Conflict of Interest between Owners and Operators - Essay Example

Conflict of Interest between Owners and Operators Abstract Persons and entities invest in the oil and gas industries through a number of binding contracts. The most significant class of agreements include exploration and production and can encapsulate contracts for sharing production, service agreements and other contractual arrangements.1 These contracts are often negotiated between companies both domestic and foreign and can also be negotiated between private entities and host countries. In many cases owners and/or operators may find themselves in a situation where their duties and interests are conflicted. By virtue of the Companies Act 2006, directors (who may be both owner and operator or merely an owner or an operator) are duty bound to avoid a conflict of interests. Similarly, case law has laid out a framework insisting that owners and operators of any corporate structure avoid a conflict of interests. This paper examines the nature of the duty to avoid a conflict of interest on the part of owners and operators in company law. This research however is industry based and focuses on the nature of that duty in the gas and oil industry. In this regard, the nature and legal consequences of oil and gas agreements are examined. Once the various methods for engaging oil and gas contracts are explained, this research then turns its attention to the law relative to the corporate duty to avoid a conflict of interest and how that duty is interpreted and applied by the courts. The duty is then tied together with the owner and operator within the oil and gas industries. Oil and Gas Agreements: Conflict of Interests Introduction It is a common principle of company law that directors are required to put the interest of the company first and to avoid situations in which there is not only a conflict of interest, but that there is a possibility of a conflict of interest. This rule is generally treated by the courts as entirely inflexible. As such it places upon the operator in an oil and gas agreement an onerous and quite often insurmountable burden as these persons are almost always involved in situations where there is a possibility of a conflict of interest. However some court judgments such as Bray and Ford have relaxed the inflexible rule, holding that not all transactions are necessarily improper or illegal. This ruling could ease the unrealistic burden on operators who quite often come into contact with persons and entities that might have an interest that calls upon the operator to exercise a duty that might conflict with the oil and gas company whom he/she represents and serves. This study examines the no conflict of interest rule, the manner in which the courts interpret and apply it and its consequences for the operator of oil and gas entities. Conflict of Interests in the Context of Oil and Gas Agreements The oil and gas industry is characterized by “capital-intensive projects” which typically involves significant planning and control of projects that bring together significant personnel, investment and other items.2 There are two common traits within the variety of oil and gas contractual arrangements. The first is the arrangement in which the investor is commissioned by the host state to administer the host state’s oil and gas resources in a manner that is consistent with the public interest. The second common characteristic of the oil and gas contract is its term. The term is typically long and can involve up to thirty years duration as it involves a number of phases in development, exploration, production, transportation, downstream events and storage.3 The most common types of oil and gas contracts are the Utilization Agreement and contracts that confer access to the oil products to third parties. These contracts can be facilitated in a number of ways, but most commonly by leases or by virtue of joint operation agreements (JOA) or by mergers and acquisitions or partnership agreements although the JOA is the most common method.4 A number of issues that are relevant to the duty of operators arise under any oil and gas contract. These issues arise from the moment of survey and carry over to appraisals and exploration; development and production and invariably involve the introduction of pollutants into the environment.5 In addition to statutory duties to protect the environment from excessive and dangerous pollutants, the operator under a gas and oil contract has a duty to avoid a conflict of interest.6 The duty to avoid a conflict of interest is a long and complex duty in company law and engages the concept of fiduciary duties. The fact is, the operator holds the property in the oil and gas contracts as a trustee for the benefit of the “non-operators”.7 Alternatively, the operator negotiates and concludes the oil and gas contract as an agent for non-operators and as such is bound by “fiduciary obligations with respect to the particular contract or property”.8 In this regard, all relationships between beneficiaries and trustees and between agents and between principals and agents impose upon the agent and the trustee fiduciary duties.9 Under the JOA, a common contractual feature of oil and gas