Joint Operating Agreements and the Operator “Hold-Neutral” Principle – Court of Appeal Addresses Participants’ Liability for Unforeseen Costs
In a recent decision, Spirit Energy Resources Ltd & Ors v Marathon Oil UK LLC  EWCA Civ 11, the English Court of Appeal has dismissed an appeal brought by Spirit Energy and TAQA in respect of their liability for a share of a pension deficit for employees engaged in joint operations. Spirit and TAQA argued that the operator of the Brae fields, Marathon, was responsible for what they characterised as its “failure to curb runaway costs” and contested they were not compelled to bear such costs.
In dismissing the appeal, the Court of Appeal has given useful guidance on the rights of an operator under a JOA to require participants to bear costs where such costs were neither foreseen nor approved by the operating committee as part of an approved work programme and budget. The case will therefore be of interest to operators and non-operators where such joint operating agreements are governed by English law.
The appeal was brought by Spirit Energy Resources Limited, TAQA Bratani Limited and TAQA LNS Limited (the “Participants”). The Participants, along with JX Nippon, are parties with non-operated interests to a joint operating agreement (the “JOA”) and unit and unitisation operating agreement (the “UUOA”) in respect of the Brae Fields in the UK sector of the North Sea. The respondent, Marathon Oil U.K. LLC, is (and was at the relevant time of the dispute) the operator under each of the JOA and the UUOA (the “Operator”).
The appeal concerned a point of construction of the JOA. The Court of Appeal in the course of its analysis did not examine the terms of the UUOA, noting that they are, mutatis mutandis, identical to the JOA.
As is typical for an operating agreement in respect of oil and gas activities, the JOA required the Participants to fund their proportionate share of expenses for joint operations, through the payment of cash calls to the Operator. An operating committee (the “OpCom”) comprising representatives of the Participants exercised control over the Operator, including its expenditure. As is standard industry practice, the JOA required the Operator to submit draft work programmes and budgets on a periodic basis for OpCom approval. Costs incurred by the Operator were then allocated as between all parties to the JOA (i.e. the Participants and the Operator) according to each party’s percentage interest share in the JOA. Significantly, the Accounting Procedure to the JOA contained a statement of purposes, described by Lord Justice Green as an “equitable allocation of costs and benefits as between Participants, and an Operator hold-neutral principle.”
The dispute arose when the Participants refused to make payments to the Operator to fund a share of a deficit in respect of a defined benefit pension scheme for certain employees employed indirectly by the Operator (the “Deficit Recovery Charges”).
The Participants argued that, properly construed, they were not liable under the JOA and therefore the Operator was liable to bear the cost of the Deficit Recovery Charges. Their principal argument was that under the JOA, the Participants were not required to pay for liabilities that they did not foresee (nor contemplate) when the OpCom approved the relevant work programme and budget that included the employment of those employees. The Participants argued the Operator was not entitled to incur expenditure unless such expenditure was set out in an approved programme and budget – for the court to hold otherwise would effectively authorise the Operator to write “blank cheques.”
In a High Court judgment of 21 February 2018, Mr Justice Knowles found for the Operator. The High Court held that the Participants had given their approval to the Operator to incur the Deficit Recovery Charges by having previously agreed work programmes and budgets that included the hiring of employees, in respect of whom the Deficit Recovery Charges arose. That the costs of the Deficit Recovery Charges were not foreseeable at the time the relevant work programmes and budgets were approved did not remove the Participants’ liability to pay their percentage interest shares of such unexpected costs. Mr Justice Knowles concluded: “there is no question but that, alongside the other costs of employees in connection with the operations, the Participants are liable to meet a share of a proportion of the [Deficit Recovery Charges] in respect of the Scheme of which those employees were beneficiaries.”
Court of Appeal’s judgment and analysis
The Court of Appeal unanimously dismissed the appeal and upheld the ruling of the High Court. In a judgment handed down on 17 January 2019, Lord Justice Green in his analysis emphasised there was no dispute between the parties that the relevant principles of contractual construction are those set out by Lord Neuberger in the Supreme Court judgment in Arnold v Britton  UKSC 36:
- The starting point is to examine the “natural and ordinary meaning” of the contractual language of the JOA, which is to be considered from the perspective of: (i) the individual clauses which impose liability on the Participants; (ii) the JOA as a whole and the inferences drawn therefrom; and (iii) a “purposive construction” of the JOA, taking into account the principles which the parties have expressly incorporated into the agreement.
- The second stage is to turn to the overarching commercial purpose or “commercial common sense” of the agreement.
The “natural and ordinary meaning” of the contractual language
Lord Justice Green examined four points:
- The JOA imposes an obligation (“shall”) on the OpCom to “agree upon and adopt” the Operator’s requirements “having regard to” previously approved programmes and budgets. Lord Justice Green described as a “strained construction of the language” the Participants’ argument that the JOA conferred a discretion on the Participants to choose which “requirements” they honour and which they do not, and highlighted that would be inconsistent with the express provisions of the JOA and the principles guiding the allocation of costs set out in the accounting procedure exhibited to the JOA (the “Accounting Procedure”).
