UK: Has The Time Arrived To Consider Taking Security Against Potential Defaulters?

With the cyclical fluctuation in oil and gas commodity prices, the UKCS has had its fair share of E&P companies going insolvent. As the UKCS matures, the profile of companies that invest in the region is changing. Many smaller parties, potentially with less access to capital, are now building positions.  The commercial exposure is that some companies will not be able to meet cash calls, creating headaches for their co-venturers.

Companies have traditionally sought comfort through their contractual right to forfeit a defaulting party's participating interest under what are fairly standard terms set out in Joint Operating Agreements ("JOAs"). Although the Supreme Court's judgment in Cavendish Square Holdings B.V. v Makdessi [2015] UKSC 67 has provided a degree of comfort over the enforceability of such provisions, it still leaves unresolved the tension that exists between the co-venturers' right to forfeit and the powers of the insolvency practitioner ("IP") appointed to protect the creditors of an insolvent co-venturer.

Default Provisions in Joint Operating Agreements

A party's failure to pay its share of cash calls when they are due is considered a default under both the AIPN and OGUK JOAs. Both JOAs provide for a rectification period, during which, a defaulting party can pay off the outstanding cash calls (as well as any additional costs incurred by the other parties as a result of the default). If a party fails to rectify the default within the specified period, the JOA will usually provide, as one of its options, that the defaulting party can have its entire participating interest forfeited by the non-defaulting parties. All well and good, one might think.

Insolvency

Problems arise if the defaulting party is insolvent. Under the Insolvency Act 1986, a company is generally and commercially deemed to be insolvent, if it is "unable to pay its debts", for which there are various tests, two tests of them being, the "Cash Flow Test", i.e. where a company is unable to pay its debts as they fall due, and the "Balance Sheet Test", i.e. where a company's liabilities outweigh its assets. If a company defaults on a cash call then, by definition of the Cash Flow Test, it is unable to pay its debts and is considered "insolvent". Once an IP has been appointed, the remedy of forfeiture may not be available to the non-defaulting parties, as the IP will take control of the defaulting party and its assets. Any recovery of sums paid by the non-defaulting parties on behalf of a defaulting party must be attempted from the position of an unsecured creditor.

Protection as a Secured Creditor

Unlike an unsecured creditor, a secured creditor has a charge over assets of the debtor. In the event the debtor is unable to repay its debt the creditor may monetise the assets over which it has a charge and be repaid the money that it is owed. In an insolvency, the secured creditor has a far greater chance of recovering all the monies owed to it compared to an unsecured creditor and this is the position that co-venturers should now consider putting themselves in, as the risk of default increases with the continuation of the current low oil price environment.   

The standard form AIPN and OGUK JOAs do not provide for the mutual granting of security among co-venturers, and thereby the creation of secured creditors. It is a case in point that all monies paid by a non-defaulting party for and on behalf of a defaulting party is paid across as an unsecured creditor. However, this should not prevent the parties to a JOA at the time they are negotiating its terms, or subsequently through agreed amendment, to provide for the mutual granting of security over their participating interest share of joint venture property, including that of their participating interest, as security for any pament made on its behalf, should it ever be in default.  

The exact nature of the security may be in the form of a floating charge over a co-venturer's pro-rata share in the assets held as joint property and/or a fixed charge over the participating interest of a co-venturer under the relevant JOA, but this is something to be agreed. Whichever form it takes, it has to be mutual if it is to be accepted.

As with the granting of security in any situation, and not just under JOAs, there are some key considerations to bear in mind:

Priority of security – If a co-venturer has already accepted a charge over its interest on an account of an earlier loan from a bank, then the value of subsequent security that the fellow co-venturers have, will be of greatly diminished value. 

Provide for a clear trigger event – The trigger event for when a charge crystallises should not be left until expiration of the rectification period, after which, ordinarily a non-defaulting party may have its participating interest forfeited. It is quite possible that an IP could be appointed by the company or its directors before the expiration of such period. The commencement of appointment of an IP should be in itself a trigger event that would give secured creditor status for the non-defaulting parties who have paid monies on behalf the defaulting party. This is essential if the protection afforded by the security is to be effective.

Equity of Redemption – The equity of redemption still applies. The non-defaulting parties, as secured creditors will be obliged to return to the defaulting party any value remaining (if any) once the defaulting party's debts to the non-defaulting parties have been fully discharged. What the non-defaulting parties do gain from this is a level of control over the disposal process of the defaulter's assets, which, if managed well, may lead to a secured creditor acquiring control over the defaulting party's participating interest in a Block as payment for the debt. It is quite possible that the participating interest ends up with the non-defaulting parties as if it had been forfeited to offset the debt, but it is only because the value of the participating interest is less than the debt owed. This might be typical of exploration assets, or even assets nearing the end of economic production, but unlikely in most other situations.    

Regulatory and third party approvals – The creation of a charge is subject to the Model Clauses of the licence, pursuant to the Petroleum Act 1998 and requires consent from the Secretary of State. Such consent is automatically granted if the licensee complies with the notification provisions under the Open Permission (Creation of Security Rights Over Licences). Co-venturers should ensure that it notifies the Oil and Gas Authority of the charge, together with the required information, within 10 days of the creation of the security. In addition to regulatory consent there may be additional third party approvals that are required and a thorough due diligence exercise would be recommended to avoid any last minute surprises.          

Conclusion

The enduring low commodity price has put a financial strain on many companies and in turn on the joint ventures in which they have an interest. Although the mutual taking of security over a co-venturer's interest has never been a popular or a common route, as the oil sector languishes in the doldrums and the risk of default increases among under financed parties, co-venturers would be prudent to consider taking security as a means to protect their stakeholders interest, rather simply hoping that any unsecured debts can be set off against the book value of an asset they hope to forfeit without triggering insolvency.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.