agreements, there are essentially two main concepts that impact the duties and obligations of the operator. One concept encapsulated by the JOA is the distribution of rights and obligations of the parties to the joint venture. This is typically laid out in a manner consistent with the parties’ interests. The second concept is the identification and specification of the manner in which the operateor is required to manage the terms and objectives of the JOA.10 The Courts’ Approach to the Operator’s Duty to Avoid a Conflict of Interest The fiduciary duty of operators corresponds with the fiduciary duties of corporate directors and generally puts forth the principal that any person who acts in the interests of others has a fiduciary duty.11 The fiduciary duties owed by directors and operators by extension is characterized by three essential elements. First, directors are required to act “bona fide” in the company’s interest and must conduct their authority for any and all collateral purposes.12 Secondly, should the director make a profit arising out of his directorship of a company, the director is accountable for that profit. Finally, when a director is engaged in an event or circumstance that could conceivably give rise to a conflict of interest, any contract concluded in those circumstances is likely be rendered null and void at the company’s request.13 The courts have typically adopted a very stringent approach to the second and third concepts which both cover the duty to avoid a conflict of interest. It was held early on in Aberdeen Railway Co. v Blaikie Brothers [1843-60] All E.R. Rep. 249 that regardless of whether or not the director acted fairly or reasonably in engaging in a transaction, the no-conflict doctrine will be strictly interpreted and applied.14 In other words, the court would not go into the merits, fairness or reasonableness of a transaction concluded by virtue of a conflict of interest. On the facts of Aberdeen Railway Co. v Blaikie Brothers Blaikie Bros entered into a contract with Aberdeen Railway for the construction of iron chairs. When Blaikie Bros petitioned the court for the enforcement of the contract, Aberdeen Railway countered that they could not be bound by the contract since the Chairman of the board at the relevant time had been a director at Blaikie Bros and there was therefore a conflict of interest.15 The court agreed with Aberdeen Railway holding that they were not obliged to honor the contract. Lord Cransworth held that there are occasions where: The terms on which a trustee has dealt or attempted to deal with the estate or interest of those for whom he is a trustee, have been as good as could have been obtained from any other person – they may even at the time have been better. But still so inflexible is the rule that no inquiry on that subject is permitted. The English authorities on this head are numerous and uniform. Operators as agents or trustees of the oil and gas arrangements in joint operations are typically in a position to maximize their own profits and to control and protect the environment. There are a number of ways that a conflict of interest may arise which might be to the detriment of the company. Based on the ruling in Aberdeen it would appear that the court is not concerned about good faith, only that a conflict of interest be avoided at all times. This would mean that any time an operator is confronting a situation in which profits can be maximized to the detriment of the company’s reputation in terms of environmental damages or divert business opportunities away from the company, the personal opportunity must be abandoned. However, it must be noted that the Aberdeen case was decided well before the implementation of the Companies Act 2006, Section 40(1). By virtue of Section 40(1) directors may bind the company to any transaction conducted in good faith. However, if the transaction is outside of the director’s power or is inconsistent with any fiduciary duty, the director will be personally liable.16 Therefore had the Aberdeen case been decided under the Companies Act 2006, it is entirely possible that the court would have permitted the contract to stand but Aberdeen would have been able to petition the courts for damages in respect of any losses arising out of the chairman of the board’s breach of fiduciary duties. Those fiduciary duties remain as they were at the time of Aberdeen ruling. It was emphasized by the court that directors are responsible for managing the company’s affairs. In such circumstances they may only conduct themselves as agents for the company. As agents they are under a residual and continuing duty to promote the interest of the company which puts them in a fiduciary relationship with the principals. In this regard: no one, having such duties to discharge, shall be allowed to enter into engagements in which he has, or can have, a personal interest conflicting, or which possible may conflict, with the interests of those whom he is bound to protect. So strictly is this principle adhered to, that no question is allowed to be raised as to the fairness or unfairness of a contract so entered into.17 The duty of operators under an oil and gas contract must be interpreted in the same manner. In this