CHAPTER 2 THE OPERATOR: LIABILITY TO NON-OPERATORS, RESIGNATION, REMOVAL AND SELECTION OF A SUCCESSOR

• Jurisdiction: United States

Oil & Gas Agreements: Joint Operations
(Dec 2007)
CHAPTER 2
THE OPERATOR: LIABILITY TO NON-OPERATORS, RESIGNATION, REMOVAL AND SELECTION OF A SUCCESSOR
Ernest E. Smith
Rex G. Baker Centennial Chair in Natural Resources Law
University of Texas School of Law
Austin, Texas
David E. Pierce
Professor of Law
Director, Washburn Business and Transactional Law Center
Washburn University School of Law
Topeka, Kansas

ERNEST E. SMITH

ERNEST E. SMITH

Rex G. Baker Centennial Chair in Natural Resources Law

The University of Texas School of Law

LLB 1962, Harvard

BA 1958, Southern Methodist University

A specialist in oil and gas law, Professor Smith is co-author of the leading casebook on Oil and Gas Law (West, 4^th ed., 2002) and the leading treatise on Texas Law of Oil and Gas (3 volumes, 2^nd ed., LEXIS Law Pub., 1998 ed. and 2007 Update). Other co-authored books on oil and gas law include the fourth edition of Hemingway Oil and Gas Law and Taxation (4^th ed., 2004) and International Petroleum Transactions (2nd ed., 2000). Professor Smith also teaches in the area of property, and is co-author of a widely used text, Cases and Materials on Property (Foundation, 8^th ed., 2002). A former Dean of Texas Law School, Professor Smith has also been a Visiting Professor at several law schools, including the University of Dundee in Scotland and Harvard Law School.

In 1998 Professor Smith received the Clyde Martz Award for Excellence in Teaching from the Rocky Mountain Mineral Law Foundation. In 2000 he received the Texas Excellence Teaching Award for the School of Law from the Ex-Students Association. In the same year Annual Institute of Oil, Gas and Mineral Law, which is co-sponsored by the Texas State Bar Section on Oil, gas and Energy law and the University of Texas School of Law and is now in its 33^rd year, was re-named the Ernest E. Smith Oil, Gas and Mineral Law Institute. The Ernest E. Smith Endowed Presidential Scholarship in Law was established in 1994, and the Ernest E. Smith Professorship in Law was established in 1996.

Phone: (512) 232-1268

Fax: (512) 471-6988

E-mail: esmith@law.utexas.edu

To a significant extent, the rapidly developing law dealing with the operator under a joint operating agreement mirrors the process that occurred with respect to oil and gas lessees.

Like the much earlier jurisprudence dealing with the oil and gas lease, the jurisprudence dealing with joint operating agreements is directed both at interpreting specific clauses of the agreement and at defining the relationship between the party charged with managing the operation and the parties whose participation in decision-making is limited.¹

Unlike early oil and gas leases, which for several decades varied enormously in their stated duration and basic terms, joint operating agreements (JOA's) have been remarkable for their relative uniformity in content and structure. Although there are numerous specially drafted agreements, virtually all JOAs currently in use are either unaltered or modified versions of the model forms promulgated by the American Association of Professional Landmen (AAPL). There have been four such forms, and they will be referred to by the dates in which they were issued: the 1956 Model Form, the 1977 Model Form, the 1982 Model Form and the 1989 Model Form. In addition, there are analogous model forms that are widely used for unit operations. The two Unit Operating Agreements (UOA) that will be discussed in this paper are the API 1970 Operating Agreement (the API UOA) and the Rocky Mountain Unit Operating Agreement Form (RMMLF UOA) that was promulgated by the Rocky Mountain Mineral Law Foundation in 1994.

Because of the relative standardization of operating agreements, concepts and holdings arrived at under one operating agreement can often be construed as applicable to all other operating agreements and, in many instances, to other jurisdictions. Such generalizations are, of course, not possible when a court is dealing with one of the clauses that differs from form to form. Unfortunately, with occasional welcome exceptions,² courts often fail to mention which form they are dealing with, although the date

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of the parties' agreement (if given), the date of the case or the quoted language usually allows and educated guess as to which form is being construed.

