Termination Provisions in Drilling Contracts
In Vantage Deepwater Company and Vantage Deepwater Drilling, Inc. (together “Vantage”) v Petrobras America Inc.; Petrobras Venezuela Investments & Services, BV; and Petróleo Brasileiro S.A. (Petrobras Brazil) (together “Petrobras”) an arbitral tribunal awarded US$615,620,000 against Petrobras for wrongfully terminating a drilling services agreement for “material breach” and other alleged reasons. The case serves as a reminder that the concept of “material breach” is not straightforward and there are significant risks in terminating such agreements without establishing proper cause.
Facts
The dispute concerned a drilling services agreement entered into between Vantage and Petrobras on 4 February 2009 (the “Contract”) and which was novated on three separate dates: 18 April 2012 (the “First Novation”), 20 December 2013 (the “Second Novation”), and 27 October 2014 (the “Third Novation”). The original Contract and the First and Second Novations were governed by English Law. The Third Novation was governed by the Laws of the State of Texas. The arbitration agreement was to be governed and construed under the laws of Texas, therefore, all procedural matters were governed by Texan law.
The Contract provided for an eight year lease which was expected to run until December 2020. The termination provisions provided:
“Clause 9.1 Termination
This Contract shall terminate without notice at the end of the Term or any extension thereof. In addition to the foregoing, and notwithstanding any other provision of this Contract, this Contract may only be terminated:
By COMPANY, for the following reasons:
....
9.1.1.2
if any relevant CONTRACTOR item suffers substantial structural damage or major breakdown not caused by Company, (a “Material Breakdown”), unless CONTRACTOR has sent written notice to COMPANY within five (5) days following occurrence of the Material Breakdown that it elects to remedy such Material Breakdown, and such remedy, in the reasonable opinion of COMPANY, can be effected within a period of one hundred and eighty (180) days from the date of such notice, (each a “Material Breakdown Suspension Period”); provided, however, that COMPANY may terminate this Contract at any time following the expiration of the Material Breakdown Suspension Period if the Material Breakdown is not cured to the satisfaction of COMPANY prior to such expiration. For avoidance of doubt, the remedy of such Material Breakdown shall not be considered as a repair of the Drilling Unit and CONTRACTOR shall not be entitled to receive any Daily Rate or reimbursement for the period commencing upon the date of such Material Breakdown and ending upon the date such Material Breakdown is remedied to the satisfaction of COMPANY;
9.1.1.3
if CONTRACTOR commits a material breach of its obligations under this Contract.
....
9.1.1.7
if CONTRACTOR repeatedly fails to conduct the Services in accordance with Good Oil and Gas Field Practices; or
.... 9.1.3
By either Party:
...
9.1.3.2
if any of the other Party’s representations and warranties are false in any material respect; provided however, CONTRACTOR shall not have the right to terminate the Contract under this Clause for COMPANY’s inability to secure COMPANY’s Authorizations in which case COMPANY shall nominate an alternative Country of operation.
Clause 9.2: Termination for convenience
9.2.1 COMPANY shall not be entitled to terminate this Contract for convenience.”
On 31 August 2015, Petrobras terminated the Contract. The termination of the Contract left a term of around five years and three months to run. In essence, Petrobras argued that Vantage was in material breach by repeated failures in Good Oil and Gas Field Practices in at least three ways:
1. By failing to properly monitor volumes, detect losses and give proper notice.
2. By violating applicable law.
3. By failing to follow its own policies and procedures.
Vantage initiated arbitration for wrongful termination and sought damages. According to Vantage, Petrobras terminated the Contract, in effect, for convenience as a response to deteriorating market conditions, and failed to negotiate in good faith.
In addition, Petrobras asserted various counterclaims alleging that the Contract was void, voidable, unconscionable and had to be rescinded, since it had been unduly awarded through illegal payments made or offered to Petrobras officials with Vantage’s knowledge, unknown to Petrobras, for the purpose of inducing the entry into the Contract.
Decision
The arbitral tribunal found in favour of Vantage and ordered Petrobras to pay US$ 615,620,000 in relation to the wrongful termination of the Contract.
