News & Insights

Energy Law Exchange

August 3, 2017

Practical Issues Under Joint Operating Agreements Relating to Withdrawals, Transfers and Changes in Control


Energy Newsletter - August 2017 | article1

The Joint Operating Agreement (“JOA”) is one of the most important documents to be considered in relation to a direct or indirect change in the ownership of interests in any oil and gas project, whether by way of (a) a withdrawal by a party from the JOA, (b) the transfer by a party of some or all of its participating interest under the JOA (“Participating Interest”) or (c) a direct or indirect change in control of a party to the JOA, whether through merger, spin-off, sale of shares or other equity interests (“Change in Control”).

A number of model forms of JOA have become available in the oil and gas industry, the most widely used of which in an international context has been developed by the Association of International Petroleum Negotiators (“AIPN”). It issued its first JOA standard model in 1990, which was subsequently revised in 1995, 2002 and most recently in 2012. In considering the issues which arise out of the withdrawal by a party, the transfer of a Participating Interest by a party and a Change in Control of a party, the options available in the AIPN Model Form will be a primary point of reference in this article, although it is noted that similar provisions are found in other model forms such as the AAPL, OGUK, CAPL and AMPLA model forms.

Withdrawal

Consequences of Issuing a Withdrawal Notice

In many JOAs, subject to a party’s not being in default (and in some cases only if the minimum work obligations under the current period or phase of the licence or concession have been fulfilled), may that party elect to withdraw from the JOA and the underlying licence or production sharing contract by issuing an unconditional and irrevocable notice to withdraw to the other parties to the JOA, ultimately resulting in the assignment of the withdrawing party’s Participating Interest, to some or all of the continuing parties, free of cost.

Before embarking on the withdrawal process a party should be mindful of some of the consequences of issuing a withdrawal notice.

  • First, the withdrawing party will remain liable for its proportionate share of a range of ongoing costs and liabilities, especially those in respect of which it had given its approval prior to issuing a notice to withdraw or which are minimum work obligations for the current period or phase of the licence or concession and for any subsequent period or phase with respect to which the withdrawing party had not withdrawn within a limited period following its vote against the relevant operation. Of particular note is that under many JOAs a withdrawing party will remain liable for its share of any future costs of plugging and abandoning wells or portions of wells in which it had participated.
  • Secondly, a withdrawing party is often required to provide a security satisfactory to the other parties to satisfy any obligations or liabilities for which the withdrawing party remains liable. This obligation to provide a security is typically not expressed to be subject to any reasonableness test. The type of security contemplated in many JOAs includes a guarantee or standby letter of credit issued by a bank, an on demand bond issued by a surety corporation, a corporate guarantee or any other form of financial security agreed to by the parties. The JOA will often stipulate that the entity issuing the security must have a credit rating which indicates that it has sufficient worth to be able to meet its obligations in all reasonably foreseeable circumstances.
  • Thirdly, a withdrawing party is not relieved of its future obligations merely because they it not be ascertainable at the time of withdrawal.

Requirement to Provide Security

If the continuing parties require the provision of a security in relation to the remaining obligations of the withdrawing party in circumstances where the extent of the future obligations of the withdrawing party are not ascertainable, the appropriate quantum of security which is to be provided can be problematic. Given that the criterion as to the sufficiency of a security to be provided by the withdrawing party is usually a subjective one, i.e., that the security is “satisfactory to the other parties to satisfy any obligations or liabilities for which the withdrawing party remains liable[,]” there is significant scope for the withdrawing party’s being ultimately required to provide a security:

  • of a type;
  • in an amount; and
  • having a duration,

which goes well beyond the withdrawing party’s expectation at the time of delivering its withdrawal notice.

To the extent that there may be any plugging and abandonment liabilities for which the withdrawing party may remain liable, the duration of the exposure which the continuing parties might assert should be the subject of a security could be quite lengthy.

It should also be kept in mind that although there is often a requirement that the obligor under the security must have a credit rating “indicating it has sufficient worth to pay its obligations in all reasonably foreseeable circumstances[,]” the right of the continuing parties to require the provision of a security is typically not conditional upon any demonstrated lack of creditworthiness on the part of the withdrawing party.

