CHAPTER 2 FARMOUT AGREEMENTS
| Jurisdiction | United States |
(May 1979)
FARMOUT AGREEMENTS
Rodey, Dickason, Sloan, Akin & Robb, P.A.
Albuquerque, New Mexico
Introduction
This paper discusses two aspects of the law relating to farmout agreements. The first involves questions relating primarily to real estate and contract matters arising under state law. The second relates to Federal tax questions arising from Revenue Ruling 77-176. Both aspects are important, and both must be considered at every stage in the negotiation and drafting of a farmout agreement.
Definition
For the purposes of this paper, a farmout agreement is defined as an agreement between a party holding mineral operating rights (which might consist of leasehold interests, mining claims, a fee interest, or another kind of interest), who is generally called the "farmor," and another party, generally called the "farmee", who can "earn" or acquire all or a portion of such rights by doing work or contributing funds for the performance of work.1
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Farmout Agreements are Executory Contracts
Farmout agreements are executory contracts involving conditional obligations. Typically, neither the farmor nor the farmee will have performed all of the conditions precedent to the performance of the obligations of the other when the agreement is executed.2 This paper will not discuss the many significant consequences which can arise out of the status of farmout agreements as executory contracts, but lawyers and landmen concerned with farmout agreements should be aware of this status and understand its significance under the contract law of the state in which the farmed-out property is situate.
Motives
Commonly, the farmor owns mineral operating rights but lacks or is not inclined to spend the money required adequately to hold, explore or develop his property. He is willing to give up a portion of his interest in the property to avoid such an expenditure, thereby reducing the financial risk that his property will after exploration or development, prove to be without commercial value. Federal and state tax incentives and a desire to obtain low cost geological information, which might be useful
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in evaluating property held by the farmor but not committed to the agreement,3 also motivate farmors to enter into farmout agreements.
The farmee, of course, has substantially different motives. Typically, a farmee wishes to establish or improve his land position in a particular area and is willing to advance funds for holding, exploring or developing a mineral property in order to do so. Although the farmor's property may not be the "best" in the area in which the farmee is interested (farmors often keep their "best" properties for themselves), it may be the best property in the area available to the farmee: presumably, the farmee has determined that the property is worth the cost of earning an interest in it pursuant to the farmout agreement. A farmee may have entered the competition for mineral property in a particular area late, and a farmout agreement may be the only way in which he can acquire a land position. An electric utility seeking to acquire a controlled source of coal or uranium would probably lack experience in mineral land acquisition, and may use a farmout agreement as a way of retaining the farmor to acquire land for it. Because utility users of coal and uranium products are typically more concerned with obtaining a controlled, assured supply than with the costs of exploration, development
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and production, farmout agreements between exploration or mining companies, as farmors, and utility companies, as farmees, appear to be becoming increasingly common.
The draftsman of a farmout agreement must understand why his client has decided to enter into the agreement and be sure that the agreement clearly provides for the accomplishment of such purposes.4
"Assignment" — "Sublease" Distinction
The differences recognized at common law and in many states between "assignments" and "subleases" could be significant under a farmout agreement. An "assignment" generally involves the transfer of the assignor's entire interest. As the result of an assignment, the assignee acquires both the burdens and benefits appurtenant to the interest assigned.5
On the other hand, a "sublease" generally involves the transfer of less than the entire interest of the sublessor and the sublessor retains some interest in the sublet property. At common law, there is no privity of estate or contract between the sublessee and the original lessor, and the benefits and burdens
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of the original lease do not run to the sublease in the absence of an express provision to the contrary.6
Although most farmout agreements probably provide for an assignment to the farmee rather than a sublease, most agreements actually contemplate a sublease rather than an assignment because the farmor typically retains some interest in the farmed out property.
The common law distinctions between assignments and subleases are not purely academic. The courts in most states to a greater or lesser extent continue to observe the distinctions and decide cases on the basis of them.7 This paper does not discuss these distinctions and the extent to which they are observed in the mineral and oil and gas producing states because such a discussion would require a small book. However, negotiators and draftsmen of farmout agreements must be aware of the distinctions and how they are treated by the courts of the state where the farmed-out property is situated.
Timing of Assignments and Subleases
The consummation of a farmout agreement requires an assignment of all or a sublease of a portion of interest in the farmedout property to the farmee. Were it not for Revenue Ruling
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77-176, farmors generally would for several reasons prefer to make the assignment or enter into the sublease only after the farmee "earned" the assignment or sublease by performing or contributing funds for the performance of the required work. By deferring the assignment or sublease until the farmee has performed, the farmee may have more incentive, at least psychological, to perform in a manner satisfactory to the farmor. The farmor can retain his entire interest in the farmed-out property until he is completely satisfied with the performance of the farmee.8 Moreover, by deferring the assignment or sublease the farmor may keep his property from becoming encumbered by the claims of a defaulting farmee's trustee in bankruptcy or creditors.9
Just as the farmor typically wishes to defer assignment or sublease until the farmee has performed, the farmee typically favors assignment or sublease as soon as he enters into the farmout agreement. An early assignment or sublease relieves a farmee who has performed of the burden of compelling the farmor to make the assignment or enter into the sublease: instead, the
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farmor resisting assignment or sublease must prove that the farmee did not perform. Moreover, by obtaining an assignment or sublease before performing, the farmee should avoid many of the problems which would result from the bankruptcy or other financial difficulty of the farmor: in many cases the farmee's interest would survive the claims of the farmor's trustee in bankruptcy or creditors.
It has been suggested that the conflicting positions of farmor and farmee as to when the assignment or sublease is to be made could be resolved by placing an executed assignment or sublease instrument in escrow, with instructions to the escrow agent to deliver the instrument to the farmee when its performance is complete. However, an escrow arrangement probably would not work if a dispute arose between the farmor and the farmee or their respective successors (including, particularly, the trustee in bankruptcy of one of them). In the event of such a dispute, a prudent escrow agent would on one pretext or another probably defer delivery until he could do so protected by a court order or other authoritative document.
Avoidance of "Merger"
In many states, a farmout agreement might be held to have "merged" into and thus been extinguished by the assignment or sublease made or entered into pursuant to the agreement.10
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Such a merger would terminate any remaining rights and obligations of both parties to the agreement. However, a draftsman can almost always avoid merger by including in both the farmout agreement and in the assignment or sublease instrument a clear expression of intent to avoid merger.
Term
The parties must agree and the draftsman must clearly provide that the right of the farmee to acquire an interest in the farmed-out property must be exercised with the period prescribed by the Rule Against Perpetuities.11
Standards of Performance and Compliance with Underlying Lease, Environmental and Other Requirements
Farmout agreements should set forth the standards to be followed by the farmee in performing any...
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