Joint operating agreements are commonplace in the oil and gas industry, used to define parties’ obligations, liabilities, and costs. In a recent decision, CL III Funding Holding Company, LLC v. Steelhead Midstream Partners, LLC; Strategic Energy Income Fund III, LP; Eagleridge Energy II, LLC; and Eagleridge Midstream, LLC, the Second Court of Appeals held that CL III, a joint owner of property, did not violate its JOA when it settled with a lien holder, acquired the lien, and foreclosed on its own property to obtain repayment for its settlement payment to the lienholder.

WBH Energy, L.P. and U.S. Energy Development Corp. entered into a joint operating agreement to develop a pipeline. Each party owned a 50% working interest in the property and paid 50% of the expenses. WBH’s affiliate served as the operator and hired Orr Construction, Inc. to build the pipeline. The operator failed to pay Orr, and Orr recorded a lien on the property.

Through a series of transactions and bankruptcy proceedings, CL III and Strategic acquired WBH’s and U.S. Energy’s interests in the property, respectively. Strategic acquired U.S. Energy’s interest through a standard sale. CL III, as a lender of WBH, entered into a settlement agreement in the bankruptcy with U.S. Energy. According to U.S. Energy, it agreed to not oppose CL III’s acquisition of WBH’s interest in the property, in exchange for CL III’s agreement to not hold U.S. Energy (and subsequently Strategic) liable for WBH’s debts on the property and allow a U.S. Energy affiliate, Steelhead, to operate the property. Throughout this, Orr’s lien remained.

CL III and Strategic entered into their own JOA for the operation of the property with Steelhead. As part of the agreement, the owners (CL III and Strategic) bore individual liability for their respective shares of the costs and expenses.

Following this, CL III settled with Orr, acquired Orr’s lien by assignment, and filed suit against Strategic to foreclose on the property. Strategic and Steelhead filed a concurrent suit, alleging that CL III violated the JOA by failing to pay the lien and filing suit to foreclose. Strategic and Steelhead argued that CL III bore sole responsibility for the lien, as WBH, as CL III’s predecessor, had been to blame for the debt and CL III previously agreed to pay off the lien as part of WBH’s bankruptcy settlement.

In the midst of this litigation, both Strategic and CL III sold their interests in the property to Eagleridge. Eagleridge agreed that it would be responsible for all CL III’s costs, expenses, claims, liabilities, and obligations related to the property.

CL III obtained a foreclosure judgment against the property. Eagleridge paid the judgment, intervened in the Strategic/Steelhead lawsuit, and aligned itself with Strategic and Steelhead. At trial, the court found that CL III breached the JOA because it (1) failed to pay off its share of expenses, and (2) sought to hold Strategic liable for CL III’s costs through its foreclosure suit. CL III appealed the trial court’s judgment.

On appeal, CL III argued that its actions did not violate the parties’ JOA, as it was not obligated to pay its share of the Orr lien, and nothing in the JOA prohibited CL III from acquiring, holding, and foreclosing on the Orr lien. The court of appeals agreed with CL III on both fronts.

First, the court held that CL III did not breach the joint operating agreement because the agreement clearly established that a bill from the operator – in this case, Steelhead – the trigger for CL III’s or Strategic’s payment obligations under the JOA. It was undisputed that Steelhead did not invoice CL III for the amount of the Orr lien. The court reasoned that if the lien did not qualify as a “property expense” until the court entered a foreclosure judgment, then it was not a JOA expense during CL III’s period of ownership, as CL III sold its interest prior to the foreclosure judgment. The court further found that if Steelhead could have billed CL III for the lien anyway, it could not blame CL III for its own failure to do so. Thus, CL III did not have a contractual obligation under the JOA to pay the lien amount to Steelhead.

Second, the court held that the JOA did not prohibit CL III from acquiring, holding, or foreclosing on the lien. The court noted that the JOA stated that Steelhead – not CL III or Strategic – bore the responsibility to keep the property free from liens other than “Permitted Liens.” Nothing in the JOA prohibited CL III or Strategic from acquiring property liens, permitted or otherwise. The court further reasoned that while the JOA stated, “no [owner] shall have any liability to third parties hereunder to satisfy the default of any other [owner] in the payment of any expense or obligation hereunder,” the Orr lien did not arise “hereunder” the JOA, and it was not a liability to satisfy the default of CL III or Strategic. The Orr lien was a “preexisting encumbrance.” Finally, the court held that the JOA’s plain language expressly approved one owner’s foreclosing on another owner’s interest to address non-performance of the JOA.

The CL III holding illustrates an age-old contractual rule in the JOA context. Courts will not “squint to discovery requirements [or prohibitions] that the parties themselves chose not to write…” If the parties wanted to require owners to pay their respective share of prior lien obligations and prohibit all foreclosure actions against one another, the JOA would state as much.