From the point of view of the continuing parties, it should be borne in mind, before deciding either:

  • to not pursue the provision of a security; or
  • to accept the form of security being offered by the withdrawing party as being an acceptable form of security,

that they usually will have a once-only opportunity to make the decision, as there is normally no requirement to later provide a security or to provide a replacement or substitute form of security if the credit rating of the withdrawing party or the security issuer or guarantor is reduced below a particular level. If the likely time for calling on a guarantee or other form of security might be well into the future, e.g., for plugging and abandonment liabilities, this may be a significant consideration for the continuing parties in determining the need for a security to be provided by the withdrawing party and the type of security that is acceptable.

From the point of view of the withdrawing party, the provision of a corporate guarantee by the parent of the withdrawing party might often be seen as the least burdensome and costly form of security to be provided. However, if there is a possibility that the parent company might wish to sell its shares in the withdrawing party prior to all of the withdrawing party’s remaining liabilities having been performed or discharged, the provision of a parent company guarantee at the time of the withdrawing party’s withdrawal could complicate any such future sale process. In such a circumstance, the parent company would seek to persuade the continuing parties to agree to its guarantee being replaced by a security to be provided by the purchaser of the withdrawing party, otherwise it would face the prospect of having to continue to guarantee the performance by an entity which has ceased to be an affiliate and to have to rely on obtaining a back-to-back security or an indemnity from the new parent company of the withdrawing party, which is not an ideal outcome.

This circumstance is usually not addressed in JOA withdrawal provisions and consequently the continuing parties are not under any obligation to consider any request to replace a guarantee or to act reasonably in relation to such a request, irrespective of the credit worthiness of the new parent company of the withdrawing party. Therefore, if, at any time after the withdrawing party’s withdrawal, it requests the continuing parties to agree to the replacement of its parent company guarantee on account of there being a sale of the withdrawing party, the continuing parties will be in a strong negotiating position either to reject the request or to extract some other concession or commitment, whether from the withdrawing party or its parent company or from the transferee, as the condition for agreeing to the replacement of the parent company guarantee.

If the possibility of the sale of the withdrawing party is already foreseen at the time of the proposed withdrawal, it may be worthwhile for the withdrawing party and/or its parent company to first seek agreement from the continuing parties as to whether the withdrawing party will have the right to substitute any parent company guarantee which may have been given to the continuing parties at the time of the withdrawal with:

  • a bank guarantee for an agreed amount and which meets specified agreed criteria;
  • a guarantee from the new parent company (subject to its satisfying an agreed creditworthiness test); or
  • the payment by the withdrawing party of a pre-agreed cash amount to the continuing parties so as to achieve the release of the withdrawing party from its remaining liabilities under the JOA.

As to whether agreement can be reached with the continuing parties on the quantum of the bank guarantee or bond or the cash amount, it is by no means certain, but if that challenge is left until the time when the continuing parties are notified of a proposed sale of the withdrawing party, the prospect of securing a favourable outcome for the parent company of the withdrawing party will be even more remote.

Stapled Interests

Another complication, from the point of view of the withdrawing party, can arise where there might be any assets or obligations which are “stapled” to the upstream interest from which the withdrawing party has withdrawn (i.e., they are contractually bound together so that they may not be bought or sold separately), such as an interest in a downstream joint venture which might be held by the withdrawing party or an affiliate of the withdrawing party or rights and obligations under an associated contract, such as a gas sale agreement for the supply of gas produced by the upstream joint venture to an LNG project. In such a case, the upstream JOA, the downstream joint venture agreement and/or gas sales agreement is likely to require that any party wishing to transfer its upstream JOA Participating Interest must also assign or transfer (or cause its affiliate to assign or transfer) its downstream interests and its rights and obligations under any associated contracts to the party to whom the upstream interest is being assigned (or to an affiliate of the assignee or transferee of the upstream JOA Participating Interest).

However, the standard JOA withdrawal provisions do not impose any obligation on the continuing parties to accept an assignment from the withdrawing party (or its affiliate) in respect of any stapled interests or contracts. Therefore, in the case of a withdrawal from an upstream JOA there is a risk that the continuing parties under the upstream JOA may not be willing to accept an assignment of the stapled interest or contract. If, for example, the terms of the gas sales agreement are unfavourable to the gas seller or the downstream project is not profitable, the withdrawing party could find that, after having given an irrevocable notice to withdraw from the upstream JOA, it is unable to persuade the continuing parties to accept an assignment of the stapled interest or to enter into an assignment and assumption agreement in respect of the associated contract, or that it can only do so on very onerous terms, in view of its weak negotiating position.