Two of the issues that have received a significant amount of attention are the standard of conduct required of the operator and - at what may be viewed as the other end of the spectrum - operator resignation or removal and the selection of a successor. Each of these topics will be discussed in turn.

I. WHAT STANDARD IS THE OPERATOR HELD TO?

One of the most important and, as yet unsettled issues under the JOA is the standard of conduct to which the operator is held. The literature on this issue is extensive. Even a very partial listing of papers appearing in the proceedings of the Rocky Mountain Mineral Law Foundation's Annual Proceedings results in a very long footnote.³

Art. V.A. of the 1989 Model Form provides the following statement:

Operator shall conduct its activities under this agreement as a reasonable prudent operator, in a good and workmanlike manner, with due diligence and dispatch, in accordance with good oilfield practice, and in compliance with applicable law and regulations, but in no event shall it have any liability as Operator to the other parties for losses sustained or liabilities incurred except such as may result from gross negligence or willful misconduct.

This is not, however, the only language bearing on the operator's standard of conduct. Art. V.II further provides that the parties do not intend to create a mining partnership, joint venture or agency relationship among themselves, and that in their relationship with each other "the parties shall not be considered fiduciaries or to have established a confidential relationship." Hence, they are "free to act on an arm's-length basis in accordance with their own respective self-interest." Nonetheless, they are subject "to the obligation . . . to act in good faith in their dealings with each other with respect to the activities" undertaken under the JOA.

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One might have wished a clearer statement - ideally, perhaps, a standard of good-faith business judgment.⁴ Since the language is far from clear, it has, unsurprisingly, given rise to extensive litigation as well as academic comment. Most of the cases discussing the standard to which the operator is held arise in litigation with non-operators, and the standard will be discussed in that context.

II. OPERATOR LIABILITY TO NON-OPERATORS

The cases involving the operator's liability to non-operators for alleged misconduct or breaches of the JOA can be divided into two general categories: In the first category are cases concerned primarily with determining the standard of conduct or level of duty that the operator owes to non-operators. These cases typically⁵ involved allegations by non-operators that the operator has either gained some benefit that should be shared with the non-operators⁶ or has taken advantage of its position in a way that harms the non-operators. The second category of cases focus on the scope of the JOA's exculpatory clause and usually involve claimed breaches of the operating agreement.⁷

A. THE LEVEL OF THE OPERATOR'S DUTY TO THE NONOPERATORS

Non-operators have often claimed that the level of duty to which the operator should be held is that of a fiduciary. The two most common arguments for such a standard are agency and joint venture.

1. Agency and Joint Venture: Fiduciary and Good Faith Obligations

An agent is subject to the instruction and control of his principal, who can revoke the agent's authority at will, even if he has contracted not to do so. See Restatement (Second) of Agency § 14, comments a & b (1958). Although there are some form JOA's that provide for the operator's removal without cause,⁸ authorize the participants to "exercise overall supervision and control" over operational matters,⁹ and establish a voting procedure for exercising such supervision as well as for approving or authorizing a relatively wide range of actions,¹⁰ such forms are typically intended for use only in specific situations, such as federal exploratory units or fieldwide unitization

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.¹¹ In the far more commonly used model forms promulgated by the AALP non-operators do not have anything thing approach this level of control The operator is given full control over all operations on the Contract Area, and has equally broad rights with respect to contracting, subject only to the JOA requirement that such contracts be "competitive" and "at the usual rates prevailing in the area." See Arts V.A & D of the 1982 and 1989 Model Forms The non-operators have no power to direct the operator in how to drill or with whom to contract. Of equal or greater significance, the operator cannot be removed at will, but only for cause.

The joint venture basis for imposing fiduciary duties under the AAPL model forms is somewhat stronger and enjoys the support of several distinguished commentators as well some occasional judicial support;¹² but this approach also presents analytical difficulties. There is little question that - absent an operating agreement -- two or more parties engaging in joint exploratory, drilling or similar activities would be deemed to have formed a joint venture and owe fiduciary duties to each other with respect to the venture. They would also have joint and several liability.

Because joint and several liability is a major disadvantage of a joint venture. one principal purpose of a joint operating agreement is to negate such an arrangement. Art. VII.A of the 1982 and 1989 Model Forms stipulates that each party's liability is several rather than joint and goes on to provide that the parties do not intend to create a partnership and that "each party shall be...