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					                       The University of Texas School of Law




                                      Presented:
                        The University of Texas School of Law
       The Oil, Gas and Energy Resources Law Section of the State Bar of Texas
                       2010 International Energy Transactions
                                January 20-21, 2010
                                   Houston, Texas




THE 2004 AIPN MODEL FORM INTERNATIONAL
        ACCOUNTING PROCEDURE
CLAIMS FOR ADJUSTMENTS AND AUDIT ISSUES AND THE
               UPCOMING REVISION


                            Ben H. Welmaker, Jr.




                                                                      Baker & McKenzie LLP
                                                             711 Louisiana Street, Suite 3400
                                                                 Houston, Texas 77002-2746
                                                                   Telephone: 713-427-5011
                                                                   Cell:       832-566-0600
                                                               ben.welmaker@bakernet.com
                                                        TABLE OF CONTENTS

I.           INTRODUCTION ............................................................................................................ 1

II.          PURPOSE OF THE 2004 AIPN AP ................................................................................ 2

      A.     Funding Work Programs and Budgets ............................................................................ 2

      B.     To Account For Money Spent ......................................................................................... 2

III.         STRUCTURE OF THE 2004 AIPN AP............................................................................ 2

      A.     Section 1, General Provisions ........................................................................................ 2

                   1.       Section 1.5, Statement and Billings .................................................................. 2

                   2.       Section 1.7, Adjustments ................................................................................. 3

                   3.       Section 1.8, Audits ........................................................................................... 3

      B.     Section 2, Direct Charges ............................................................................................... 3

                   1.       Section 2.2, Salaries, Wages and Related Costs ............................................. 3

                   2.        Section 2.7, Services ...................................................................................... 3

                   3.       Section 2.11, Taxes and Duties ....................................................................... 3

      C.     Section 3, Indirect Charges ............................................................................................ 3

      D. Section 4, Acquisition of Material; Section 5, Disposal of Materials and Section 6,
      Inventories .............................................................................................................................. 3

IV.          2004 REVISIONS TO THE AIPN ACCOUNTING PROCEDURE.................................... 4

      A.     Revisions to Section 1.8.2 on Affiliate Audits .................................................................. 4

                   1.       Reasons for the Revisions ............................................................................... 4

                   2.       Summary of Revised Section 1.8.2 and the New 1.8.3 .................................... 4

      B.     Revisions to Section 2, Direct Charges........................................................................... 5

                   1.       Explicit Restriction to Work Programs and Budgets ......................................... 5
              2.      Structure of the Obligation to Pay .................................................................... 5

V.        RECENT ACCOUNTING PROCEDURE ISSUES .......................................................... 6

     A.   Similarities Between AIPN and COPAS Forms ............................................................... 7

              1.      General Comparison ........................................................................................ 7

              2.      Similar language .............................................................................................. 7

              3.      Applicability of Judicial Precedents .................................................................. 7

     B.   COPAS Cases Relevant to the AIPN AP ........................................................................ 8

              1.      Statements and Billings - Requirements of a Billing ......................................... 8

              2.      Payments and Advances - Compound Interest ................................................ 8

              3.      Prior Payment Not Required ............................................................................ 8

              4.      Meaning of Rendered ...................................................................................... 9

              5.      Operator Reasonably Disposed of Records ..................................................... 9

              6.      Convertible Overriding Royalty......................................................................... 9

              7.      Purpose of the Conclusive Presumption After 24 Months ............................... 10

              8.      Conclusive Presumption Rebuttable .............................................................. 10

              9.      Pleadings as Written Exception and Claim ..................................................... 10

              10.     Time For Making a Written Exception and Claim............................................ 11

              11.     Effect of 24-Month Period On Applicable Statute of Limitations...................... 11

              12.     Resolution of a Claim Within the Statute of Limitations .................................. 12

              13.     Meaning of the Word Adjustment ................................................................... 12

              14.     Adjustments Favorable to Operator................................................................ 12

              15.     Effect of Other Agreements ............................................................................ 13

              16.     Indirect Charges, Section 3 ............................................................................ 13

     C.   Profit Sharing Payments as Direct Costs of Salaries, Wages and Related Costs ..........14

              1.      Profit Sharing Laws in South America ............................................................ 14

              2.      Work Program and Budget ............................................................................. 16
            3.      Other Applicable Provisions of the Operating Agreement and 2004 AIPN AP 16