If the withdrawing party fails to persuade the continuing parties (or their affiliates) to accept an assignment of the stapled interests and contracts, the withdrawing party may then find itself to be not only in breach of its contractual obligation to assign the stapled interests and contracts to the transferees of the upstream JOA Participating Interest but also to no longer be capable of performing its obligations under the stapled contracts, e.g., it would no longer be able to meet its continuing obligation as a seller under an associated gas sale agreement, once it has transferred its upstream JOA Participating Interest to the continuing parties.

Accordingly, if the withdrawal provisions do not adequately deal with stapled interests and contracts, prior to issuing its irrevocable withdrawal notice, a party seeking to withdraw from its upstream JOA should foreshadow to the continuing parties its intended withdrawal, so as to ascertain the reaction from the continuing parties and to understand the requirements of the continuing parties.

Transfers

Whether to Include any Constraints in JOAs

Under many JOAs, the holder of a Participating Interest which intends to transfer all or a portion of its Participating Interest (“Transferor”) may not dispose of any of its Participating Interest to a third party (i.e., to a non-affiliated party) without having offered to the continuing parties either a right of first refusal (or right of first offer) or a pre-emptive right (or matching right) in respect of the Participating Interest proposed to be sold.

The merits for including such provisions in JOAs, weighed against the commercial disadvantage which results from the fettering of a party to freely assign or deal with its Participating Interest, has been much debated and the drafting of these provisions has been the subject of judicial decisions in various jurisdictions. However, for the purposes of this article, it is noted that the inclusion of rights of first refusal or pre-emptive rights is quite widespread and the options available in the AIPN Model Form are quite frequently used.

Right of First Refusal

In the case of a right of first refusal, in JOAs based on the AIPN Model Form:

  • the Transferor must give notice to the continuing parties of its intention to dispose of all or a portion of its Participating Interest prior to entering into any agreement for the disposal of that Participating Interest and must invite the continuing parties to submit offers for that Participating Interest within a specified period of time; and
  • if the Transferor considers that none of the offers received from any of the continuing parties is an acceptable basis for negotiating a sale agreement or if a stated negotiation period expires without an agreement being reached or being likely to be reached within a certain additional period, the Transferor may dispose of the Participating Interest to a third party provided that the terms and conditions are no more favourable to the transferor than the best terms and conditions offered by any of the continuing parties.

Typically the clause will be drafted so that the Transferor is not permitted to enter into any agreement (whether in the form of a binding sale agreement or a non-binding heads of agreement or memorandum of understanding) with a third party for the “transfer” of any of its Participating Interest until the period allowed to the continuing parties to make an offer to purchase the Transferor’s Participating Interest (e.g., a 30 day period) has expired or, if an offer is made by any of the continuing parties, until the expiry of the specified period for negotiating a sale agreement with such continuing parties (e.g., up to a further 60 days).

The risk for the Transferor is that, by the time that it is free to enter into an agreement with a third party, the sale opportunity may have passed. In other words, unlike the case where there is a pre-emptive right, it is usually not possible to first enter into a sale agreement which includes a condition precedent to the effect that the pre-emption right has been waived or not exercised within the specified period and then wait to see if the condition precedent has been satisfied.

This constraint can be especially inconvenient where the sale of a Participating Interest is part of a wider transaction or package sale, e.g., if the Transferor is wishing to negotiate the sale of interests under several JOAs which relate to a single project, where the interests under one or more JOAs are subject to the continuing parties’ right of first refusal but the interests under the other JOAs are not subject to a similar right of first refusal. In such a circumstance the Transferor has to choose among the following:

