“The panic appears to be over. Now is the time to get worried.”
William Keegan (1938–), British author and journalist
A signed and recorded joint operating agreement (JOA) is often the first line of defense for an operator dealing with distressed partners. For example, a JOA generally grants an operator a lien upon the oil and gas rights of a non-operator in default and may establish certain penalties that can be assessed against a party who does not pay their share of development. But what happens when there is no JOA?
In short, the rules of cotenancy govern. Cotenants have an equal and coextensive right to occupy the premises so long as they do not exclude the other cotenant(s) from their equal right of access. An occupying cotenant must account to the non-occupying cotenants for all profits, but can recover the expenses that the occupying cotenant incurred to generate such profits. In most oil producing states, this means that one owner may develop minerals without the consent or joinder of its co-owners, but must proportionately share the proceeds of development minus the costs of development and production. If oil and gas operations are unsuccessful, however, the entire burden falls upon the developing concurrent owner.
Unfortunately, these general rules do little to explain what an operator can do to recover the debts owed by a distressed partner for development costs. So what tools does an operator have without a JOA?
What can an operator setoff?
One tool to collect debt owed by a distressed partner is the right to offset mutual debts. The doctrine of setoff is generally broad enough to permit an operator to offset debts owing in one well with production in another well when there is no JOA explicitly establishing the right to do so. This concept, known as the right of setoff, was recognized by the U.S. Supreme Court when it explained that “[t]he right of setoff (also called ‘offset’) allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding ‘the absurdity of making A pay B when B owes A.’” Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18-19 (1995).
Generally, the doctrine of setoff will permit the offset of mutual debts on unrelated transactions, including the netting of obligations owed on unrelated wells. Setoff can be a powerful tool because it affords an operator the opportunity to immediately collect 100% of the debt owed by a defaulting cotenant. That said, although the doctrine is widely recognized, operators should be aware of a few precautions when deciding to exercise the right of setoff.
First, where possible, an agreement that expressly provides for the offset of mutual obligations should be sought. This “best practice” will fortify the right of setoff and reduce the risk that a defaulting cotenant will challenge the setoff in the future. Second, a company exercising the right of setoff must ensure that there is no preexisting contractual agreement or statutory obligation (such as a royalty obligation) which would prohibit or contravene setoff. And third, although the doctrine of setoff is widely recognized, there is little case law specific to its use in the context of oil and gas cotenants. The doctrine of setoff can be raised as an equitable defense in litigation, but the risk that a defaulting cotenant will challenge the setoff cannot be eliminated.
Ultimately, an operator must exercise its business judgment when setting off debts from unrelated wells. In many cases, the immediate benefit of being able to collect a debt is well worth the risk that a defaulting party might challenge the setoff.
Can operators use state lien statutes?
State oil and gas lien statutes may provide an operator with additional remedies in the case of a defaulting cotenant. Although lien statutes are most commonly used by oil and gas service providers, some courts have recognized that operators may also use these statutory liens. John Carey Oil Co. v. W.C.P. Investments, 533 N.E. 2d 851 (Ill. 1988) (owner operator could attach statutory oil and gas lien upon interest of nonoperating co-owner under Illinois Oil and Gas Lien Act); Amarex v. El Paso Natural Gas Co., 772 P. 2d 905 (Okla. 1987); Kenmore Oil Co. v. Delacroix, 316 So. 2d 468, 469 (La. Ct. App. 1975).
When available, state lien statutes have specific procedures that must be closely followed in order to obtain a statutory oil and gas lien. These statutes generally provide that the mineral lien must be perfected within a certain period of time from when the labor or services were last performed by filing information that defines the nature and amount of the lien with the appropriate state authority. Individual state laws also differ regarding what property to which the lien extends. For example, North Dakota’s lien statute states that the lien extends to the whole of the leasehold and includes the proceeds of production. N.D.C.C. § 35-24-03. But in Texas, the statute does not specifically reference proceeds of production as property subject to the lien, and Texas courts have held that mineral liens do not attach to the proceeds of production. See e.g. In re Hess, 61 B.R. 977, 978 (N.D. Tex. 1986); Tex. E. Transmission Corp., 254 F.Supp.114, 118 (“in Texas the lien acquired by recording a judgment cannot attach to oil and gas after severance, or to proceeds resulting from its sale.”). Although the scope and availability of lien rights varies from state to state, the filing of a lien can be a useful tool when dealing with distressed partners.
What about force pooling?
Finally, a force pooling order from the state regulatory agency may help an operator recover and in some states, secure the debts of a defaulting cotenant. Most oil and gas producing states have a statutory provision allowing an operator to compel the integration of a non-participating working interest owner into a pooling arrangement. After certain notice and hearing requirements are met, the state agency can integrate the owner into the pooled area and require the sharing of costs and revenues. Force pooling may help an operator resolve outstanding debts with a cotenant in several ways.
First, the entry of a state force pooling order will clarify that an operator must pay a non-participating working interest owner only after the operator has deducted that owner’s share of drilling and completion costs. Although this right already exists under the rules of cotenancy, legal disputes often arise about which costs are considered “reasonable and necessary.” A force pooling order will define, by statute, what costs can be recovered by the operator.
Moreover, many states establish a “risk penalty” that, to compensate for the operator’s assumption of drilling risk, allows the operator to recover more than the non-participating owner’s proportionate share of costs. In Colorado, for example, an operator may recover 200% of the force pooled owner’s share of drilling and completion costs. C.R.S. § 34-60-116. In these cases, a force pooling order is doubly helpful because it allows the operator to recover costs in excess of those actually expended.
Finally, in certain states, a force pooling order may authorize a lien on production to secure the debt of the non-participating cotenant. In North Dakota, for example, the state force pooling statute provides that the operator has “a lien on the share of production from the spacing unit accruing to the interest of each of the other owners for the payment of his proportionate share of such expenses.” N.D.C.C. § 38-08-08 (2015). A similar provision exists in Oklahoma except that it provides that the operator “shall have a lien on the mineral leasehold estate or rights owned by the other owners therein and upon their shares of the production” until the operator is paid the amount due under the pooling order. Okla. Stat. Ann. tit. 52, § 87.1 (2015). In these states, upon executing the necessary steps to perfect a lien as provided by state statue, the operator will have a lien on production and/or the cotenant’s mineral estate until the cotenant’s share of costs has been recovered.
Even without a JOA, a savvy operator can do more than worry. There are many effective legal tools that operators can use to recover and secure debts. Those who take proactive steps to review these remedies now will be at an advantage later.
Risa Wolf-Smith is a Partner at Holland & Hart and has in-depth experience in oil and gas business bankruptcy reorganizations and workouts.
Elizabeth Spencer is Of Counsel at Holland & Hart and specializes in regulatory and transactional work for oil and gas businesses.