model form operating agreement

It’s deju vu all over again in Chesapeake Operating, Inc. v. Sanchez Oil & Gas Corp. More accurately, it is a variation of Reeder v. Wood County Energy, LLC, et al. applied to Louisiana operations. For the impact of the exculpatory clause protecting the operator from liability in the 1989 Model Form JOA, see my post (co-authored by Marty Averill), “Operator Not Liable for Breach of 1989 Model Form Operating-Agreement, Part Two”. 

This one is a bit different.  Chesapeake and Sanchez entered into a JOA to operate leases in Louisiana. Chesapeake sued Sanchez for failing to pay its proportionate share of drilling and completion costs. Sanchez asserted the defense that Chesapeake had breached the  JOA in, as the court put it, “several ways”,  and did not perform its work in a good and workmanlike manner.

The key issue was the scope of the exculpatory clause, and whether Sanchez was required to prove that Chesapeake acted with gross negligence when it breached the JOA. The clause mirrors Article V.A of the 1977 and 1982 Model Form JOA’s (I assume one of those forms was at issue, but the court didn’t say):

 Chesapeake  . . .  shall be the Operator  . . .  and shall conduct and direct and have full control of all operations on the Contract Area . . .  . It shall conduct all such operations in a good and workmanlike manner, but it shall have no liability as Operator to the other parties for losses sustained or liabilities incurred, except such as may result from gross negligence or willful misconduct.

Sanchez argued that the clause only applied to claims that Chesapeake had not conducted the operations in a good and workmanlike manner; Chesapeake responded that the exculpatory clause also applied to allegations that it breached the JOA.

The court noted that the Fifth Circuit construed an identical clause in Stine v. Marathon Oil Company, and held that protection of the exculpatory clause extended to breaches of the JOA and that the operator was not liable unless its actions were grossly negligent or willful. The court also noted that three Texas appellate courts had reached the opposite conclusion, holding that the clause only applied to claims that the operator failed to act as a reasonably prudent operator.

The court stated that clause would apply to Sanchez’s defenses if Stine controlled but would not apply if the Texas appellate decisions controlled. The court stated that it could only rely on the appellate decisions if they “comprised unanimous or near-unanimous holdings from several—preferably a majority—of the intermediate appellate courts of the state in question.”Here, although the appellate courts were unanimous, they were not a majority of the Texas appellate courts. Thus, the court deemed itself bound to follow Stine.

The clause applied to Sanchez’s affirmative defenses. Because Sanchez had not presented evidence that Chesapeake’s breaches resulted from gross negligence or intentional misconduct, the court dismissed Sanchez’s defenses.

Big and Important Caveat: Chesapeake is a Texas case ostensibly applying Louisiana law. It is not from a Louisiana court.  The parties agreed that Louisiana and Texas law would be identical, so the court looked to Texas cases. I’m sure there are Louisiana non-operators who would (and will) take issue with this result.

Co-authored by Marty Averill

If you are a non-operator under the 1989 Model Form Operating Agreement, pay close attention to Reeder v. Wood County Energy, LLC, et al.  The Texas Supreme Court ruled that the operator is not liable to non-operators for breach of the agreement except in the cases of gross negligence or willful misconduct.

 This is a departure from Texas decisions which historically have held that the exculpatory language at the heart of the case extends only to claims that the operator failed to act as a reasonable prudent operator in connection with operations, but not for breaches of the JOA.

 The Decision

 The question before the court: What is the standard for resolution of a breach of contract claim against the operator? Article V.A.1. requires the operator to “ . . . conduct its activities under this agreement as a reasonable prudent operator, in a good workmanlike manner, with due diligence and in accordance with good oil field practice, …”. So far so good. But then comes the exculpatory clause: “. . . but in no event shall it have any liability as Operator to the other parties for losses sustained or liabilities incurred except such as may result from gross negligence or willful misconduct.”

 The difference between the forms is, “its activities under this agreement …” (‘89 form) and “… all such operations …” (’77 and ’82 forms). The court concluded that there is a substantial difference between those terms.

 The Litigation

 The parties were not getting along on major operations decisions. Reeder, the operator, sued Wood County Energy (in which he was a 45% partner) and the other non-operators alleging that as operator he had the exclusive right of possession of certain well bores and for other claims. The defendants counterclaimed that he illegally produced oil, fraudulently reported oil from one formation as being produced from another, and failed to sustain production in the quantities required by the JOA. All parties alleged conversion, violations of the Texas Thief Liability Act, and a host of other misdeeds.

 The jury found that Reeder breached his duties as operator. The non-operators were awarded damages and a declaration that Reeder owned no interest in the two formations at issue. The Court of Appeals agreed, but the Supreme Court reversed.

 The Takeaway

 It will be more difficult for non-operators under te 1989 form to recover against the operator for any claim, including breach of the contract, unless the non-operator can prove that the operator is guilty of gross negligence or willfulness conduct. Those are difficult burdens to meet.

 The court also discussed the legal sufficiency of the evidence necessary to support a jury verdict for gross negligence or willful conduct.

Stay tuned for a more thorough analysis of the case, including how the court could have resolved it in favor of the non-operators, why that result might have been better for the industry, how the ruling can be addressed when negotiating future agreements, and the sufficiency of evidence in this kind of  case.