            4.      Is Mandatory Profit Sharing a Tax Measured by Income? .............................. 16

VI.    ISSUES RELATED TO REVISION OF THE 2004 AIPN AP ......................................... 17

            A.      2004 AIPN AP Section 1.8.1 .......................................................................... 17

            B.      2004 AIPN AP Section 1.8.3 .......................................................................... 17

            C.      2004 AIPN AP Section 1.8.4 .......................................................................... 17

            D.      2004 AIPN AP Section 1.8.7 .......................................................................... 18

            E.      2004 AIPN AP Section 2.2.1 .......................................................................... 18

            F.      2004 AIPN AP Sections 2.2.2 and 2.2.7......................................................... 18

            G.      2004 AIPN AP Section 6, Inventories ............................................................. 18

VII.   CONCLUSION ............................................................................................................. 18
BAKER & MCKENZIE LLP


        THE 2004 AIPN MODEL FORM INTERNATIONAL ACCOUNTING
                             PROCEDURE
     CLAIMS FOR ADJUSTMENTS AND AUDIT ISSUES AND THE UPCOMING
                              REVISION

I. INTRODUCTION

        The Association of International Petroleum Negotiators (AIPN) publishes an
accounting procedure for use in the international oil and gas industry. The AIPN
accounting procedure is designed to be attached as Exhibit A to the AIPN Model Form
International Operating Agreement, the latest form of which is the one published in 2002
(“Operating Agreement”).1

        The AIPN first published an accounting procedure in 1992. The 1992 form was
revised in 2000 and then again in 2004. (The latest form, the 2004 AIPN Model Form
International Accounting Procedure, will be referred to in this paper as the “2004 AIPN
AP.”) The 2004 AIPN AP itself is now about to be revised by an AIPN committee
charged with looking into what additional changes and updates need to be made to the
form and with coordinating that revision with the currently ongoing revision of the
Operating Agreement.2 The AIPN plan is to publish the revised Operating Agreement
and the revised 2004 AIPN AP at the same time so that both version have the same
revision date.

        This paper will review the purpose and structure of the 2004 AIPN AP, the
principal revisions made to the 2000 version of the AIPN accounting procedure to
produce the 2004 AIPN AP and then some of the issues that have arisen under the US
accounting procedure form published by the Council of Petroleum Accountants Societies
(COPAS) which are relevant in construing the 2004 AIPN AP, particularly Section 1.8 on
Audits and related provisions such as Section 1.7 on Adjustments. In addition, the paper
will review some of the issues which the AIPN committee charged with revising the 2004
AIPN AP may be looking at in the upcoming revision of that form.

        One of the tasks assigned to the revision committee is to create an accounting
procedure exhibit for the AIPN 2006 Model Form International Unitization and Unit
Operating Agreement. That form will be created after the committee has finished
revising the 2004 AIPN AP. That new accounting procedure form is not expected to be
substantively different from the revised 2004 AIPN AP.




1
    Operating Agreement, Article 1.1 (definition of Accounting Procedure).
2
 The Co-Chairs of the AIPN committee to revise the 2004 AIPN AP are the author of this paper, Ben H.
Welmaker, Jr. and Kerry W. Speers, Financial Advisor, ExxonMobil Business Services Exploration
Company.


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II. PURPOSE OF THE 2004 AIPN AP

       Accounting procedures serve a number of purposes but the two most important
ones are funding Work Programs and Budgets3 under the Operating Agreement and
accounting for how Joint Account funds are spent by the Operator.

