Judge Marvin Isgur ruled today in the contentious
Comanche operator dispute between the Sanchez Energy debtors and Blackstone affiliate Gavilan Resources. Judge Isgur found that Sanchez Energy Corp., not Gavilan Resources LLC, materially breached the joint development agreement, or JDA, governing the operation of the Comanche field by failing to negotiate in good faith to reach an agreement on the development of the wells subject to the JDA and by failing to negotiate in good faith an equitable division of JDA assets after first proposed by Gavilan. Judge Isgur found that Sanchez deviated from the planned design for the field without the necessary permission to do so. The judge also found that Sanchez’s unilateral decision to deviate from the 2018 plan “falls totally short of the reasonable best effort standard” governing the contract and the breaches were “highly material,” and that Gavilan “did not engage in any wrongful conduct.”
Key to Judge Isgur’s decision were the “mechanics” of the JDA governing the development of the Comanche field. Judge Isgur found that although the JDA named Sanchez the operator, the JDA was not a “normal” operating agreement because it provided for management by an operating committee, or OpCom, that effectively functioned as a board of directors and held ultimate authority over all budgetary and work plan decisions and modifications. The OpCom was composed of Sanchez and Gavilan representatives and operated by unanimous consent. Judge Isgur observed that “in the beginning” all parties recognized how the JDA worked, although at some point Sanchez unilaterally determined that the OpCom structure was “not satisfactory.”
Judge Isgur found “as a matter of fact” that Sanchez breached the JDA by failing to negotiate a 2019 work plan for the development of the Comanche field in good faith as required under the JDA. He recognized that there was a “continuous, long running, never ending dispute” between Gavilan, which wanted to develop high-tech wells, and Sanchez, which proposed a plan using low-cost “gen 16” wells. Although the parties were “allowed” to disagree over which well design to use, the JDA provided “an elaborate process” for deciding the issue - the OpCom, he noted.
Judge Isgur stated that he was “disheartened” by Sanchez’s proposal, since the latter “knew that its [work] plan would displease Gavilan,” and because the plan, if adopted, would only be modifiable by unanimous OpCom consent. After the adoption of Sanchez’s plan, any one of Sanchez’s representatives on the OpCom could have voted to keep the “gen 16” wells in place, leaving Gavilan with no recourse, Judge Isgur continued.
He concluded that Sanchez’s plan for “gen 16” wells was an “abomination” and could not have been proposed in good faith. “In my view, what Sanchez did was to try to take complete control away from Gavilan,” he stated, adding that Gavilan was not required to submit to such treatment.
Judge Isgur rejected Sanchez’s claim that Gavilan breached the JDA by failing to negotiate the 2019 budget in good faith. The judge found as evidence of Gavilan’s good faith the latter’s proposal in September 2018 of an alternative 2019 work plan calling for tighter spacing on wells and testing in the upper and lower Comanche field, a proposal that was not required under the JDA. In response, Sanchez sent a one-page 2019 budget and work plan that Judge Isgur found was unacceptably vague and insufficient to engage in good-faith negotiations, as required by the JDA.
Judge Isgur also rejected Sanchez’s argument that Gavilan acted in bad faith by engaging in “project free bird,” a plan under which Gavilan allegedly tried to seize control of the Comanche field. “Project free bird,” while contemplated, was never put into action, he said. “Gavilan’s actions spoke much louder than its words,” which were “inconsistent with the implementation of the free bird plan,” he added. Judge Isgur concluded that project free bird “was never invoked as a proper scheme to wrest control from Sanchez.”
Judge Isgur found that as a result of Sanchez’s breach and failure to cure within 30 days as required under the JDA, Gavilan properly exercised its rights under the JDA by sending Sanchez a default letter on Jan. 16, 2019, and seeking an equitable division of the operatorship of the Comanche field. This default letter predated Sanchez’s first assertion on Jan. 30, 2019 that Gavilan had committed a material breach by allegedly failing to negotiate the 2019 work plan in good faith, he stated. Judge Isgur also found that Sanchez breached the JDA in 2019 by failing to equitably split the company’s assets after Gavilan had properly asserted its equitable division rights under the JDA.
Judge Isgur next addressed Sanchez’s alleged breach of the JDA by drilling wells in the latter half of 2018 that were noncompliant with the company’s 2018 work plan. Discussing the parties’ informal “technical agreement” on July 27, 2018, by which Gavilan purportedly allowed Sanchez to deviate from the 2018 plan, Judge Isgur noted that Gavilan should have done more complaining on this issue. Sanchez may have a laches defense with respect to the wells drilled before Gavilan notified Sanchez that modifications required OpCom approval, he added. Judge Isgur stated that he was not making any laches determination, but concluded that with respect to wells that are not subject to a potential laches defense that Sanchez’s unilateral change to the development design of the wells breached the JDA.
In so finding, Judge Isgur referred to internal Sanchez emails stating that “we don’t have approval with Gavilan apparently” and “this is the kind of stupidity from Gavilan we have been dealing with since we started the project,” as well as the trial testimony of Sanchez CEO Tony Sanchez that the company did not need Gavilan’s approval for the change. Judge Isgur also found that Sanchez could not claim the implied right to deviate from the 2018 work plan under the reasonable prudent operator standard. He concluded that Sanchez’s actions were “simply wrong,” that Sanchez’s breach was “intentional” and “highly material” and that the unilateral decision to deviate from the 2018 plan fell “totally short” of reasonable best efforts.
At the end of the hearing, Judge Isgur complimented the parties’ “professional” work on the case. He noted that he saw some of the “finest” lawyers in Houston and some of the best people in the state working on the dispute. He emphasized that his ruling was against the company, and not any individual.
Judge Isgur’s ruling will have collateral effects in both Sanchez’s and Gavilan’s bankruptcy proceedings. Namely, the breach of the JDA will shift operatorship rights from Sanchez to Gavilan, which conveys a significant operatorship value premium to Gavilan regarding its interest in the Comanche oil and gas assets. Also, the shift in operatorship may affect the consummation of the
recently approved midstream settlement. In an
objection to the settlement, Gavilan asserted that since the settlement involves changes to the distribution of production out of the Comanche asset, “the conditions to close on the Settlement Agreement cannot be met” unless Sanchez retains its operatorship rights and the practical ability to direct production.
Editors’ Note: This story has been revised to correct the dates of Sanchez’s defaults as described in a proposed order submitted by Gavilan Resources after Wednesday’s hearing.