DEFAULT, AND HOW THIS CAN BE DEALT WITH IN A JOINT VENTURE

This post will focus mainly on joint ventures and joint operations in the upstream hydrocarbons industry, but many of the issues and solutions discussed here are equally applicable to joint ventures in other industry sectors

So, to begin! The question of default – how to avoid it, or to deal with it, if it cannot be avoided – involves an area of serious risk for a consortium and all its participants; the failure of one party will increase the amount which the other parties will have to pay to maintain the performance of the joint venture

Apart from this, it should also be borne in mind that the principal objective of a default provision, is protection against the lack of financial resources to cover the venture’s joint expenditures

There are a number of industry model forms to reduce the problem of default in petroleum industry joint ventures. But it is noteworthy that these model forms are not a rigid set of rules, and that in fact joint venture or joint operations contracts are free to adopt any measures that they wish. That said, in practice nearly all of them choose one of the standard regional forms to kick-off the drafting process. This approach reduces the time spent in negotiations, as most of the terms should be reasonably acceptable for the parties

Note, however, that the model forms tend to prescribe the accepted practice in a particular region, so not every model form will be entirely appropriate for your own purposes

In the hydrocarbons industries, almost all of the joint ops contracts which have been signed to date, have adopted one of the standard form models of agreement, and these contracts will therefore use either a forfeiture or a buy-out mechanism, and in a limited number of  cases, mortgage or lien mechanisms, which are in effect variants of forfeiture. The only exception to this rule is seen in joint ops contracts signed before the nineteen-seventies, as these early forms did not provide for any default mechanism

Noteworthy also, with regard to these early JVAs, is the fact that the great majority of them completely or partially ignored decommissioning issues since this was not then a historical concern; and all of them ignored exploratory risk

One alternative to the default mechanisms we have discussed, is theoretically simple; the parties to the JV could be responsible for providing enough accessible up-front cash to meet all of the required expenditures

Another alternative is the parent company guarantee. The reader may know that it is common to find large international holding companies establishing local companies in the country where the relevant operations are being conducted. Often, these subsidiary companies might not have sufficient financial resources to guarantee their commitments, since they are able to commit only their own capital, and not that of the parent companies or their shareholders. Consequently, it is fairly common for the parent company to receive requests for guarantees related to the activities of their subsidiary companies

Bank guarantees, letters of credit, and insurance-guarantees are all financial securities provided by a bank, and are yet another option to manage default situations. The use of these securities is widespread in relationships between host governments and their licensees. Unlike guarantees and credits from a parent company, these arrangements with banks provide immediate access to cash which makes them far more attractive for the non-defaulting parties

Mortgages and other forms of secured interest, are a further option. The joint venture parties can use their participating interest in the consortium (including related rights such as their share of property and production), to guarantee the fulfilment of financial commitments. A number of mechanisms are available to the parties to do this. In the hydrocarbons sector, for example, the most common mechanisms are the mortgage and the lien. The key point, in this context, is the common concept that all of them impose restrictions on each individual party’s rights related to the participating interest (including related rights) so that it can be used to guarantee future payments. The establishment of liens or mortgages might ensure the payment of on-going costs. A lien or a mortgage could be created over each party’s share of production for instance, or participating interest, or any other property. For exploration activities, however, this solution is very unlikely to be useful. First, because there is no production during this stage. Second, most of the installations and equipment are put into place after the design of a development plan for a discovery. It is difficult, therefore, to imagine equipment or installations which are valuable enough to provide security for a lien, except in the case of drilling rigs or platforms, as long as they are acquired in the name of the consortium or one of the members of the joint venture rather than rented from a third party

A more complex solution for the security of the joint enterprise might be found outside the scope of either the petroleum title or the relevant joint venture. This is known as the cross-default mechanism. Under that mechanism each joint venture party must own other assets which provide a guarantee of its financial commitments in the consortium. This default mechanism would involve several (or at least more than one) title to an asset, so a default in one title would trigger the default on another title. That said, this type of cross default is not yet well known in the hydrocarbons industry, since it involves several obstacles outside the control of the parties, such as third parties’ rights (for example, pre-emptive rights and right of first refusal) and governmental approval. In other words, the parties involved in the other licence, or indeed the government, might not allow the implementation of such a provision because it would allow the access of an outside party to their petroleum title

Another potential solution is a premium mechanism which consists of an obligation upon the defaulting party to pay a fee to the non-defaulters to compensate for the default. Although this mechanism should deter a potential default, it will not solve the original difficulty, namely: “how can a premium be paid if there is no production or if the ‘asset’ is in fact a liability?” Additionally, a premium mechanism would face uncertainties similar to those relating to the forfeiture mechanism. These would make it difficult to determine the value of the premium in relation to the amount of the default

The right of set-off is another possible way to solve a default concern. In this case, a non-defaulting party would have the right to offset any other payment it was supposed to make to the defaulting party. In theory, a set-off solution might be effective. But in practice, it only works if this right includes any payment (inside and outside) the petroleum title otherwise it will experience the same problems as the other mechanisms (because the petroleum title must be an asset with positive value)

This post is for information purposes only. It is not intended to constitute legal advice. For legal advice on a specific matter, please contact the author

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