CHAPTER 6 PROTECTION AGAINST JOINT VENTURE LIABILITIES: THE RMMLF MODEL FORM, BANKRUPTCY AND RELATED CONCERNS

• Jurisdiction: United States

Mining Agreements III
(May 1991)
CHAPTER 6
PROTECTION AGAINST JOINT VENTURE LIABILITIES: THE RMMLF MODEL FORM, BANKRUPTCY AND RELATED CONCERNS
Harold G. Morris, Jr.
Lindquist, Vennum & Christensen
Denver, Colorado

In the exploration and development of mining prospects in the United States it is common for two or more parties to enter into some form of written agreement, often styled as a "mining venture agreement." Such an agreement allows for the sharing of expertise, costs, and profits and spreads and allocates the economic risk of the enterprise. For tax and other reasons¹ it is also common for the parties (the "Participants") to structure their agreement along the lines suggested in the Model Form Mining Venture Agreement published by the Rocky Mountain Mineral Law Foundation (Form 5), and referred to in this paper as the "Model Form." Using the Model Form as a reference tool, this paper examines potential problems, under United States laws, faced by a financially sound Participant when another Participant encounters financial difficulties.

Through the use of examples illustrating the operation of various provisions of the Model Form, this paper will discuss how creditors of one Participant may impose vicarious liability on the other Participant, and how Form 5 seeks to protect against those claims and other problems caused by the financial difficulties of the debtor Participant. This paper will also discuss how the U.S. Bankruptcy Code (the "Code")² may defeat or alter these contractual provisions. For simplicity, a two-party Venture Agreement is assumed in these illustrations, but the general principles discussed will apply as well in multi-party agreements.³ For ease of reference, the financially sound Participant is referred to as the "Deep Pocket" and the financially beleaguered Participant is referred to as the "Debtor."

The purpose of this examination is not to question the wisdom of the Model Form venture structure, from just this single perspective. Instead, the intent is to identify some of the more obvious ways by which a Deep Pocket may lose all or part of what it bargained for in entering into its agreement with the Debtor, and the efficacy of provisions in Form 5 and similar agreements designed to protect the Deep Pocket against such calamities. These results will then be contrasted with protections utilized in Australia and New Zealand in the succeeding paper by Mr. Coyl.

Consequences of Joint Venture Liability

Benefits of the bargain struck by the Deep Pocket can be "lost" to the Debtor, its creditors or assignees in numerous ways, primarily effectuated through the Code, but not always. These untoward results typically fall into one of three categories.

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First is an increase in costs, which may largely go uncompensated, requiring the Deep Pocket to pay twice for goods, services or related liabilities. The Debtor, as a non-managing Participant, may fail to make required contributions. Or, the Debtor, as Manager, may fail to pay third parties for services or products purchased for the Venture's benefit. Similarly, the Debtor, as Manager, may incur uninsured tort or regulatory liability for which the Venture is ultimately held responsible. The primary contractual protections for the Deep Pocket against these defaults by the Debtor consist of encumbrances upon or transfers of the Debtor's title to Venture assets.

These protections are lien rights, security interests and dilution or relinquishment provisions. The second surprise for the Deep Pocket is that these security devices or title redistribution mechanisms may either fail or be unenforceable, leading to a loss of security or, in the worst case, title. The third surprise is that the Debtor may, under certain circumstances, seek to change the terms of the Venture Agreement and/or to assign its rights, and potentially the rights of the other Participant, to a third party without the other Participant's consent, participation or approval.

There are, however, certain defenses and protections to the exercise of these fearsome powers. This paper will highlight the Model Form contractual provisions and other matters upon which the Deep Pocket can construct its defenses and preserve as much of its bargain as U.S. law allows. Provisions of the Model Form receiving detailed discussion below are reproduced as Appendix A to this paper. Key Code provisions are reproduced as Appendix B. To commence an examination of these matters, we turn first to the initial formulation of the Venture.

