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Fiduciary obligations in the oil patch

David Delman, Hogan Lovells

As the boom in oil and gas exploration and production continues in the United States, it is worth reviewing the legal obligations that may arise between stakeholders in such projects. With millions and, perhaps, billions of dollars at stake, developers and their co-venturers may find themselves at each other throats when leaseholds thought to be dry turn out to hold vast reserves unlocked through technological advances in horizontal drilling and hydraulic fracturing.

Except for the Majors, the enormous expense and high risk involved in exploration are often shouldered by groups.  Relationships can be formed in a variety of ways, such as formal partnership, joint venture, joint operation, and limited liability company agreements hammered out with the assistance of legal counsel, or through informal handshake understandings. Depending on how deals are structure and the surrounding circumstances, courts may impose amongst the players extra-contractual obligations of absolute loyalty and transparency, preventing parties from acting solely in their own individual self-interest.

When general partnerships or joint ventures are formed, the law in every state imposes upon each participant a strict and exceedingly high standard of conduct called fiduciary duty. What does this mean? Fiduciary obligations encompass the highest obligations known at law requiring absolute loyalty, transparency and a prohibition against acts that would conflict with or unfairly benefit one party over another. Once fiduciary obligations exist, they are devilishly difficult, but not impossible, to disclaim. In order to disclaim fiduciary duty a written disclaimer must be so “clear and unequivocal” that it would effectively have to be nailed to the foreheads of all parties involved.

What is less certain is whether members of limited liability companies or participants in joint operation agreements owe fiduciary obligations toward one another. For limited liability companies, the trend across the country is to imply general fiduciary duties by default on LLC managers and managing members. Two court decisions at the end of 2012 from the Chancery Court of Delaware have led the way. While the first case, written by Chancellor Leo Strine (considered by many to be the country’s leading jurist in corporate matters), was criticized by the Delaware Supreme Court, it nonetheless affirmed the existence of a contractual fiduciary duty. Two weeks later, however, Vice Chancellor Laster in a different case enthusiastically embraced Chancellor Strine’s views, holding decisively in favor of default (non-contractual) fiduciary obligations between managing members and managers of LLCs. 

In Texas, however, the law is not as clear. In a case decided in the spring of 2012, a Texas appellate court refused to recognize a general fiduciary duty between majority and minority members of an LLC, but nevertheless imposed such obligations when the sole managing member controlled the business and failed to disclose critical information that might have affected the redemption value of the minority member’s interests. In Allen v. Devon Energy Holdings, the minority member, Allen, invested $700 and pledged a $34,300 certificate of deposit as collateral for a line of credit. Ten years later, wanting to buy Allen out, the managing member made pessimistic assessments, suggesting a negative impact to the venture. Despite this, $8 million was offered and accepted, with written disclaimers from Allen attesting that he had undertaken independent investigation of the facts. Twenty months later, the majority shareholder sold his interest to Devon Energy for a whopping $2.6 billion, twenty times the value used to calculate Allen’s redemption price.  Comparing $8 million versus $160 million, Allen sued claiming, among other things, breach of fiduciary duty. The Texas Appellate Court permitted the claim to proceed to trial, ruling that because the managing member had dominate control over the business and, thus, possessed special knowledge that he allegedly withheld from Allen, a formal fiduciary duty existed in the context of a redemption. The written disclaimers, according to the court, were not explicit enough to block Allen’s case.

Turning to joint operating agreements (JOAs), the law here is even more uncertain. For example, under Texas law, while JOAs do not create formal fiduciary duties, they may nonetheless exist between the parties in the form of a partnership, joint venture or agency relationship. Accordingly, in a JOA context, fiduciary duties may be implied given the circumstances.  In Kansas, on the other hand, the Supreme Court there has held that the operator of a JOA must treat the non-operator in a manner that is consistent with fiduciary principles. 

Bottom line:  In business combinations, be they partnerships, joint ventures, LLCs and JOAs, the trend is to impose fiduciary obligations at law, or to imply such obligations if the circumstances warrant and there is a whiff of unfair advantage or sharp dealing. The only way to avoid fiduciary duty is to have exceedingly explicit disclaimers in the operative agreements and even then, courts will struggle to get around them. 

About the author
David Delman is a partner at Hogan Lovells. Delman represents clients in commercial, construction, engineering, fiduciary, professional liability, and oil and gas/energy disputes in domestic and international forums, as well as in other areas. He also focuses on the negotiations of contracts, joint ventures, and teaming agreements in the engineering and construction industry.

 

 

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