  • to delay the signing of a sale agreement in relation to all of the Participating Interests that it is wishing to sell, until the expiry of the offer period under each JOA pursuant to which transfers of Participating Interests are subject to a right of first refusal – with the risk being that while waiting for the expiry of all of the applicable offer periods, the Transferor might end up losing the opportunity to make the sale;
  • to initially only enter into a sale agreement in respect of the Participating Interests under those JOAs which do not include any right of first refusal provision and to later separately deal with the Participating Interests which are subject to the right of first refusal condition once the applicable offer period available to the continuing parties under the JOA has expired. This choice carries the risk that the Transferor is not able to persuade the purchaser of the other Participating Interests to subsequently acquire the outstanding Participating Interests (with the result that the Transferor may be left with some stranded and less marketable interests), or the risk that, at that later time, the Transferor can only persuade the purchaser of the other Participating Interests to acquire the outstanding Participating Interest on terms which are much less favourable to the Transferor;
  • to initially only enter into a sale agreement in respect of the Participating Interests under those JOAs which do not include any right of first refusal provision and to include in that sale agreement a condition precedent to the effect that completion may not occur unless and until:
    • a sale agreement on similar terms has been entered into in respect of the Participating Interests under the JOAs which do include a right of first refusal provision; and
    • all of the conditions precedent under that later sale agreement have been satisfied,

but there is still the transaction risk that completion may not occur, based on the actions of any of the continuing parties under any of those JOAs; or

  • (depending on how the term “Transfer” is defined in the applicable JOAs), to enter into a put and call option agreement with the transferee in respect of:
    • all of the Participating Interests; or
    • each Participating Interest which is subject to a right of first refusal,

which includes a condition precedent to the exercise of either option that the continuing parties have waived or not exercised their rights of first refusal before the expiry of the offer period. –This would be on the basis that such options only create an equitable interest to prevent any other dealings by the Transferor, subject to the waiver by the continuing parties of their right of first refusal and that it does not constitute a disposal or alienation by the Transferor of its Participating Interest or of any rights which are derived from the underlying licence or JOA.

Once the right of first refusal constraint under any applicable JOA has expired, the Transferor will be able to transfer its Participating Interest to any third party within a specified period of time, e.g., 180 days plus any time required for obtaining government approvals. However, the terms and conditions of the transfer must be more favourable to the Transferor than the best terms and conditions offered by any of the continuing parties and for this purpose, for non-cash sales, the cash-value of the consideration must be agreed by the parties or be determined by an expert. Furthermore, even if the JOA does not include any express statement that the sale to the third party must be for cash consideration or that a cash value is to be determined, the Transferor will most likely still need to be prepared to demonstrate that the terms of the sale were more favourable than those offered by the continuing parties, e.g., the Transferor may need to consider obtaining an independent expert to indicate a cash value of any non-cash consideration.

Pre-Emptive Right

In the case of a pre-emptive right, in JOAs which are based on the AIPN Model Form:

  • once the final terms and conditions of a sale agreement with a third party have been fully negotiated, the Transferor must disclose all terms which are relevant to the acquisition of the Participating Interest (and, if applicable, the determination of the cash value of the Participating Interest) in a notice to the continuing parties, accompanied by a copy of all instruments or relevant portions of instruments establishing the terms and conditions;
  • the continuing parties have the right to elect, within a certain period of time, to acquire the Participating Interest on the terms and conditions negotiated with the third party, in the case of a cash transfer (except where sale is part of a wider transaction). Or if the transaction is not a cash transfer or is part of a wider transaction then the price will be the cash value proposed by the Transferor, unless any of the continuing parties gives a notice of its disagreement as to the cash value notified by the Transferor and agreement is not reached with the continuing parties wishing to acquire the interest as to the applicable cash value, in which case the cash value shall be as determined by an expert; and
  • if none of the continuing parties elect to acquire the Participating Interest within the specified time, the Transferor is permitted to complete the disposal of its Participating Interest within a certain period of time on terms which are no more favourable to the third party than the price and terms notified by the Transferor to the continuing parties.

Where the sale of a Participating Interest is part of a wider transaction or package sale it is quite common that:

  • the continuing parties may not acquire the Transferor’s Participating Interest unless and until the completion of the wider transaction (as modified by the exclusion of the Participating Interest which is subject to the pre-emptive right) has occurred; and
  • the right of pre-emption terminates if for any reason the wider transaction terminates without completion.

