsequent panels of the circuit court of appeals. Here, there is no clearly contrary subsequent holding of the Texas Supreme Court; nor is there subsequent statutory authority, squarely on point, available for guidance. Arguably, there are unanimous or near-unanimous intermediate appellate court holdings disagreeing with Stine, but they don t come close to a majority of Texas s 14 intermediate appellate districts. Therefore, even though Stine has never been followed, the preconditions for departing from Stine are not shown to exist in this case. 73 Samson s motion for summary judgment was denied on grounds of prematurity, and the court s analysis serves as nothing more than a possible forecast that it will follow Stine if these arguments arise again. To prevent such a result, the parties should consider adding a clause to the JOA which states that the exculpatory clause does not apply to any contractual obligations the operator may have under the JOA. V. OTHER JOA ISSUES A. Tarrant v. Capstone Oil & Gas Co. Tarrant 74 is an operator removal case involving a dispute between an operator and working interest owners over costs associated with the workover of a well. Tarrant, 72 at at P.3d 866 (Okla. Civ. App. Div ). -17-