CHAPTER 2 BASIC CONTRACT PRINCIPLES IMPACTING EXPLORATION PROJECTS

• Jurisdiction: United States

Oil and Gas Agreements: The Exploration Phase
(May 2004)
CHAPTER 2
BASIC CONTRACT PRINCIPLES IMPACTING EXPLORATION PROJECTS
David E. Pierce
Professor of Law
Washburn University School of Law
Topeka, Kansas

David E. Pierce is a professor at Washburn University School of Law in Topeka, Kansas where he teaches Contracts I & II, Oil & Gas Law, Advanced Oil & Gas Law, and Hazardous Waste Regulation. Prior to entering law teaching Professor Pierce was an in-house oil and gas attorney for Shell Oil Company in Houston, Texas and before that he engaged in the private practice of law in Kansas.

Professor Pierce earned a B.A. from Kansas State College of Pittsburg, a J.D. from Washburn University School of Law, and a Masters of Law (LL.M.-Energy Law) from the University of Utah College of Law.

Professor Pierce has written extensively on contracts and oil and gas law topics. He is the author of the Kansas Oil and Gas Handbook, a co-author of Cases and Materials on Oil and Gas Law, a revision and upkeep co-author of Kuntz on the Law of Oil and Gas, and an editor of the Oil and Gas Reporter.

CONTENTS

I. INTRODUCTION

II. CONTRACT FORMATION ISSUES

A. Effectively Controlling the Creation of a Power of Acceptance

1. Offer or Preliminary Negotiations?

2. The Letter of Intent

3. Intermediate "Contract" to "Negotiate"?

4. Liability for Reliance?

5. The Farmout "Offer" and "Preliminary Negotiations"

B. Preparation of a More Formal Agreement

C. Effectively Controlling the Exercise of a Power of Acceptance

1. Managing the Offer: Lapse, Revocation, Acceptance

a. Lapse

b. Revocation

c. Acceptance

d. Acceptance by Conduct: A Contract Solution to the Tort of Trespass

e. Notice of Acceptance

2. Soliciting the Offer: Management Approval Clause

3. Managing the Acceptance: Rejection, Counter-Offer

a. Rejection

b. Counter-Offer

D. Consideration

1. I Want Them Bound, But I Don't Want To Be Bound

2. Modification

E. Statute of Frauds

III. SURVEY OF COMMON EXPLORATION CONTRACT PROBLEMS

A. Too Few Contractual Agreements

B. Too Many Contractual Agreements

C. What Is the Contract? What Does it Mean?

IV. POWER POINT HANDOUTS

"The movement of the progressive societies has hitherto been a movement from Status to Contract." ¹

I. INTRODUCTION

"Exploration" is defined as "the investigation of unknown regions." ² Contract law has always played a major role in managing the "unknown." The basic premise of American contract law is that parties can agree to order their affairs as they see fit, with minimal intervention by courts and legislatures. ³ This remains the model, particularly when dealing with exploration projects where traditional give-and-take bargaining occurs among sophisticated parties. For example, in Nearburg v. Yates Petroleum Corp., ⁴ the New Mexico Court of Appeals refused to grant Yates a second chance to elect to participate in drilling a well when it failed to respond within the 30-day time frame set by the operating agreement. ⁵ In reversing the trial court's "equitable" approach to the issue, the Court of Appeals states: "A court should . . . not interfere with the bargain reached by the parties unless the court concludes that the policy favoring freedom of contract ought to give way to one of the well-defined equitable exceptions, such as unconscionability, mistake, fraud, or illegality." ⁶

However, such "freedom" also means courts will be reluctant to rescue a party from what turns out to be a bad bargain. Freedom of contract creates both a "right" and the "obligation" to ensure it is used properly to accomplish your intended goals. The purpose of these Special Institutes on "Oil and Gas Agreements" is to assist those attending in using this freedom to accomplish your goals while minimizing unanticipated or unintended consequences of such freedom when defining your client's destiny by contract.