A.         Funding Work Programs and Budgets. The Operating Agreement provides,
           “Each Party shall pay when due, in accordance with the Accounting Procedure, its
           Participating Interest share of Joint Account expenses, including cash advances
           and interest, accrued pursuant to this Agreement.”4 That, in effect, provides the
           means by which the Operator obtains funds from the parties to carry out the most
           important function of the Operating Agreement which is to implement the
           approved Work Programs and Budgets.5

B.         To Account For Money Spent. Accounting for how money is spent that is
           collected to fund Approved Work Programs and Budgets is also an important
           function of the 2004 AIPN. That is confirmed by Section 1.1.1 of the 2004 AIPN
           which provides, in part, as follows:
                   The purpose of this Accounting Procedure is to establish equitable
                   methods for determining charges and credits applicable to operations
                   under the [Operating] Agreement which reflect the costs of Joint
                   Operations….

III.       STRUCTURE OF THE 2004 AIPN AP

       The basic structure of the 2004 AIPN remains unchanged from the prior version,
the 2000 AIPN Model Form International Accounting Procedure. The principal
provisions of the 2004 AIPN are described below.

A.         Section 1, General Provisions. If the number of relevant court precedents
           discussed later in this paper are any indication, this section is probably one of the
           most important parts of the 2004 AIPN AP. Among other things, it covers:
           1.     Section 1.5, Statements and Billings. The means for collecting money
                  from the parties to carry out Work Programs and Budgets.




3
  Unless defined in this paper, terms appearing with initial letter capitalized have the meaning given to
them in the document to which they relate.
4
 Operating Agreement, Article 3.3(C). The importance of Work Programs and Budgets is reflected in one
of the recent revisions to Section 2 of the Accounting Procedure discussed later on in this paper.
5
    Work Programs and Budgets are defined and provided for in Article 6 of the Operating Agreement.


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     2.      Section 1.7, Adjustments. The procedure for revising charges by the
             Operator to the Non-Operators – the subject of the largest number of
             relevant court precedents.

     3.      Section 1.8, Audits. The primary means for the Non-Operators to confirm
             the correctness of charges to the Joint Account by the Operator. This
             section was the most important area revised by the committee which
             prepared the 2004 AIPN AP.

B.   Section 2, Direct Charges. The section details, by numerous examples, what may
     be charged by the Operator for direct costs incurred in Joint Operations. Some of
     the topics covered are described below.

     1.      Section 2.2, Salaries, Wages and Related Costs. Personnel costs are
             described in some detail. As will be seen below, correctly interpreting
             what the drafters of the section intended, however, requires looking at the
             provision in the context of other sections of the 2004 AIPN AP and
             articles of the Operating Agreement.

     2.      Section 2.7, Services. This sections covers services to the Joint Operations
             by the technical and professional staffs of Third Parties, Affiliates of the
             Operator, Non-Operators and Affiliates of Non-Operators. The section is
             important as more and more Operators are project-specific Affiliates of
             larger companies and as operating functions are shared across
             Operator/Non-Operator lines.

     3.      Section 2.11, Taxes and Duties. Taxes assessed on the Joint Operations
             are important direct charges to the Joint Account with the important
             exception of taxes measured by or based upon the income of a party. The
             provision is mirrored by Article 4.2(B)(9) of the Operating Agreement.

C.   Section 3, Indirect Charges. The purpose of this section is to cover those costs
     that really cannot be covered by direct charges, as explained by Section 3.1,
     because they cover the cost of general assistance and support services of the
     Operator and its Affiliates which it is not practical to identify to specific projects.
     The overhead rates provided in Section 3.2 have traditionally been the object of
     much discussion and negotiation.

D.   Section 4, Acquisition of Material; Section 5, Disposal of Materials and Section 6,
     Inventories. These are material handling, pricing, disposition and tabulation
     provisions which are not normally the subject of litigation. Except as to matters
     of form, these provisions were not revised by the 2004 AIPN AP.




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IV.    2004 REVISIONS TO THE AIPN ACCOUNTING PROCEDURE

        The principal changes made by the committee that revised the 2000 version of the
AIPN Accounting Procedure relate to Sections 1.8.2 on Affiliate Audits and the first part
of Section 2 on Direct Charges.

