Date contracts, spell out specifics to avoid court
JACOBSEN’S COUNSEL Joel Jacobsen
When the Little Red Hen asked who would help her plant, tend, harvest and mill the wheat, the other animals said, “Not I.” But when she asked who would help her eat the cake, they all eagerly volunteered. Oil and gas exploration, with its high costs and high risk but potentially rich returns, has its own recurring version of the Little Red Hen problem.
Joint operating agreements, or JOAs, are a valuable means for raising the capital necessary to search for oil or gas. But it’s inevitable that the parties to a JOA will sometimes cherish conflicting opinions about the advisability of drilling a particular well. One challenge in drafting a JOA is to create a mechanism by which one party can withhold financial support for a particular project without sacrificing the JOA itself.
Under the terms of an industry-standard contract, potential conflicts are avoided by an elaborate optin procedure. When one party proposes an operation, the others decide whether to participate. If they choose to say, “Not I,” they don’t have to contribute any funds toward the drilling. But they also don’t get to share in any profits until the costs have been recovered four-fold.
Crucially, though, nonparticipants are bound by their decision for only 120 days from the date of the proposal. If the initiating party “actually commence(s) the proposed operation” within that time period, the nonparticipants receive only a reduced share of profits. But if work doesn’t actually commence until after that period, the parties are automatically returned to their original share-and-share-alike footing. Bottom line: A lot of money can ride on the question of whether operations actually commence within 120 days.
Back in 1999, the New Mexico Court of Appeals ruled that “any activities in preparation for, or incidental to, drilling a well are sufficient” to show the commencement of operations. Then, in 2016, the same court retreated from that broad statement. In a case I first wrote about fourteen months ago, the court credited Echo Production Co., the party that proposed a particular drilling operation, with applying for necessary permits and “enter(ing) into a contract with a drilling company” within the 120-day window, actions that certainly qualify as “activities in preparation for” drilling. But, the court ruled, because Echo did no on-site work after the initial surveying and staking, it didn’t actually commence operations before the time expired.
Our state Supreme Court agreed to review the Court of Appeals’ decision. (In the jargon, it granted Echo’s petition for writ of certiorari.) During the 13 months the case was pending in our state’s highest court, the intermediate court’s non-final decision was controlling law in New Mexico, thanks to Rule of Appellate Procedure 12-405(C), which states that non-final Court of Appeals decisions are to be treated as final. That rule makes no logical or legal sense, and this case illustrates its negative effects.
In February of this year, the Supreme Court reversed the Court of Appeals. The key question, the court concluded, was whether Echo had demonstrated a “goodfaith intent to diligently carry on drilling activities until completion” during the 120-day period. A company’s good faith can be demonstrated by back-room preparations as much as by on-site activities. In fact, the court held, if it were indisputably true that Echo entered into a binding contract with a driller within the 120 days, that would have been conclusive proof of commencement.
However, when Echo executed the drilling contract, its representative didn’t date it, creating uncertainty as to when, exactly, it was signed. The Supreme Court sent the case back to the trial court to resolve that uncertainty, inaugurating another round of litigation. So the first of the case’s lessons is straightforward: When you sign a contract, date it. That routine little notation with the two slash marks may one day save your company a fortune.
The great advantage of using standard contracts is — or should be — that everyone knows what they mean, minimizing the potential for future disputes. During the zigzag course of the Echo Production litigation, our courts managed to eliminate that advantage. In just the past 18 months, the same clause of the same standard contract governing investment in New Mexico’s most important industry has had three different legal meanings. So I would suggest a second lesson to be drawn: the parties to a New Mexico JOA should add an extra page spelling out exactly what activities will count as the commencement of a proposed operation, so as to eliminate the involvement of our courts altogether.