Keywords: freedom of contract, oil and gas industry, Association of International Petroleum Negotiators, AIPN
Basic Concepts and Principles
As a general rule, Brazilian law adopts the principle of freedom of contract. Contracting parties are authorized to determine the specific terms and conditions that will be applicable to their contractual relationship, to the extent such terms and conditions are not forbidden by law and do not affront the public order. Moreover, the contracting parties are committed to act in accordance with the principles of probity and good faith, tightly connected with the pacta sunt servanda principle (Latin for "agreements must be kept"), as provided for in article 422 of the Brazilian Civil Code.
In the specific context of the oil and gas industry, a party's freedom to choose with whom and on what terms to contract becomes particularly important given the significant investment of time and money intrinsic in exploration and production joint ventures. Because the joint operations cannot stop simply due to lack of funds, the parties will normally need to be as clear and specific as possible in their Joint Operating Agreements ("JOA") in order to discourage and manage any party's payment default.
The importance of this is reflected by the forfeiture mechanism included in the "default clause" of the Association of International Petroleum Negotiators ("AIPN") Model Form JOA. According to the JOA, a defaulting party would be forced to forfeit its participating interest under the JOA to the other parties, without any compensation, if it fails to timely pay its cash obligations to the joint venture.1 Specifically, the clause states:
If a Defaulting Party fails to fully remedy all its defaults by the thirtieth (30th) Day following the date of the Default Notice, then, without prejudice to any other rights available to each non-defaulting Party to recover its portion of the Total Amount in Default, each non-defaulting Party shall have the option, exercisable at any time thereafter during the Default Period, to require that the Defaulting Party completely withdraw from this Agreement and the Contract.2
However, application of the forfeiture mechanism is subject to debate in Brazil, particularly when considering the importance given to the principles of fairness and the protection against unjust enrichment in the Brazil legal system (and civil law countries alike). Opponents of the mechanism assert that property should not be taken away from a party without proper compensation and without reasonable grounds. Moreover, it is felt that there should be a balance between the value of the forfeited asset and the defaulted amount. For instance, if a petroleum-producing field value is estimated at USD 100 million and the defaulting party's debt is only USD 1 million, a Brazilian court would likely intervene to protect the interest of the defaulting party if it seeks judicial protection based on principles of equity.
In order to help parties avoid this controversy, which is particularly strong in countries with a civil law tradition, the new Model Form JOA released by AIPN in 2012 included a number of alternative options to deal with default. These options should be carefully chosen by the parties, taking into consideration the laws and practices of each jurisdiction.
Forfeiture Versus Buy-Out
One of the alternative default options in the AIPN 2012 Model Form allows for adopting distinct remedies for periods before and after an oil and gas commercial discovery is made, with forfeiture often being applied to the first period, and a buy-out alternative being recommended in the latter stages. Under the buy-out mechanism, the defaulting party is paid a certain consideration by the non-defaulting parties (the consideration paid is after deduction of the amount in default, the costs for valuation of the asset and, usually, a fixed discount percentage). The main part of the buy-out mechanism of AIPN Model Form JOA 2012 is transcribed below:
If a Defaulting Party fails to fully remedy all its defaults by the thirtieth (30th) Day of the Default Period, then, without prejudice to any other rights available to each non-defaulting Party to recover its portion of the Total Amount in Default, at any time afterwards until the Defaulting Party has cured its defaults, any non-defaulting Party shall have the option, exercisable in its discretion at any time, to require that the Defaulting Party offer to sell and assign all of its Participating Interest to any non-defaulting Parties wishing to purchase such Participating Interest.3
This distinction is based on the need to establish a remedy that approximately balances the value of the forfeited asset and that of the default vis a vis the actual ability of parties to effectively determine the value of an asset during the exploration and production stages.
Determining the value of an exploratory license—a license in the exploration stage, where no commercial discovery of oil and gas has been made—is not a simple task and, in the best of cases, any valuation would be merely an estimation, subject to a great degree of uncertainty. Should a buy-out alternative be applied to an exploratory license, this uncertainty could result in an undesirable situation where the defaulting party could be favored at the expense of the non-defaulting parties. In other words, application of the buy-out mechanism during exploration stage could result in two distinct scenarios:
A. The non-defaulting parties compensate the defaulting party for its withdrawal based upon their evaluation of the exploratory asset. After conclusion of exploratory works, a commercial discovery is made and the defaulting parties will finally benefit from their investments (whereas the defaulting party will have received an indemnity that may or may not represent the fair market value of its share, depending on how precise the preliminary evaluation was); or
B. The non-defaulting parties compensate the defaulting party for its withdrawal based upon their evaluation of the exploratory asset. After conclusion of exploratory works, there is no commercial discovery and the license is relinquished to the granting authority. At the end, the defaulting party will have been indemnified and the non-defaulting parties will have lost all of their investments.
However, application of a forfeiture alternative during the exploration stage results in only one possible scenario in which the defaulting party is effectively punished for its default and the unjust consequences of scenario (B) above are avoided.
After a commercial discovery is made, the license becomes a producing asset (even if actual production has not started yet), and an asset valuation becomes a less complex and risky task. Consequently, application of a forfeiture alternative in such a situation could be rejected by a court in Brazil (and most civil law jurisdictions) and replaced with an offset system that will take into account the value of the asset and the defaulted amount; if production has already started under a commercial basis, an offset could be allowed between the proceeds of production and the defaulted value.
The contracting parties' adoption of distinct remedies for both the exploration and production stages would certainly increase enforceability of forfeiture/buy-out provisions. Such affirmative steps would: (i) evidence a fundamental distinction between exploratory and producing licenses, which directly affects the capability of parties to effectively assess the value of the asset; (ii) avoid an undesirable situation where a defaulting party is favored at the expense of the non-defaulting parties; and (iii) evidence that the parties, seeking to observe the principles of equity, have consciously negotiated and agreed upon remedies that are appropriate to the nature of each phase of the contract, thereby avoiding the unfair application of forfeiture to any situation that arises.
1 In this regard, it is worthy to recall that, to ensure continuity of operations, usually the JOAs are subject to a "pay first, complain later" principle, under which the party appointed as operator makes the cash calls and the non-operators are obliged to pay without question. Complaints are to be made only if payment has already been made and by means of an audit process.
2 Extract from article 8.4 (Remedies) of default clause of AIPN Model Form JOA 2002.
3 Extract from article 8.4 (Remedies) of default clause of AIPN Model Form JOA 2012.
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This article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.