Operator Authorities: Deceptively Clear or Clearly Deceptive?

   

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GettyImages-dv762033IN 2014, ONE OF Western Australia’s most successful natural resources partnerships started unraveling. Santos, the non-Operator partner of the multi-billion-dollar Spar gas joint venture, took Apache, the other partner, and Operator, to court. Santos claimed that Apache had breached the joint venture agreement by taking certain actions prior to receiving the Operating Committee’s formal approval, including completing front-end engineering and design, corresponding with regulators, awarding contracts for major equipment, and conducting other activities related to the project’s development. The Western Australia Supreme Court ruled in favor of Santos, stating that Apache – despite being motivated by time and cost advantages from moving quickly – had circumvented the oversight of the Operating Committee through which Santos was entitled to influence or have input into matters such as budgets, contract awards, and project timing.1

In the midst of the dispute, a fairly standard clause in natural resource joint venture agreements was dragged into the limelight: “The Operator has exclusive charge and conduct of operations as agent on behalf of the parties under the supervision and control of the Operating Committee.” The court asserted that there was no inference that an Operator could act without the authority of the Operating Committee.

This standard clause – present in some form in almost all natural resource joint venture agreements – has the potential to give many joint venture Operators and co-venturers considerable grief.

BETWEEN A ROCK AND A HARD PLACE

The clause effectively allows the Operating Committee to direct all joint venture matters unless these are explicitly and clearly delegated to the Operator. Absent such clarity, joint venture Operators find themselves caught in a quandary: Should they take decisions in the interest of speed and efficiency, running the risk of invoking the ire and potential litigation of non-operating partners? Or should they refrain from taking seemingly routine decisions until approved or informally endorsed, at the risk of imperiling project timelines and cost savings? 

The absence of clarity also leaves many co-venturers feeling short-changed, believing that the joint venture agreement gives them broad governance authority through the Operating Committee. In contrast, the Operator holds a fundamentally different view that the Operating Committee is not actually intended to be a joint deliberative governance body or a forum to collectively direct joint operations. Rather, the Operator believes it is intended solely for the Operator to secure contractually-required approvals.
We recently analyzed a sample of 38 joint venture agreements in the natural resources industry to understand how joint venture Operator authorities are defined (See Box “About the Research”). Our analyses revealed that Operator authorities are not well defined. In joint ventures operated by a dedicated management team, the consequences of ill-defined Operator authorities are real but relatively benign, as the Board can always clarify what it retained and what it believes is best vested in management. Not so in ventures operated by one or more co-venturers, where the lack of clarity pits partners against each other.


Box: About the Research

About the Research_1

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This article focuses on a subset of 24 joint ventures from our broader sample which are operated by one or more partners.2 Using data from these 24 joint venture agreements, this article seeks to: illustrate where joint venture agreements lack clear definitions of Operator authorities; and emphasize the importance of addressing these gaps. 

Alternative cuts on the data, including specific benchmarks of Operator authorities, pass-mark voting thresholds for decisions not fully delegated to the Operator, and related analyses on this and other subsets of joint ventures from the sample will be covered in subsequent articles within this series. 

ILL-DEFINED OPERATOR AUTHORITIES

Gaps in legal agreements. Our analysis of the 24 joint ventures operated by one or more co-venturers showed that most joint venture agreements fail to fully define Operator authorities on key fiscal, contracting, and operating decisions.

We assessed 34 decisions that are fairly common in natural resources joint ventures, and that may require Operating Committee approval. Of these, there were 19 decisions where 50% or more of the agreements were silent on the Operator’s authorities (Exhibit 1). We additionally reviewed the provisions contained in the Association of International Petroleum Negotiators (AIPN) model joint operating agreement, a standard joint venture agreement form used in the oil and gas industry. The AIPN model form joint operating agreement includes some reference to only 21 of the 34 decisions. Decisions where the majority of joint venture agreements and the model joint operating agreement were silent include the incurrence of non-budgeted expenses, entry into long-term contracts, writing of purchase orders for goods or services, and others where the absence of clear delegations to the Operator can cause repeated frictions and inefficiencies.3 


Exhibit 1: Extent to which Operator Authorities Defined against Key Fiscal, Contracting, Financial, and Operating Matters

Extent to which Operator Authorities Defined against Key Fiscal, Contracting, Financial, and Operating Matters

*Does not reflect possibility that capital expenses are part of work program and budget as not explicitly called out.
** Includes tendered contracts and contracts where unspecified distinction between sole source or tendered.

Source: Company filings; Water Street Partners’ Analysis
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Subjective language creating the risk of differing interpretations.
We also observed that to the extent joint venture agreements define a delegation, many add qualifications and conditions to the delegated authority. Through these qualifications and conditions, the parties endeavor to provide more objectivity to language that could be prone to conflicting interpretations. For example, one agreement allows the Operator to make modifications to the annual work program and budget if these modifications are “minor”. It further goes on to establish certain objective criteria that help determine whether an Operator modification to the annual work program and budget is “major” (i.e., not “minor”) and therefore requires the approval of the Operating Committee. In this venture agreement, a modification is deemed “major” if it will change the number of wells by at least 15%, the transmission system from pipeline to barge, the cost of the fabrication authorization for expenditure (AFE) by more than 10%, or the timing of initial production to 90 days later, and others.

But in some instances, the qualifications and conditions actually increase the possibility of differing interpretations by adding language that is subjective. Another joint venture agreement, for example, requires the Operator to consult each of the coventurers prior to executing any third-party contract that is within the ordinary course of business, and with a cumulative value greater than 10% of the fair market value of the joint venture on an annualized basis. The agreement goes on to specify a formal consultative process, including the requisite notice period and written details. Despite all the detail, the agreement is silent on crucial aspects of the consultation and approval requirements – leaving the Operator and co-venturers to draw their own inferences. One could easily infer that: (i) third-party contracts within the ordinary course, and with a value less than 10% of the fair market value of the joint venture, can be executed by the Operator without consultation; and that (ii) third-party contracts outside the ordinary course require formal approval. However, what happens to third-party contracts that are subject to the formal consultative process, but where the co-venturers express strong reservations? To what ... Click Below to Continue Reading... 

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Apache subsequently won the case on appeal. The WA Court of Appeal overturned the first instance decision, ruling that Apache did not breach the JOA in conducting development activities without authorization from the Operating Committee, as these activities (i) were conducted by Apache at its own expense and not charged to the joint account until after Santos approved the Development Plan, and Work Program and Budget; (ii) did not jeopardize the title, or involve the use of joint property; (iii) did not interfere with, or prejudice the working of the Operating Committee; and (iv) did not confer any timing advantage on Apache.

Determining what decisions are delegated to the Operator and what decisions the Operating Committee must approve requires a significant amount of attention and is not always clear from the terms of a joint venture agreement. Such decisions are spread throughout various sections of the legal agreements. In some instances, it is unclear whether decisions not specifically called out are intended to be included within another decision. For example, in several agreements it is unclear whether decisions related to the work program and budget are inclusive of decisions related to capital expenditures or whether third-party contracts, if not specific, are inclusive of both sole source and tendered contracts.

This includes ventures which are effectively operated by one or more co-venturers even if structured as joint venture Operating Companies. For example, ventures with a lead operating partner who is the de facto Operator; or mixed-operator type ventures with function-, phase-, or asset-based division of labor among the co-venturers.