However, it is quite possible that the very reason for the wider transaction’s incompletion is that the pre-emption right in respect of the particular Participating Interest was exercised or was not waived within a certain period of time. Therefore, as is more common in the case of Change in Control transactions, where the market value of the Participating Interest is less than a certain percentage of the aggregate value of the assets of the party which is subject to a Change in Control, it may be appropriate to seek to include a stipulation in the JOA to the effect that where the transfer of the Participating Interest is part of a wider transaction, the pre-emption right is to only apply if the Participating Interest represents more than a specified percentage of the value of the wider transaction or package sale.

Continuing Liability of Transferor

It is quite common for there to be an exception to the right of first refusal or pre-emptive right procedure when the Transferor intends to transfer all or a portion of its Participating Interest to an affiliate. However, in some instances there is a requirement for the Transferor to guarantee the performance of its affiliate and that if the transferee ceases to be an affiliate of the Transferor for the interest to be transferred back to the Transferor, irrespective of whether, following the Change in Control of the affiliate, it might be able to meet all of the financial and technical capability requirements that apply in relation to assignments to third parties.

Where there is no requirement to retransfer the Participating Interest on a Change in Control of the affiliate transferee, the Transferor will seek to ensure that, following any subsequent Change in Control of the transferee (.ie., when it ceases to be an affiliate of the Transferor), the Transferor’s guarantee of the performance of its affiliate transferee ceases to operate and that instead the continuing parties are entitled to require that a new security is provided by the transferee. If this issue is not adequately addressed at or before a Change in Control of the affiliate transferee, the Transferor could be placed in the invidious position of potentially having to guarantee the performance of a non-affiliated entity following the Change in Control or to decide that the sale of its affiliate transferee should not proceed.

A somewhat similar circumstance can arise in JOAs which are based on the AIPN Model Form because, in respect of any transfer of a Participating Interest, both of the Transferor and the transferee of the Participating Interest shall be liable for the Transferor’s Participating Interest share of obligations which have accrued prior to the transfer (e.g., expenditure approved by the operating committee prior to the transfer of the Transferor’s Participating Interest). One of the options in the AIPN Model Form extends this obligation so as to include costs of plugging and abandoning wells in which the Transferor participated. The Transferor ought to seek to modify this residual liability in the JOA deed of assignment and assumption, at least in the case where the transferee (or its guarantor) is demonstrated to be credit worthy.

Change in Control

Development of Separate JOA Provisions for Change in Control

The JOA provisions relating to the Change in Control of a party are typically quite similar to those which apply to transfers (i.e., there is either a pre-emptive right or a right of first refusal, unless following the Change in Control there is ongoing control by an affiliate).

In older form JOAs (such as the pre-2002 AIPN Model Forms) the manner of dealing with Change in Control was merely to include general language in the article dealing with transfers, such as “any transfer of all or a portion of a Participating Interest whether directly or indirectly by assignment, merger, consolidation, or sale of stock, or other conveyance[.]” This general language created uncertainties and unintended results. The more explicit and specific Change in Control provisions such as in the later AIPN Model Forms overcome these concerns. However, there are a number of provisions which still need to be carefully considered.

Financial Capability of Party Subject to Change in Control

In many JOAs, there is a requirement for the party which is subject to a Change in Control to provide evidence reasonably satisfactory to the other parties of its continued financial capability after the Change in Control and, if such evidence is not provided, any of the other parties can require the party which is subject to a Change in Control to provide security satisfactory to the other parties for its Participating Interest share of any obligations or liabilities which the other parties may reasonably expect to incur under the licence or production sharing contract and the JOA during the then-current phase or term of the licence or production sharing contract.

While it would seem that the obligation is intended to be met prior to the Change in Control occurring there is no express statement to this effect, nor is the right to complete the transaction which results in the Change in Control stated to be subject to the satisfaction of the obligation.

Participating Interest Proportion of Value of Party Subject to Change in Control

Under most JOAs, in respect of transactions which result in a Change in Control of a party, but where there is ongoing control by an affiliate, there is no requirement to comply with the preferential purchase right procedure in respect of the Participating Interest which is the subject of the JOA.