- Proceeding in his analysis of the contractual language of the JOA, Lord Justice Green noted article 10.1 of the JOA concerns “all” costs and expenses of “all” operations and stipulates that such costs and expenses “shall” be “borne” by the Participants. Again, such language is mandatory and not discretionary:
“10.1 All costs and expenses of all operations under this Agreement in or in respect of the Contract Area or the Licence, including the handling, treating, storing and transporting, whether within or outside the Contract Area, of Petroleum produced from the Contract Area, and all costs and expenses properly incurred by the Operator in its performance of the relevant provisions of the Decommissioning Security Agreement except for costs and expenses which are solely attributable or relevant to a Party, shall be borne by the Participants in proportion to their respective Participating Interests from time to time except as herein otherwise specifically provided. Furthermore, the costs of all assets, including materials and equipment acquired for the Joint Account of the Participants shall be for the account of the Participants in accordance with their Participating Interests from time to time, and, similarly, liabilities shall be borne in such proportions.”
- The article of the JOA that governs settlement of costs as between the Participants refers in “the broadest possible terms” to “all costs and expenses of whatsoever kind that are incurred in the conduct of operations,” which “shall be determined and settled in the manner” as set out in the Accounting Procedure. Lord Justice Green described the language in its use of “shall” as mandatory and all-encompassing – confirmed by the use of the words “all” and “of whatsoever kind.” He further highlighted there was nothing in the contractual language that carves-out costs, the full nature and extent of which was unknown and/or unknowable at the point in time when the head of cost was first approved and authorised.
- Turning to the overall purpose of the relevant clause of the JOA, Lord Justice Green referred to the express inclusion in the Accounting Procedure of the relevant purposes, namely an “equitable allocation of costs and benefits as between Participants, and an Operator hold-neutral principle.” The hold-neutral purpose supports the conclusion that nothing in the accounting procedures should lead to the Operator bearing a loss – i.e. that the Participants should be liable for the Deficit Recovery Charges.
Lord Justice Green concluded that the “natural and ordinary meaning” of the JOA “including by reference to its purpose” compels the conclusion that the Participants must bear their share of the Deficit Recovery Charges.
The overarching commercial purpose
Lord Justice Green observed there was no need to have resort to commercial common sense or rationale “since the JOA itself, in setting out its guiding purposes in [the Accounting Procedure], has identified by what criteria the commercial rationale of the JOA is to be measured.” On this point, Lord Justice Green dismissed arguments advanced by counsel for the Operator as follows:
- If it was the intention of the parties upon contracting to resolve the issue of unexpected costs via negotiation and agreement the parties would have said so explicitly. Instead the parties chose the sensible mechanism of prior approval of the Operator’s work programmes and budgets as the means by which they supervised the Operator’s activities and approved the related expenditures that they would, under the JOA, be required to bear in the future.
- It was not for the Operator to be held liable for the costs of the Deficit Recovery Charges, insofar as it was within the Operator’s power to take steps to ameliorate pension liabilities and therefore curb these runaway costs. Rather, the rationale behind the Operator being required to annually set out its future operating programme and budget accompanied by relevant estimates, assumptions and contingencies is to enable the OpCom to consider and to revise, approve or reject the budget.
- Furthermore, there is “no identifiable logic whereby the Participants can take the benefits but avoid the risks” – a Participant could not, having approved the Operator’s operations and its budget, and thereby induced the Operator to incur pension liabilities, then refuse to agree to bear its allotted portion of the costs leaving the portion it would otherwise bear to be borne by the Operator. Lord Justice Green added he was “unpersuaded that this could ever be considered commercially rational in the context of an agreement of this sort.”
Estimates and the “blank cheque”
Significantly, Lord Justice Green noted that it was the nature of the joint operations that the authorisation of the OpCom covered costs that might, at the time of the approval of a programme and budget, be uncertain as to their nature and scope and indeed this was why the Accounting Procedure required detailed information as to estimates to be provided to the OpCom: “[t]o the extent that the liabilities were much larger than expected, this did not alter the underlying analysis. The Operator was authorised to write a cheque to cover pension payments, whatever they might turn out to be.”
Lord Justice Green emphasised that the right to write a “blank cheque” was not conferred upon the Operator, such that it could spend the Participants’ money with impunity and without control or protection. He noted that in any event such protection is afforded from the common law, such that the Participants would not be liable for any expenditure incurred by the Operator in bad faith or dishonesty.
The Court of Appeal decision in Spirit v Marathon is significant insofar as it concerns a dispute among parties to a JOA. There is a scarcity of English court decisions interpreting JOAs – such operating agreements often contain an arbitration clause, meaning the outcome of any dispute will not be known (arbitral awards are generally not made public). The judgment is therefore a welcome addition to the body of case law on the rights and obligations of operators and non-operators engaged in joint operations in the oil and gas sector.
The judgment will be well-received by operators engaged in oil and gas activities, as a firm endorsement of the hold-neutral principle in joint operations – i.e. an operator should neither profit nor sustain a loss from its role in the joint operations.
For JOA participants with non-operated interests, the judgment may create some uncertainty over their liability for unforeseen and/or unexpected costs incurred by an operator and not expressly approved under a work programme and budget. However, it remains that this case concerned JOA participants’ liability for the funding of a pension deficit for employees engaged in joint operations – it is not clear how the English courts would allocate liability for other unforeseen categories of cost.
It is also not clear from the judgments of the High Court and Court of Appeal whether the JOA in dispute was based substantially on an industry standard, such as the “model form” of JOA published by the Association of International Petroleum Negotiators (AIPN) or Oil & Gas UK (OGUK). It is therefore not clear how the Court of Appeal’s decision might be applied in future cases, where the JOA in dispute is based on one of those industry standard forms. What is clear, however, is that the JOA for the Brae fields did not incorporate those provisions of either the AIPN or OGUK model form JOA which provide for limited budget over-runs.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.