regard, the operator must conduct and manage the affairs of the oil and gas enterprise to which he/she is subjected as an agent for that entity, always avoiding a conflict of interest. This means that the operator must promote the interest of the company and this entails the company’s reputation and statutory obligations relative to the protection of the environment. It also means that the operator as an agent for the oil and gas entity must also avoid any opportunity to make a personal profit regardless of how fair it might be. Although that contract may still be enforced under Section 40(1) of the Companies Act 2006, the operator may still be personally liable to the company for any losses accrued as a result of that personal profit. The courts have not always adhered to the strict inflexibility rule relative to the conflict of interests principle however. In Bray v Ford [1896] A.C. 44 Lord Herschell ruled that it was possible to depart from the inflexibility rule in “many cases, without any breach of morality, without any wrong being inflicted”.18 Essentially, the court ruled that persons in a fiduciary position do not automatically commit an improper or illegal act when making a profit in the course of their duties. However the burden is on the fiduciary to prove that he/she had the authority either under the trust or some other legal authority to obtain a profit failing which the fiduciary is accountable to the trust in respect of any such profit.19 The rule in Bray was significant for establishing a broad range of relationships in which a fiduciary duty will exist. The fiduciary relationship is not strictly attributable to trustee-beneficiary relationships, but will also arise in the course of commercial relationships, company directors, partnerships and the like. In this regard, the conflict of interest applicable to trustees is similarly applicable in these other types of relationships.20 It therefore follows that operators who are ultimately agents for the oil and gas entity are fiduciaries and are therefore required to avoid situations in which there may be a conflict of interest. As Lord Herschell explain, the fiduciary is not permitted to make a profit, or to put “himself in a position where his interest and duty conflict” unless there is an express provision to the contrary.21 This rule was not intended to be based on questions of morality. It intends only to recognize that “human nature being what it is, there is danger, in such circumstances,” of a fiduciary “being swayed by interest rather than by duty” with the result that it prejudices “those whom he was bound to protect”.22 Essentially at common law, a director is required to conduct himself/herself in a manner characterized as bona fide and in this vein, in the company’s interests. In the construction and application of this common law rule, it was held in The New Zealand Netherlands Society "Oranje" Inc. v Kuys [1973] l W.L.R. 1126 that although common practice and the course of dealing may reduce the fiduciary duty, the general principles of law required that the director place the company’s interest first and foremost. In his/her position of trust, the director may not put himself/herself in situations in which the company’s interest conflicted with his/her own interest or with the interest of any other associated person.23 Although the court in The New Zealand case maintains that the fiduciary duty may be reduced implicitly, it takes the duty even further, by conferring upon the director a duty to take account of the interest of others with whom he is associated. In applying this rule to operators the duty to avoid a conflict of interest becomes an entirely onerous one. Operators will often be associated with governments, other businesses and members of the local community in which they conduct their operations. Invariably, this extended duty will require that operators take full account of the environmental damages that might flow from their operations. In other words, making a personal profit will not be the only way that an operator may be vulnerable to conflict of interest situations. In other words, the operator may have an interest in maximizing the company’s profits but must always be mindful of the interest of third parties such as the host government and community in which his operations are conducted. In this regard there may be a conflict of interest and duty. The ruling in Broadman and Phipps [1967] 2 A.C. 106 takes the fiduciary duty to an even higher plain which is entirely relevant to the oil and gas operator. Broadman requires that any unauthorized profit requires that the fiduciary becomes liable in circumstances where “a reasonable man looking at the relevant facts would think that there was a real possibility of conflict”.24 In other words, whether or not there was a conflict of interest appears to be irrelevant. All that is necessary to establish a conflict of interest is that a possibility can be inferred upon a reasonable interpretation of the relevant facts and circumstances. In Broadman a solicitor administered a business that a trust in which he advised trustees. Acting on information that he came by in the course of acting for the trustees, the solicitor purchased some of