Risks During the Earning Phase — Code § 365

The bankruptcy question most frequently occurring, in my experience, arises well before the threat of any actual filing crystallizes. This is perhaps due to the fact that mineral exploration is so difficult and few ventures actually survive beyond an exploration phase. Typically, a prospect is located and partially explored by a person or small company with limited means. It seeks initial funding of exploration by a Deep Pocket which will earn an interest in the prospect by conducting and funding far more detailed exploration. If the results warrant, the parties then embark upon further exploration, development and, ultimately, mining. The Deep Pocket is first concerned about protecting its interest during the earning period if the property owner should seek bankruptcy protection.

This overriding concern stems from Code § 365, which applies to executory contracts and unexpired leases. Subsection (a) allows the Debtor, with court approval, to "assume or reject any executory contract or unexpired lease of the debtor." While in other contexts⁴ the Deep Pocket will be concerned about assumption, during the earning period the Deep Pocket is most

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concerned about rejection of its contract with the Debtor. For most practical purposes⁵ , rejection works a termination of the contract and is treated as a breach by the Debtor as of the date of its bankruptcy filing.

The Code does not define the term executory contract. According to legislative history, "it generally includes contracts on which performance remains due to some extent on both sides."⁶ If performance on one side of the contract is complete, the contract is no longer executory. The most widely quoted characterization states that a contract is executory where the obligations of both the Debtor and the other party are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.⁷ This definition has not been adopted in the Tenth Circuit, however, where the requirement is that neither party has completely performed and the obligations of each remain complex.⁸ The complexity requirement might seem to be fertile ground for litigation, but for the fact that the sole obligation to pay a "significant" sum of money has been held to satisfy the definition.⁹

From the standpoint of the Deep Pocket, the Model Form deals with this Code § 365 problem admirably. Pursuant to Section 5.2 of the Model Form, the funding party is immediately vested with title to an undivided interest in the property, commensurate with its Participating Interest in the Venture, in exchange for an absolute obligation to commit, as its "Initial Contribution," an agreed upon level of funding. Commentary to the Model Form cautions, however, that this suggested resolution may be difficult to negotiate.¹⁰ The Participant owning the property often refuses to part with record title until required expenditures have been made. Alternatively, the funding party may desire to opt out at certain times prior to the completion of full funding. Given these competing concerns, parties often postpone execution of a formal venture agreement like the Model Form until the initial funding and exploration is complete, at which time the funding party receives a conveyance of its undivided interest. Some sort of exploration agreement or option governs the rights and obligations of the parties during the earning period, rather than the Model Form agreement.

Any such option or exploration agreement is in all likelihood an executory contract for purposes of Code § 365. Clearly, until complete performance, it is executory on the part of the earning party. The Debtor must ultimately make a conveyance and, given the unique nature of real property, such an obligation is likely to be viewed as complex. Whether or not complex, it is

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inarguably executory prior to delivery of the deed.¹¹ How then, can the earning party protect its investment?

First, apart from § 365 concerns, the earning agreement or a memorandum thereof should be recorded.¹² Second, the agreement should be structured to leave the conveying Debtor with precious few, if any, obligations. As discussed above, an outright absolute conveyance often cannot be negotiated. As discussed below,¹³ any such conveyance might be questionable if the earning party is not obligated unconditionally to meet the funding requirement. The obvious solution is an escrow which takes everything, including delivery of the deed, out of the potential Debtor's hands. Regrettably, this arrangement has received far from uniform acceptance as an exception to § 365 by debtor-oriented courts.¹⁴ Similarly, absolute requirements imposed by contract on the Debtor, to convey property upon a bankruptcy filing, are unenforceable as "ipso facto" clauses. Any such provision would receive condemnation under Code § 365(e)(1), Code § 363(1) and/or Code § 541(c)(1)(B). Each of these provisions precludes enforcement of any termination, modification or forfeiture of the Debtor's rights under contract that is conditioned on a bankruptcy filing or the insolvency or financial condition of the Debtor.

One practical solution to this dilemma might be the negotiation of a fee simple determinable or fee simple subject to a condition subsequent, with rights of reverter or re-entry satisfactory...