Farmout Agreement Worked Over by the Court

Originally published by Charles Sartain.

Co-author Chance Decker

What could go wrong when the well recovers two times its costs in nine months? Plenty, as we see in Dimock v. Sutherland Energy.

In a Seismic Exploration and Farmout Agreement, Dimock farmed out a 15-section area in Hardeman County, Texas, to Sutherland to drill the Hamrick #3.  Project payout was that point when revenues equaled two times Sutherland’s capital costs. The parties disagreed over whether payout occurred. The question was whether a $1 million seismic shoot after the well was drilled was a capital cost.

First, why do I care?

• “Boilerplate” in contracts are there for a reason.
• Should important terms be defined? This case suggests yes.
• Grammar matters. An errant comma cost one of the parties money and time.
• Defending a fiduciary duty claim will not be an enjoyable experience due to the high standard of behavior required of fiduciaries in Texas. Avoid fiduciary duties if you can. Seek them from the other guy if you can.

 

Here are noteworthy contract provisions (the ones that are, in one form or fashion, in most every farmout, so pay attention) and how they were addressed by the court:

Land and seismic costs

Exhibit A to the SEFA was a JOA, apparently a Model Form, which defined Sutherland’s capital cost as costs incurred “ … for land and seismic for the Hamrick #3 area 3D shoot, … a $50,000 prospect fee, and cost for drilling, testing, completing, and equipping, the initial earning well”.

Land and seismic costs were not defined.

Result

According to Dimock, the comma after “equipping” made the definition of capital costs ambiguous. Good try, but in honor of Mrs. Brown, my eighth grade English teacher, the court rejected it.  Placement of the comma to indicate a modifying element was not grammatically correct.

The court also declined to conclude that “land and seismic costs” was ambiguous merely because the terms were not defined. But to determine what costs were included will require a trial.

Operator’s right to shoot seismic

The SEFA gave Sutherland “ … the sole, exclusive and irrevocable right to conduct Seismic Exploration Operations … “ and the right “ … to use its sole discretion to determine the type, nature, timing, and extent of all Seismic Exploration Operations.”

On the other hand, the JOA prohibited the Operator from undertaking any project reasonably estimated to require an expenditure in excess of $25,000, except in connection with drilling, etc. that was previously authorized.

But the SEFA also provided, “ … in the event of any conflict between the operating agreement and [the SEFA], [the SEFA] shall be the governing agreement.”

Result 

According to Sutherland, the JOA was not in effect at the same time as the SEFA because the well was not drilled until later, so the JOA provision didn’t matter. The effective dates were the same for both. The court said if the parties had wanted a different effective date they could have written it that way.

The court of appeal also said that the primacy of the SEFA could have been a reason for the trial court to rule that Sutherland had the right to conduct the seismic operations. (The trial court ruled for Sutherland on that point but didn’t say why.)

Fiduciary duty

The JOA created Sutherland’s fiduciary duty to properly account for the distribution of well proceeds to Dimock.

Result

Dimock’s claim that Sutherland breached its fiduciary duty by failing to distribute well proceeds will be tried to a jury. Don’t act so surprised. This provision is in the Model Form JOAs.

Fraud

Dimock accused Sutherland of fraud by saying it needed to shoot seismic before it could drill the well and that’s why Dimock agreed to that provision. That claim will be tried.

Today’s interlude features girl singers you should know about: Suzy Bogguss and Sara Barealis

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