the business’s shares for himself. The solicitor informed the trustees as well as the beneficiaries of his intention to purchase the shares when the trust could have also purchased the shares. Although the solicitor acted honestly and gave notice of his intention to acquire the shares it was held by a margin of 3-2 by the House of Lords, that the solicitor was in the position of constructive trustee and therefore liable for any profits made on the purchased shares. It was held per Lord Cohen that “information and opportunity owed to” the representation as an agent of the shares “held by the trustees”.25 It would appear from the ruling in Broadman that operators walk a very thin line. That fact is, operators come into contact with other oil and gas operations and may come across information and opportunities connected with the oil and gas company that they operate and may not have an interest in that opportunity. Based on the ruling in Broadman, taking advantage of those opportunities will be a conflict of interest regardless of the oil and gas company’s lack of interest in cashing in on those opportunities. In such circumstances the operator who acts in good faith, informing the oil and gas company of the opportunity will nonetheless be accountable for any profits or interest acquired. In Consul Developments Pty. Ltd. v D.P.C. Estates Pty. Ltd. [1975] 5 A.L.R. 231 the fiduciary duty takes on a far more serious tone and identifies what can be characterized aobvious misconduct and what may not be so characterized. In this case a solicitor conducted property development via a company known as DPC. A family company conducted a similar business by virtue of a company referred to as Consul. The director of DPC passed on redevelopment project opportunities to Consul maintaining that DPC did not have the resources to take advantage of those redevelopment project opportunities. In return the director of DPC was compensated by receiving a share of the redevelopment profits obtained by Consul. He issue for the High Court was whether or not Consul’s constructive knowledge could form an adequate ground for founding liability.26 Stephen J. ruled that there was a difference between negligence and dishonesty. Stephen J. stated that it was insufficient to found what he referred to as: That species of constructive notice which serves to expose a party to liability because of negligence in failing to make enquiry.27 Stephen J. maintained that when the defendant had not been the recipient of trust property, “something more was required”, and that would be “actual knowledge of the fraudulent or dishonest design” in order for conclusions to be drawn that the defendant was involved in “fraudulent dishonest activity”.28 Drawing on this ruling, it would appear that the operator may be at liberty to take advantage of an opportunity in terms of knowing receipt if he or she acts honestly and without fraudulent design. In other words, mere negligence will not expose him/her to liability or accountability if he knowingly receives a profit or takes advantage of an opportunity honestly. As Stephen J. went on to state: If a defendant knows of facts which themselves would, to a reasonable man, tell of fraud or breach of trust the case may well be different, as it clearly will be if the defendant has consciously refrained from enquiry for fear lest he learn of fraud.29 Obviously, Consul takes account of situations in which a person acting as fiduciary will inevitably come across information and opportunities that he or she might be able to take advantage of honestly and without prejudice to those to whom he/she owes a fiduciary duty. The problem for operators and all other fiduciaries is knowing when or where to draw the line. Queensland Mines Limited v Hudson [1978] 18 A.L.R. 1 appears to strike a fair balance. In Queensland, the defendant directed a mining company that was provided with an opportunity to take up a license for the development of mining operations. The defendant lacked the resources to accept the opportunity and therefore turned it down. The director resigned his position as director of the defendant and accepted the opportunity for himself. The defendant company was at all times fully aware of the director’s intention.30 Subsequently the plaintiff company from which the director resigned, attempted to obtain an order from the court for the defendant’s profits. However, the court did not agree on the grounds that the plaintiff had not accepted the licenses so that the opportunity fell to the defendant and not in his fiduciary capacity. Moreover, the plaintiff was fully aware of the director’s intention and as such acquiesced in it.31 It therefore follows that operators coming across opportunities from which they can make a personal profit must ensure that the oil and gas company to which they are attach are fully aware of the opportunity and only if they reject it for the company is he/she at liberty to take up the opportunity for themselves. Case Comparisons The rule in Aberdeen Railway Co. v Blaikie Brothers [1843-60] appears to be based entirely on principle in that the fiduciary must be entirely committed to his/her duties. It does not matter whether or not he/she acts in good