No JOA, That’s OK: Practical Solutions For Operators in A Cotenancy Relationship

“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.

Recording JOAs In the Face of Looming Bankruptcies: Better Now Than Never

While the oil and gas industry has experienced a significant downturn as a result of the collapse of global and regional oil prices, it wasn’t so long ago that times were booming and wells were being drilled at a rapid pace. During the recent boom years, everyone in the industry was scrambling to keep ahead of the curve, and some tasks previously viewed as routine fell to the way side. One action item that has been increasingly overlooked in recent years is the recording of a joint operating agreement, or a memorandum thereof (generally herein, including the recording of a memorandum applicable, a “JOA”) to provide notice of the operator’s lien rights. Considering the current downturn, the failure to record a JOA could come back to bite operators as defaults and bankruptcies appear to be looming for many players in the industry. As an operator, there still may be time to repent and record those agreements in order to protect your rights and interests.

The most current 1989 A.A.P.L Model Form of Operating Agreement, and most other commonly used agreements for joint operations, contains provisions whereby each party to the JOA grants a lien upon any interest it owns or acquires in real or personal property in the contract area covered by the agreement to secure such party’s obligations under the JOA.1 The form JOA contains provisions allowing for the recording of a memorandum (or “recording supplement”) of the JOA, or the agreement itself, which is acceptable in most states, to perfect the liens granted in the agreement.

It is generally well known that recording the JOA acts to perfect the operator’s lien of record as to competing lienholders. For example, if a JOA is recorded and there is later recorded a judgment lien against a non-operator, the operator’s lien would be superior to the claims of the later judgment creditor. As the current industry slowdown continues, and the risks of bankruptcies of non-operators looms, what is the impact of the failure to record a JOA upon the filing of Chapter 11 bankruptcy by the non-operator?

Upon filing for bankruptcy under Chapter 11 of the bankruptcy code, the appointed bankruptcy trustee of the debtor has the authority to either accept or reject “executory contracts.” 11 U.S.C. 365. An executory contract is a contract wherein there are ongoing or unperformed obligations on both sides. It is generally held and expected that JOAs will most likely be deemed executory contracts under the bankruptcy code. If a bankruptcy trustee accepts an executory contract, that will mean that the debtor, as an ongoing concern, will cure past defaults under the contract, compensate for default damages or losses, and give assurances for future performance. However, a bankrupt debtor that is a non-operator under a JOA will often have an incentive to reject a JOA as an executory contract. If a JOA is rejected, then ongoing rights and obligations of operators and non-operators, including the non-operator debtor, will likely be governed by common law tenants-in-common principles. If a bankruptcy trustee rejects an executory contract, then that is treated as a breach of the contract and the creditor party to the executory contract is granted damages resulting from the default under the rejected contract. Whether a JOA is recorded or not will not impact whether a JOA is an executory contract, but it will impact whether or not the damages granted to the operator under the rejected JOA will be secured or unsecured. If a JOA was never recorded, then the operator will be deemed an unsecured creditor and join the pool of other unsecured creditors (which creditors will either not get paid at all or may get pennies on the dollar for outstanding debts). But if the JOA was properly placed of record to perfect lien rights, then the damages afforded to the operator upon rejection of the JOA as an executory contract will give the operator a secured lien.

Of course, just because a recorded JOA perfects an operator’s lien, that does not mean it is necessarily first in time and has a superior lien position. For example, a non-operator may have granted a prior recorded mortgage or deed of trust for the benefit of a bank, which first-recorded lien could trump a later-recorded JOA (or memorandum thereof). Ideally, operators should obtain subordinations to the JOA from holders of outstanding mortgages or deeds of trust (much like operators do for important oil and gas leases or surface use agreements), but in practice this rarely occurs. But certainly recording the JOA will perfect the operator’s lien as to subsequently recorded liens (and remove the operator from the general unsecured creditor pool in bankruptcy).

The question facing land departments now is: what if we didn’t record a JOA at the time of execution – is it too late? The answer, as most other answers offered by attorneys, is: it depends. Within 90 days of filing for bankruptcy, any payments made for prior debts by a debtor in bankruptcy to certain creditors, but not others, can be held to be preferential transfers under the bankruptcy code. A preferential transfer is most typically a payment made to and for the benefit of one creditor, to the detriment of other creditors, within 90 days of the bankruptcy filing. A Texas bankruptcy court has held that recording a JOA within 90 days prior to the bankruptcy filing was a preference that benefited a single creditor to the detriment of other creditors and was thus invalid.2 You cannot forecast if and when a non-operator will file for bankruptcy. But one thing is certain – it doesn’t hurt to record the JOA. If you record and a non-operator does file for bankruptcy within 90 days, the recording may be invalidated. But if the non-operator files for bankruptcy on the 91st day, you may have been fortunate enough to perfect your operator’s lien. Also, while you may have lost lien priority during any delay in failing to promptly record the JOA, you might still have time to perfect your lien as to other subsequent lien claimants down the road (and you may still have time to secure a first-position lien). Being a second position lienholder on oil and gas assets under a JOA behind the first lien of, for example, a non-operator/debtor’s bank, will still grant you certain advantages in terms of negotiating an acquisition of those assets or preserving some rights to proceeds (certainly over and above the rights of unsecured creditors).

So in the face of potential loan defaults, judgment liens, bankruptcies, and all the other unfortunate events that result from oil and gas downturn cycles, operators should act soon to record JOAs. Obviously, priority should be given to agreements where there are sizeable and mounting debts by certain non-operators. While there may be findings down the road that the late recording of a JOA fails to perfect lien rights, there are no good reasons not to simply record JOAs today.

1See Article VII.B of 1989 Model Form Operating Agreement.
2See In Re Wilson, 69 B.R. 960 (Bankr. N.D. Tex. 1987).