II. CONTRACT FORMATION ISSUES

It is easy to create a contract. ⁷ The absence of formalities means an enforceable agreement may arise before a party consciously realizes their actions have given rise to a contractual relationship. This is made possible by the American objective theory of contracts: what would a reasonable person be led to believe by the other party's actions? Although the person making the statements or sending the letter may have subjectively intended not to make an "offer," or exercise a "power of acceptance," if that person's objective (outward) manifestations indicate otherwise, such objective manifestations will control over the person's true subjective intent. ⁸ As with most rules of contract law, this creates a "burden" and an "opportunity." The burden occurs when a person fails to account for the rule and gives off objective messages not in accord with their subjective intentions. The opportunity is the ability to control the situation to ensure the person's "objective" message is consistent with their "subjective" intentions. This is what lawyers do, or should do, for their clients.

Controlling the formation of a contract involves making the parties' contractual status clear at all stages of a transaction leading up to the consummation of mutual assent. The critical task is distinguishing when the parties are engaging in "preliminary negotiations" leading up to the creation of a "power of acceptance," the "offer," ⁹ or the exercise of a "power of acceptance," the "acceptance." The lawyer's role, and drafting task, is ensuring every party, at every stage of the contract formation process, can at any time answer the following two questions:

(1) Has a power of acceptance been created (is there an offer)?

(2) Has a power of acceptance been exercised (is there an acceptance)?

Until there is a power of acceptance that has been exercised, the parties are engaged in preliminary negotiations which means, in most situations, they have no contractual restraints on their freedom of action. They can walk away without liability, or continue to negotiate in hopes of creating, and exercising, a power of acceptance.

The analysis is simply determining whether the activity constitutes preliminary negotiations or rises to the level of an event, either offer or acceptance, which has the potential to limit a party's freedom of action. ¹⁰ Each party has it within their power to minimize doubt about their status as preliminary negotiator, offeror, or acceptor.

A. Effectively Controlling the Creation of a Power of Acceptance

1. Offer or Preliminary Negotiations?

The challenge is to distinguish manifestations that constitute an "offer" from mere preliminary negotiations. The Restatement (Second) of Contracts defines an "offer" as:

The manifestation of willingness to enter into a bargain, so made as to justify another person in understanding that his assent to that bargain is invited and will conclude it. ¹¹

"Preliminary negotiations" are defined as:

A manifestation of willingness to enter into a bargain is not an offer if the person to whom it is addressed knows or has reason to know that the person making it does not intend to conclude a bargain until he has made a further manifestation of assent. ¹²

The lawyer's role, when they are involved at this stage of the transaction, is to ensure everyone involved "knows or has reason to know" of their contractual status.

The easiest way to do this is to employ the sort of language courts will look for ¹³ while ensuring it objectively conveys the message that is consistent with the client's subjective intent. For example, if the client wants to ensure it is creating no power of acceptance in the other party, consider using the following language to objectively express the client's subjective intent:

PRELIMINARY NEGOTIATIONS ONLY. This correspondence does not create any sort of offer or power of acceptance. Instead, the statements made in this letter merely constitute preliminary negotiations.

2. The Letter of Intent

The letter of intent is often used to memorialize negotiations. The "intent" of the letter is typically to enter into a contract-if the parties can come to an agreement on all the essential terms. The letter of intent states what the parties have tentatively agreed upon, and what remains to be done. However, when it appears the next formal step may not be forthcoming, the party desiring to complete the deal may argue the letter of intent gave rise to contractual obligations. The fundamental issue is what was the "intent" of the parties when entering into their letter of intent. The goal for the drafting attorney is to make the intent clear: Is a present contract intended, with some mere formality to be agreed upon? Or, do the parties intend they will not be bound until, and unless they are able to agree upon some additional form of agreement?

Even when the parties try to express their intent, sometimes it becomes equivocal. For example, in ACT I, LLC v. Davis, ¹⁴ the parties entered into a "letter of intent" regarding the exploration and development of coalbed methane leases. Davis owned coalbed methane leases and ACT wanted to earn the right to acquire 35% of the Davis working interest in return for arranging financing to develop the leases. After setting out the basic description of the deal, the letter of intent stated:

The parties understand and agree that the transactions contemplated by this letter are non-binding and subject to the following:

(a) Completion of definitive agreements incorporating terms of this letter on or before April 20, 2000 which deadline shall automatically extend for successive 10 day increments until any party gives notice of its intent to terminate this Letter of Intent delivered to all parties at least two (2) business days prior to such termination. ¹⁵

The parties entered into an extension agreement on May 4, 2000 which gave ACT until May 20 "to obtain financing arrangements for the Project . . . ." ¹⁶ The extension also stated:

"The parties agree to continue to...