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Devon Shire
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Author of the value investing newsletter detailing the formation of the "Punch Card Portfolio" (http://valueinvestorcanada.blogspot.com/). Devon Shire is an accountant and an investor with 15 years experience managing a private portfolio. Devon Shire's preferred portfolio management... More
My company:
Canadian Value Investing
My blog:
Canadian Value Investor
My book:
CVI - Punch Card Portfolio
  • Proposal to raise liability caps / requirements misunderstood by markets 0 comments
    Jul 13, 2010 11:18 PM | about stocks: RIG, DO, ESV, ATPAQ, SGY, BP, DVN, EXXI, COP
    I received an e-mail from a reader who had noticed my bit on breach of contract and existing leases. An intelligent piece on the proposals currently circulating in Washington.

    Here it is:

    "The financial impact on small drillers of legislative proposals to raise liability caps and financial responsibility requirements is misunderstood by market participants unfamiliar with case law defining the government's contractual obligations. Though these proposals could bar small operators from future leasing activity, they could not, as many fear, destroy the value of current lease agreements. Because this legislation would be deemed a breach of contract, it would enable small drillers to receive compensation for the full value of their in-ground assets from the United States. Contract law would seek to put the non-breaching drillers in as good a position they would have been absent the breach--and it is entirely possible that some would use the breach to improve their position.

    The case law (discussed, for instance, in Jackson Coleman's Senate testimony) leaves little doubt that greatly increased liability caps and financial responsibility standards would breach existing lease agreements. The Supreme Court in Mobil Oil (as well as the Federal Circuit in Amber Resources) construed the same language contained in the current MMS leasing form and found that the statement that a lease is subject to "all other applicable statutes and regulations" must be construed as incorporating "only statutes and regulations already existing at the time of the contract...[h]ence these provisions mean that the contracts are not subject to future regulations promulgated under other statutes, such as new statutes." 530 US at 616.

    Since the proposed new law "substantially impairs the value of the contract to the injured party", it should be deemed a "total breach," which permits the leaseholder to seek damages for the remainder of the contract. Amber Resources, 538 F.3d at 1368. The leaseholder could elect either to continue performance and seek damages for increased costs (recovering, or instance, cost of insurance), or end the contract, give the property back to the government and seek damages in one of three forms: restitution (return of amounts paid to the government), expectation damages (providing profits that would have been earned), or reliance damages (returning amounts expended in reliance on the contract). Drillers might, for instance, claim the discounted value of the future cash flows less future expenses as a measure of expectation damages.

    Such a breach would, thus, give leaseholders an opportunity to put their assets back to the government at values determined through expert testimony and fair judicial process. For companies whose share values that have been deeply discounted by a fearful market, this would provide an attractive alternative means to realize the fair value of their assets. While some may choose to keep their leases and sue only for insurance costs, others may decide that it is to their advantage to discontinue their contracts, trading market and execution risk for litigation risk as the surest way to realize shareholder value.

    Of course, it is unlikely that drillers will ever be given these options, because Congress will, at some point, realize the costs and futility of its efforts to create retroactive law in this context and retreat to prospective legislation for new leases."

    Disclosure: Long ATPG

    Disclosure: Long ATPG, ESV, DO
    Stocks: RIG, DO, ESV, ATPAQ, SGY, BP, DVN, EXXI, COP
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