The majority of the Tribunal found that Petrobras had not proved a material breach of contract that justified termination of the Contract. The meaning of “material breach” had not been defined in the Contract. However, the Tribunal referred to the definition in the Contract of “material breakdown” which provided that “material” means something “substantial” and “major”. The arbitral tribunal considered that Petrobras had not acted reasonably in refusing to accept the proposed cures for the fluid loss events that it had sought to use as the basis for termination of the Contract. Further, even if the fluid loss events were Vantage’s fault, the arbitral tribunal considered that they were not sufficient to trigger a right of termination. In its reasoning, the arbitral tribunal considered it relevant that neither Petrobras nor the Bureau of Safety and Environmental Enforcement had considered the fluid loss events to be “serious” at the time.
Petrobras had also sought to argue that Vantage did not perform in accordance with Good Oil and Gas Field Practices. However, the arbitral tribunal considered that it was more likely than not that the referred fluid loss events were caused by Petrobras’s actions, rather than Vantage’s violations of Good Oil and Gas Field Practices.
In terms of the corruption and bribery allegations, the Tribunal considered that Petrobras did not prove with clear and convincing evidence that illicit payments had been made to Petrobras officials with Vantage’s knowledge.
Without deciding on the merits of the bribery allegation, the arbitral tribunal decided that Petrobras could not rely on a bribery defence because it had knowingly ratified the Contract in the First and Second Novations. In fact, the arbitral tribunal noted that when the Second Novation and Third Novation were entered into, Petrobras was aware of the bribery allegations and yet continued with the Contract. Also, the Second Novation and First Novation were formed without the involvement of anyone who was alleged to have been involved in bribery.
The dissenting arbitrator refused to sign the final award on the basis that Petrobras had been denied the fundamental fairness and due process protections it should have been entitled to in the arbitration.
Petrobras has indicated that it intends to appeal the decision. Given that the seat of arbitration is Texas, the appeal will also be held in Texas.
Commentary
As explained in our commentary on Seadrill Ghana Operations Limited v. Tullow Ghana Limited [2018] EWHC 1640 (Comm), the English Courts remain cautious of oil companies terminating drilling unit contracts for alleged breach or force majeure at times when market rig rates have fallen. This arbitral award suggests that arbitrators exhibit the same caution.
The decision of the arbitral tribunal demonstrates the importance of accurately defining the meaning of “material breach” in agreements and/or understanding its true meaning in the relevant contractual context. Interestingly, it is not apparent the extent to which English Court authority on the meaning of “material breach” in similar termination provisions was brought to the arbitrators’ attention.
In Dalkia Utilities Services plc v Celtech International Limited [2006] EWHC 63 (Comm), the parties agreed that it must mean something less than a repudiatory breach or it would add nothing to the parties’ common law rights. However, they could not agree on what it did mean. The Court identified that many authorities refer to "material breach" as something more than a trivial or minimal breach. Also, in deciding the meaning of "material breach" the Court should have regard to the contractual consequences of material breach occurrence. As a consequence, it may be that the arbitrators applied a higher threshold to establishing a right of termination than previous English law cases would suggest.
In this case, the arbitral tribunal resorted to the meaning of “material” in a clause of the Contract relating to “material breakdown”. As demonstrated by the arbitral tribunal’s interpretation, the difficulty with the use of the term “material” is that the relevant court or tribunal will have a degree of discretion in making its decision, which may leave the parties in a position of uncertainty when assessing the merits of issuing a notice of termination.
In relation to the allegations of corruption, under the Contract, the parties had agreed to follow the US Foreign Corrupt Practices Act 1977. In the UK, the applicable anti-corruption legislation is the UK Bribery Act 2010, which has been in force since July 2011. Together, the US Foreign Corrupt Practices Act and the UK Bribery Act 2010 are considered to be the most expansive forms of anti-bribery legislation in terms of illegal activities and jurisdictional reach.
In this case, the fact that there had been a novation of the Contract at a date after Petrobras realised that the Contract may have been obtained by illicit methods was of importance. If at any point a party realises there has been any form of corruption that could taint the contract, it should follow all of the steps required under the relevant legislation and contractual mechanism. The arbitral tribunal considered that the Contract would be voidable by the innocent party however it would not be automatically void. This would mean that if Petrobras had succeeded in arguing that the Contract had been procured by bribery it could have avoided the Contract, however, there was no requirement under English law to refuse to enforce the Contract.
This case again demonstrates that companies should exercise caution when terminating drilling unit contracts in a falling market, as arbitral tribunals and courts might suspect ulterior motives and be slow to accept that termination provisions have been properly invoked.
Tribunal: James M. Gaitis, Esq.; William W. Park; and Judge Charles N. Brower.