faith. The court is only concerned with the actual fact of a conflict of interest. This approach to the no conflict rule appears to be unfair and unjustified. If a company has no real interest or lacks the resources to pursue an opportunity there is no real justification for denying the fiduciary the opportunity to take it up. Certainly, it makes sense to discourage fiduciaries pursuing their own interests, but Aberdeen fails to take account of situations where it is entirely human to take advantage of an opportunity that might get taken up by the competition should the company refuse to take advantage of it. Bray v Ford does appear to be more realistic in ruling that not all transactions that pose a conflict of interest are improper or illegal. By shifting the onus on the defendant for the purpose of proving that the transaction giving rise to the conflict of interest claim was permitted, Bray departs from the inflexible approach adopted in Aberdeen. Obviously, if the company knew of an opportunity and failed to take it up, the fiduciary acted with implicit permission. Essentially, this was the ruling in Consul Developments Pty Ltd. v. D.P.C. Estates Pty. Ltd. Broadman and Phipps are also unjustifiably strict and falls in line with the Aberdeen case. While Aberdeen refuses to depart from the strict no conflict rule, Broadman calls upon fiduciaries to avoid the possibility of conflict of interest. This is entirely unreasonable as it is entirely possible for just about any range of transactions to qualify as presenting a conflict of interest possibility. The ruling in this case is far different from the ruling in Queensland Mines Limited v Hudson which strictly speaking does not ignore relevant facts as to whether or not there was a conflict of interest. An inquiry into the merits and propriety of the transaction is the only way of truly determining whether or not there was a conflict of interest. It therefore follows that the earlier cases, particularly the Aberdeen case is entirely too strict and onerous to expect of fiduciaries, particularly operators who come across opportunities that their companies have no intention of pursuing. Conclusion The courts have for the most part been persistent in their attempts to lay out a framework conducive to preventing fiduciaries acting in what might be deemed a conflict of interest.32Far too often the courts have tended to ignore evidence of whether or not the fiduciary committed anything improper or unlawful. Bray introduced a method by which fiduciaries may have the benefit of inquiring into this aspect of the conflict of interest by shifting the burden of proof. This is far more preferential to the previous position where no inquiry was permitted under the inflexible rule of no conflict of interest. The courts have taken a less strict approach to the inflexible no conflict of interest principle by ensuring that opportunities are at least placed before the company first. This is only fair as it strikes a fairer balance between deliberate maximizing of personal profits and maximizing the profits of the company. In the final analysis the courts are concerned that the fiduciary put the interest of the company first and foremost. This does not have to necessarily mean, walking away from an opportunity whether or not the company wished to take up the opportunity. In reality, the duty to put the interest of the company first means ensuring that the company has an opportunity to take up the transaction first. Once the company rejects this opportunity there are no reasonable grounds to deny the fiduciary the opportunity. Bibliography Textbooks David, Martyy, R. Upstream Oil and Gas Agreements: With Precedents. (Sweet and Maxwell, 1996). Farrar, J.H. and Hannigan, B.M. Farrar’s Company Law. (Butterworths, 4th Edition 1998). Jahn, Frank; Cook, Mark and Graham, Mark. Hydrocarbon Exploration and Production Vol. 55. (Elsevier 2007). Smith, E. E. International Petroleum Transactions. (Rocky Mountain Mineral Law Foundation, 2000). Taylor, M. and Tyne, S. Taylor and Winsor on Joint Operating Agreement. (Longman Group UK Ltd, 1992). Yahaya, Shamsu. Does the Operator in a Joint Operating Agreement Owe a Fiduciary Duty to Non-operators? (GRIN Verlag 2010). Articles/Journals Bernardini, Piero.‘Stablization and Adaptation in Oil and Gas Investments.’ (2008) 1(1) The Journal of World Energy Law and Business, 98-112. Gao, Zhiguo. ‘Environmental Regulation of Oil and Gas in the Twentieth Century and Beyond: An Iintroduction and Overview.’ cited in Zhiguo Gao (ed) Environmental Regulation of Oil and Gas (Kluwer Law International, 1998). Hodson, Peter. ‘Can Trustees Profit? A Hong Kong Perspective.’ (1995) 1(3) Trusts and Trustees 19-20. Johnston, Joseph, F.‘Natural Law and the Fiduciary Duties of Business Managers.’ (Spring 2005) 8(1) Journal of Markets and Morality, 27-51. Cases Aberdeen Railway Co. v Blaikie Brothers [1843-60] All E.R. Rep. 249. Bray v Ford [1896] A.C. 44. Broadman and Phipps [1967] 2 A.C. 106. Consul Developments Pty. Ltd. v D.P.C. Estates Pty. Ltd. [1975] 5 A.L.R. 231 Queensland Mines Limited v Hudson [1978] 18 A.L.R. 1 The New Zealand Netherlands Society "Oranje" Inc. v Kuys [1973] l W.L.R. 1126. Statutes Companies Act 2006 Read More