In the case of many JOAs where a right of first refusal or a pre-emptive right is afforded to the other parties in respect of a Change in Control, the definition of “Change in Control” will include a condition that the market value of the Participating Interest in the licence or production sharing contract held by the affected Party represents more than a specified percentage of the aggregate market value of the assets held by that party and its affiliates that are subject to the Change in Control. The words “and its affiliates that are subject to the Change in Control” are important to be included because:

  • on the one hand, if the Change in Control provision only considers whether the market value of the party’s Participating Interest in the licence represents more than a specified percentage of the aggregate market value of the assets held by that party and on the other hand, the Change in Control occurs at the level of a parent company or other higher level entity, which has a wide range of assets with a collective value which is significantly greater than the Participating Interest, the exception to the preferential purchase procedure in respect of the Participating Interest would not be triggered; and
  • on the other hand, if the Change in Control provision is much broader and merely considers whether the market value of the party’s Participating Interest in the licence represents more than a specified percentage of the aggregate market value of the assets held by that party and its affiliates (i.e., irrespective of whether those affiliates are also subject to the Change in Control) the exception to the preferential purchase procedure would be triggered in respect of many Change in Control transactions simply because the party is part of a large corporate group with significant asset-rich group members, even though the Change in Control transaction might only apply to the party which holds the Participating Interest and does not apply to any of its affiliates.

Form of Transfer Notice

In JOAs which are based on the AIPN Model Form and which include the pre-emptive right option rather than the right of first refusal option, once the final terms and conditions of a Change in Control have been fully negotiated, the acquired party must disclose “all such final terms and conditions as are relevant to the acquisition of such party’s Participating Interest and the determination of the cash value of that Participating Interest” in a notice to the other parties, which is to be accompanied by a copy of all instruments or “relevant portions of instruments establishing such terms and conditions[.]”

Each other party shall then have a right to acquire such Participating Interest for the cash value, on the final terms and conditions negotiated with the proposed acquirer that are relevant to the acquisition of a Participating Interest for cash.

It has not been entirely clear how these provisions should be applied in practice. However, a JOA with Change in Control provisions which were based on the AIPN Model Form was considered in the recent Australian case, Santos Offshore Pty Ltd v Apache Oil Australia Pty Limited [2015] WASC 242 (“Santos v Apache”), which may be of guidance beyond Australia. In the pre-emption notices sent to Santos under the JOA, the Apache parties included certain terms of the sale agreement that the Apache parties claimed were relevant to the Participating Interest and which the Apache parties said were adjusted “to reflect and replicate the same legal and commercial outcomes for [Santos] in relation to the Participating Interests as the legal and commercial outcomes for [the purchaser from Apache][.]” Santos argued that the notices were invalid.

The court held that only the terms and conditions which “bear upon, or operate upon, or are closely connected or related to” the Participating Interest need to be disclosed and that a wider view would result in every term and condition in the sale agreement being “relevant to” a Participating Interest, which was not the intention of the clause. Regarding the Santos right to acquire the Participating Interest for a cash value on the “equivalent” terms and conditions set out in the notice, the court held that this was a reference only to the terms and conditions that have a bearing on the cash value of the Participating Interest and did not allow the Apache parties to modify the terms and conditions of the Apache sale agreement so that Santos would be offered “equivalent” legal and commercial outcomes as were received by the purchaser from Apache under the sale agreement.

It should be kept in mind that the AIPN Model Form is intended to deal with Changes in Control, including where there is non-cash consideration, in order to ensure that transactions are not able to be structured so as to evade the pre-emption process. While this does mean that there needs to be some modification to the transaction terms so as to establish a transaction which is capable of being pre-empted, the Santos v Apache case seems to indicate that modifications are only permitted for the limited purpose of separating the Participating Interest from the rest of the assets held by the company being sold and for establishing a cash value of that Participating Interest.

Conclusion

With the widespread use of model form JOAs, such as the AIPN Model Form, it is tempting to not spend time considering the implications of the various seemingly quite standard provisions. However, it can prove to be well worthwhile for a party to take the time to consider its longer term objectives and potential future transactions when negotiating the terms and conditions to be included in a JOA, or when carrying out its due diligence on any JOA in respect of the acquisition of a Participating Interest, especially those provisions which can affect its possible future withdrawal from the JOA or any future transfer of its Participating Interest or a Change in Control which relates to that party.