CHAPTER 4 DUTIES AND OBLIGATIONS REVISITED -- WHO BEARS WHAT RISK OF LOSS?
| Jurisdiction | United States |
(May 1990)
DUTIES AND OBLIGATIONS REVISITED -- WHO BEARS WHAT RISK OF LOSS?
Clanahan, Tanner, Downing & Knowlton
Denver, Colorado
I. Introduction
The operating agreement, and here we will focus on the AAPL Form 610-Model Form Operating Agreement, may be described as an agreement among several owners which provides for the orderly development of, and sharing of revenues and expenses pertaining to a defined area of land. In the course of this development, numerous responsibilities are prescribed by this agreement on both the operator and the non-operators. In prescribing these duties and obligations, the agreement has the additional effect of defining which parties must bear the risk of loss for various foreseeable events, and it is this bearing of the risk of loss, and ascertaining what that loss may be, that is the central focus of this paper.
In many instances, the risk of loss is not shifted from the party who would otherwise be responsible for such loss, the agreement merely reciting the customary legal relationships. There are other instances, where by joining the agreement, a party may have signed on for obligations not directly attributable to his contributed interest, not within his control, and perhaps, not even within his contemplation. Along with this study of determining who must bear the risk, is the question of the form of the consequence. The risk may involve losing an interest, the payment of money, losing operatorship, or incurring liability to third parties. Under the circumstances contemplated by the operating agreement, these results may well be quite equitable, or by the way the risk is shifted, may provide a defaulting party some significant advantage. To assess when a risk of loss may arise, it is necessary to determine the duties or obligations imposed on the parties to the operating agreement, the standard of care or performance they must bring to bear on these duties or obligations, and the result of such failure to meet this standard.
Notwithstanding the clearly contractual nature of the relationships created by a joint operating agreement, when analyzing these issues, negligence concepts from the law of torts quickly finds its way into the discussion. Perhaps it is just nostalgia for one who began his career as an insurance defense lawyer that thinking of torts should wind its way through one's analysis of a contract which establishes duties and a standard of conduct which when breached often result in damages. But, as we will see in our review of Article IV.B.2., Article V.A., and Article X., conduct amounting to negligence is anticipated by the agreement.
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While we will spend some passing time regarding the liabilities of the parties to third parties, this has been addressed thoroughly by other articles.1
II. Contract Provisions Assigning the Risk of Loss
A. General Obligations of the Parties
The agreement wastes no time in setting forth the general position that permeates the entire agreement. In Article III.B., the agreement provides that unless changed by the provisions, all costs and liabilities incurred in operations under this agreement shall be borne and paid, and all equipment and material acquired in operations on the Contract Area shall be owned by the parties as their interest are shown in Exhibit A. It is perhaps important to note that notwithstanding the general contract provision of reasonableness, the contract does not require, and it is arguably the case, that it does not matter whether the costs or liabilities are incurred as a result of prudent operations or improper behavior so long as such behavior falls short of gross negligence or willful misconduct. A sort of team spirit or espirit de corps permeates the operating agreement by the fashion in which the parties put their trust in one another to carry out the goals of the agreement.
When, for the most part, the parties to the agreement agree among themselves to bear all costs and liabilities in their percentage shares, it does not require an excessively detailed review to see that notwithstanding the often exhaustive analysis of partnership, trustee, agency, or other types of legal relationship analysis given rise to fiduciary, quasi-fiduciary, utmost fair dealing, or the like standards of conduct, the decisions actually seem to turn on either the express contract provisions pertaining to the parties' behavior, or did one party do something to the others that he would not want done to himself?2 The breach of the latter
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takes many forms of expression. Any reviewing court faced with this problem will frequently find a remedy to correct the impropriety. It is unfortunate for the rest of us that frequently the court will often be forced to grab for duties in the nature of a fiduciary relationship or utmost fair dealing or the like to prevent private profiteering or exploitation of the remaining parties. The majority of the disputes between operators and non-operators can be addressed by referring to the actual agreement itself, and it has been well argued that the courts and commentators would do us all a service by confining their analysis to the agreement whenever possible.3
B. Loss of Title.
Article IV. of the operating agreement deals with losing a lease or interest contributed to the operating agreement whether the loss is caused by a failure of title,4 loss by non-payment or erroneous payment of an amount due5 , or for other causes6 not covered specifically by the two prior categories. The mechanism for bearing the risk of such a loss makes sense. The party who loses the interest whether through its own fault by failure to make the necessary payment, or having title fail must bear the burden of this risk. This responsibility is mitigated by the fact that the agreement provides mechanisms to avoid any unjust enrichment of the remaining parties, assuming that the party who loses his interest has paid his share of drilling costs.
If the interest is lost by operation of some event which truly should have been outside the control or anticipation of a party, the loss is a joint loss, again evidencing that spirit of cooperation that assuming good faith efforts, the parties are in this venture together.
The 1956 agreement took this idea to somewhat of an extreme by current standards, inasmuch as failure of title and losing leases for other causes were treated as the joint
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responsibility of all parties.7 This may be explained in part by the fact that the 1956 agreement requires title examination and approval of the entire affected area, whereas the later agreements take the more restrained view that title will be examined only on the drillsite and/or the drilling unit around the proposed well.8
Beginning with the 1977 form, the language is straightforward. The party whose lease or interest is affected by a title failure shall bear alone the entire loss, and may not recover from the operator or the other parties development or operating costs which it may have previously paid.9 The later agreements provide for no retroactive adjustment of expenses incurred or revenues received; all adjustments are prospective. Likewise, the adjustments to Exhibit A are made effective as of the date of failure.10
In keeping with the concept that the party whose title has failed must bear alone the impact of this failure, liability to third parties for prior production is borne in their respective proportions by the party or parties who shared in this prior production.11 The 1989 agreement goes on to shore up this subparagraph (e) by requiring that each party shall severally indemnify all other parties for any liability to account to third parties.
Notwithstanding these requirements that the party whose interest has failed for reason of title or payment deficiencies must bear the impact of these failures, the agreement will not allow the other parties to the agreement to be unjustly enriched.12 Where the party whose lease has failed has not recovered his costs in connection with the producing well, the other parties to the agreement whose interest will increase, must dedicate the increase to the reimbursement of these costs. Thus, the other parties to the agreement will not be in a position to profit by having one of their members receive no further revenues, but have paid his share of all costs. The same result is obtained where a
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third party who is determined to be the recognized owner pays his way into the well.
The 1977 agreement does not provide for a period of time to cure a loss based on failure of title. While this was corrected in the 1982 agreement to allow 90 days to cure this interest, there still existed the problem of a separate party under the agreement obtaining the curative lease.13 Depending on the reason for losing the lessee, a new lease may constitute an extension or renewal lease which would have to be offered to the other parties pursuant to the provisions of Article VIII. Using this provision, the party losing the interest would not be in a position to re-establish his original ownership interest as set forth in the initial Exhibit A.14 The 1989 agreement has addressed this issue by requiring any curative acquired within 90 days of the failure of the interest to be offered to the party whose interest has failed or was lost, and further, that the provisions of Article VIII.B. shall not apply to such acquisition.15
By tracing the evolution of the sharing of risks from the 1956 through the 1989 form, one observes that with regard to losing an interest, the risk has moved from the group as a whole to the parties responsible for delivering and maintaining the interest in the Contract Area. As these parties possess the necessary control and information to properly maintain this interest, there is no policy reason mandating that this risk be borne in any other...
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