CHAPTER 7 DEALING WITH THIRD PARTIES

• Jurisdiction: United States

Oil and Gas Acquisitions
(Nov 1995)
CHAPTER 7
DEALING WITH THIRD PARTIES
John English
Butler & Binion, L.L.P.
Houston, Texas

I. INTRODUCTION

In the past, companies engaged in the oil and gas business often sought to rely on each other's good will because they realized that, due to the nature of the business, they had worked together earlier and would have to work together in the future. As a result, they did not worry too much about detailed contracts and, instead, relied on each other to conduct their affairs in a fair and equitable manner.

Now, however, the oil and gas industry in the United States and Canada is undergoing a transformation — major oil companies are focusing their exploration efforts overseas and dramatically reducing their ownership in producing oil and gas properties owned and operated in North America. As a result, acquisitions of oil and gas properties continue to occur at a high rate, both by large independents who seek to grow and diversify their holdings through purchases of large blocks of properties from majors and by smaller independents who seek growth potential by adding particular properties that fit well with their existing properties.¹ As a result, a large number of companies are strangers to each other; therefore, the participants in the industry have altered their conduct. The "what goes around comes around" syndrome has, for the most part, become a thing of the past. In addition, as the value of reserves and the sophistication and expertise of operations increase, disputes among working interest owners both among themselves and with third parties have become more frequent. As a result, now more than ever, there is increased scrutiny and analysis of one of the major institutionalized documents in the industry: the joint operating agreement.²

A natural consequence of these developments is that the many legal issues arising in oil and gas acquisitions have become more and more important to natural resources companies and their counsel.³ Accordingly, it is more critical now to carefully structure expected behavior; whenever possible, this should be done in writing because, as a lawyer, you can rest assured that if a dispute does arise, one of the first actions taken by all parties will be a review of the joint operating agreement to determine whether its provisions address and (hopefully) resolve the problem.

This paper will examine four areas of concern under joint operating agreements: preferential purchase rights, maintenance of uniform interests, areas of mutual interest, and changes of operator. It will cover briefly the differences in the provisions of the forms of joint operating agreements most used in today's industry, outline the common law applicable

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to these provisions, and offer some suggestions to assist counsel in dealing with these provisions.

At the outset, note that because of the level of cooperation and efforts at amicable settlement of disputes in prior years, there is a paucity of cases construing some of these provisions. As a result, there will necessarily be a certain amount of reasoning by analogy done in this paper.

II. NATURE OF THE OPERATING AGREEMENT

Simply stated the joint operating agreement is a contractual arrangement between two or more parties that provides the mechanics for sharing in the cost of exploring, developing, and operating one or more mineral properties in which more than one party owns an interest. To some extent, these agreements also govern the sharing of oil and gas produced from the properties covered by the operating agreement.⁴

As all of you know, there is no "standard form" oil and gas lease. The same rule applies here: there is no "standard form" operating agreement. Nevertheless, there is considerable similarity in the basic provisions of most operating agreements. This results in large part from the development of model forms of the instrument which have received widespread acceptance in the oil and gas industry. In 1956, the American Association of Petroleum Landmen ("AAPL") published the first version of its model form operating agreement, designated AAPL Form 610.⁵ Although there are other accepted forms of operating agreements, it is the AAPL form which is generally perceived to be the most popular form in current use.⁶ Because of that popularity, the AAPL Form 610 has been used as the basis for this paper.

III. PREFERENTIAL PURCHASE RIGHTS

A. Provisions in the Model Form

The AAPL Form 610 Model Form Operating Agreement (which is referred to in this paper as the "Model Form") published in 1956 provides that any party desiring to sell all or any part of its interests under the agreement or its rights and interests in the Contract Area⁷ shall promptly give written notice to the other parties with full information concerning the proposed sale, including the name and address of the prospective purchaser (who must be ready willing and able to purchase), the purchase price, and all other terms of the offer. The other parties then have an optional prior right, for a period of ten days after receipt of the notice to purchase their proportional interest on the same terms and conditions. This right does not apply to mortgages of interests, transfers by merger, reorganization, consolidation, or a sale of all of its assets by a party, or a sale or transfer of its interests by a party to a subsidiary or parent company or subsidiary of a parent company, or to any company in which any one party owns a majority of the stock.⁸ The provision in the Model Form published in 1977 and 1982 are almost identical except that the portion

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exempting sales of all assets by a party was deleted; the result being that a sale of all a party's assets to any entity other than a subsidiary or parent company of the seller or a subsidiary of a parent company of the seller will require compliance with this article.⁹ The Model Form published in 1989 added a requirement that the notice given by the seller must include a legal description sufficient to identify the property; in addition, this Model Form also exempts from the provision any sale by a party of all or substantially all of its Oil and Gas assets to any party.¹⁰

Each Model Form requires that the seller's notice be written. In their respective "Notice" provisions, each edition of the earlier Model Form requires that all notices be in writing, and sent by United States mail, telegram, or by teletype. The Model Form published in 1982 and 1989 also authorize use of telecopier or telex. The Model Form published in 1989 also authorizes the use of a courier service. They each further provide that "originating" notices shall be effective when received, while "responsive" notices shall be effective when properly addressed and deposited in the United States mail, or with the telegraph company or (in the Model Form for 1989) the courier company, or sent by teletype, or (in the Model Form for 1982 and 1989) telex or telecopier.¹¹

B. Considerations in Drafting

The provision creating the preferential purchase right serves two purposes:

1. It assures the holder of the preferential purchase right (the "Holder") an opportunity to acquire further interests in the Contract Area. It allows those owners who may have been at risk during the exploratory period to have an opportunity to acquire an additional interest in the property before a third party who did not participate in such risks.

2. It assures the Holder that he has some control in excluding undesirable participants who may not have the necessary financial ability to bear their share of expenditures or who might frustrate further development of the property due to a difference in management and engineering philosophies which the current owners oppose.¹²

Accordingly, if you are negotiating an operating agreement and your company or your client wishes to acquire all or any part of a party's interest in the Contract Area and, by doing so, increase its interest, leave in this provision; if your company or your client wishes to have some control over those parties with whom it must deal, leave in this provision.¹³ It has been noted however, that many landmen suggest deleting the provision because they believe it restricts the marketability of the interest. It is felt that prospective purchasers will be reticent about offering to purchase an interest when other parties have a preferential right to purchase on the same terms; there is also concern that the preemptive right will cause problems in "package" sales where each property offered for sale is not valued separately.¹⁴

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In addition, if you are using the 1977 or the 1982 editions of the Model Form, remember that these versions do not contain the provision exempting sales by a party of all of its assets; the result is that a sale of all a party's assets to any entity other than a subsidiary or parent company of the seller or a subsidiary of a parent company of the seller will require compliance with this article.¹⁵

C. Analysis

1. Nature of the Right. The preferential purchase right granted in an operating agreement exists only in favor of the parties to the agreement and their successors and assigns; in fact, a conveyance "subject to" an operating agreement will not be sufficient to create a preferential purchase right in favor of a grantee who was not a successor in interest to a signatory to the operating agreement.¹⁶

The right granted by this provision is not an option.¹⁷ An option creates in the optionee the power to compel the owner to sell at a stipulated price whether or not he is willing to sell. A preferential right of purchase does not; it merely requires the owner, when and if he decides to sell, to offer the property first to the Holder at the price and upon the conditions that someone else has offered. The details of a particular preemptive right depend upon the contract between the owner and the buyer; the...