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Article: January 2019: Energy Litigation Update

Business Litigation Reports

Arbitrational Tribunal Upholds Oilfield Forfeiture Clause. An arbitral tribunal seated in Paris has recently issued an award confirming the proper characterization and effect of the forfeiture provision found in many oil and gas Joint Operating Agreements, a subject which has been debated within the industry for some years but has received very little consideration by courts or arbitrators.

Oil and gas projects involve significant costs and significant risks. Uncertainties regarding the size and recoverability of reserves, the many technical difficulties that can arise in drilling wells and extracting oil or gas, and the fluctuating prices of oil and gas mean that no project can be guaranteed to be a financial success. Even if a project ultimately proves to be profitable, significant capital expenditure will be required before first oil can be achieved and any income generated, let alone before positive cash flow will be realized.

For these reasons, oil and gas companies rarely undertake projects on their own. Instead, they generally form consortia so as to spread the capital expenditure and risks associated with their projects. Although there a variety of standard forms of contract used to govern the relations between the parties to an oil and gas consortium, almost all such contracts will:

(a) require the parties to contribute (directly or indirectly) to capital and operating expenditure incurred by the Operator on behalf of the consortium in proportion to their percentage participating interest in the project;

(b) to make such contributions in full and without set-off whenever they are required to do so by way of cash calls issued by the Operator, even if they dispute the demand, with any such disputes being determined at a later date (known as the “pay now, argue later” principle); and

(c) provide various mechanisms to address a party’s failure to pay some or all of its cash calls when required, known as a “default.”

The latter mechanisms may vary from contract to contract, but will usually extend to the forfeiture of revenue and voting rights in the project and, if the default persists, the forfeiture of the defaulter’s participating interest in the consortium for no consideration. In the industry’s view, such mechanisms are necessary in order to provide the non-defaulting parties with means to ensure a project can continue when a party is defaulting on its obligation to contribute to its share of ongoing expenditure. In the meantime, the non-defaulting parties are required to pay their proportionate share of the defaulting party’s cash calls. Such provisions have been commonly found in oil and gas Joint Operating Agreements for decades. However, they are very rarely invoked due (in part) to the uncertainty as to whether the exclusion provisions are enforceable or whether they might be found to be penal in nature, and they have therefore been considered in very few reported cases.

In October 2017, one of Quinn Emanuel’s clients issued a notice to a co-venturer in a Brazilian offshore oil field development compulsorily requiring a defaulting consortium member to withdraw from the Joint Operating Agreement and to transfer its participating interest to the other consortium members in proportion to their participating interests. Under the forfeiture clause in the Joint Operating Agreement, which was in the AIPN 1995 standard form, the defaulting party which was required to transfer its interest “at no cost.” However, instead of doing so, it commenced an arbitration challenging the validity of the notice and the contractual provisions pursuant to which it was issued. The hearing of the challenge proceeded on the assumption that all of the (disputed) facts alleged by the defaulting party were proven, and included assumptions that it had invested nearly 100 times the amount of the cash calls of which it was in default at the time of the withdrawal notice. It was also assumed arguendo that the that Operator had incurred excessive costs in breach of the Joint Operating Agreement and that the other non-defaulting parties were also in breach of other provisions. Against that factual background, the defaulting party argued that the “pay now argue later” clause was unenforceable under Brazilian law if gad faith is alleged. It further maintained that the forfeiture provision itself was invalid and/or that its operation was unlawful under the Brazilian constitution and various articles of its Civil Code (a civil law system). Finally, and in the alternative, it argued that the forfeiture provision was a penalty clause (or clausula penal) the effect of which should be moderated by requiring the non-defaulting parties to pay it compensation for the loss of its participating interest. (Although penalty clauses are generally enforceable under civil law systems, they can be moderated if the penalty is considered to be disproportionate or excessive; by contrast, penalty clauses are generally unenforceable under common law systems.)

The arbitrators heard legal argument and testimony over four days from three professors qualified in Brazilian law, as well as an expert in oil and gas industry contracts.

By the time the hearing was held, oil production had started at the field and the project in question had also been the subject of court proceedings in Brazil. The issues in dispute in the arbitration had also become common knowledge in the industry and, given the rarity of such cases, the outcome of the hearing was keenly awaited by oil and gas companies around the world.

In the event, the tribunal held that the “pay now argue later” clause was enforceable such that the conditions for the right to require the defaulting party to withdraw had come into existence by the time the notice was served. Second, the arbitrators confirmed the proper characterization and effect of the forfeiture provision – namely that it is not penal in nature. Rather than to punish or deter, its commercial purpose is to enable co-venturers to continue with a project in circumstances where one of them has effectively ceased to participate by withholding cash calls. In circumstances where a party no longer wishes to participate, or is unable to do so, the Joint Operating Agreement anticipates that it will voluntarily withdraw and transfer its participating interest to the continuing co-ventures at no cost. It cannot have been intended that such a party could be better off by defaulting on its obligations, rather than voluntarily withdrawing, and then seeking compensation for the loss of its interest. So the tribunal held.

This is an important decision for the oil and gas industry, as it will help settle the long-standing debate as to whether the standard forfeiture clause is penal. It will also be welcomed by the industry, for which dealing with defaulting partners has become an increasing problem during periods of falling oil prices.