A.     Revisions to Section 1.8.2 on Affiliate Audits. Section 1.8.2 was revised and a
       new Section 1.8.3 was added concerning audit of the Joint Account for Operator
       Affiliate charges.

       1.     Reasons for the Revisions. There are two principal reasons for the
              revisions.

              a.      Alignment With Current Practice. Most Operators now act
                      primarily through one or more Affiliates. Different Operators
                      permit differing degrees of Non-Operator audit of Affiliate
                      charges. The new Section 1.8.3 provides four alternatives to
                      accommodate differing Operator policies.

              b.      The Text of Old Section 1.8.2. Another reason the committee
                      decided to take a look at the sections on Affiliate audits was a
                      structural issue with the old Section 1.8.2. Look at the key
                      provisions of old Section 1.8.2:
                      1.8.2 Operator shall endeavor to produce information from its
                              Affiliates… to support charges …to the Joint Account ….
                              The …scope [of the audit] shall be subject to the approval
                              of the Affiliate …, such approval not to be unreasonably
                              withheld. …[T]he …Non-Operators shall select …public
                              accountants …, subject to the approval of the Affiliate …,
                              such approval not to be unreasonably withheld.
                      The underlined portions illustrate that much was left to agreement
                      with an Affiliate who is not even a party to the Operating
                      Agreement and accounting procedure. The committee felt that
                      Affiliate consent should not impede the process.

       2.     Summary of Revised Section 1.8.2 and the New Section 1.8.3. Section
              1.8.2 was revised simply to provide that Operator would endeavor to
              produce information from its Affiliates reasonably necessary to support
              Affiliate charges to the Joint Account. A new Section 1.8.3 was created to
              provide for four alternative audit methods of Affiliate charges. The first
              alternative consisted of any combination of (a) a full Affiliate audit, (b)
              audit by an internationally recognized independent public accounting firm
              designated by the Affiliate or (c) an audit report from an internationally
              recognized independent accounting firm. The second alternative consisted
              of just (c) above. The third consisted of just (b) above and the fourth was
              just (a) above. The significant enforcement provision for each method,


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            however, is that no amounts paid to an Affiliate of Operator, which the
            Non-Operator seeks to audit, may be charged to the Joint Account if the
            Affiliate of the Operator does not allow audit of such amounts by
            whichever alternative is selected.

B.   Revisions to Section 2, Direct Charges. The first sentence of Section 2 was
     revised as follows:
            Operator shall charge the Joint Account for all costs and expenditures
            incurred in connection with Joint Operations.by Operator for the conduct
            of Joint Operations within the limits of approved Work Programs and
            Budgets or as otherwise specified in the Agreement.

     There are at least two considerations that need to be taken into account in looking
     at the revision of Section 2.

     1.     Restriction to Work Programs and Budgets: Before being revised, as
            shown above, the problem perceived with the first sentence of Section 2
            was that on its face, it appears to authorize any expenditure the Operator
            wants to make in connection with Joint Operations whether connected
            with an approved Work Program and Budget or not. It may be argued that
            you get to the same point with the original language as with the revision
            by first looking at the definition of Joint Account in Article 1.38 of the
            Operating Agreement: “accounts maintained by Operator in accordance
            with the provisions of this Agreement, including the Accounting
            Procedure.” That is not too helpful, however, since it simply refers you
            back to the Accounting Procedure. Moving on, look at the definition of
            Joint Operations in Article 1.39 of the Operating Agreement: “those
            operations and activities carried out by Operator pursuant to this
            Agreement, the costs of which are chargeable to all Parties.” That is much
            more helpful and arguably you arrive at the same place you would with
            the revision because absent an emergency or a permitted cost overrun, a
            cost cannot be charged to a party unless it is part of an approved Work
            Program and Budget. The question, though, is why not say it directly and
            avoid the textual interpretation exercise just described? Concerns were
            expressed on the committee that the revised language might be too
            restrictive. That is an interesting development if the original language and
            the revised language are supposed to arrive at the same place. So, maybe
            the revision was needed after all or maybe the issue needs to be revisited
            by the newly formed revision committee.

     2.     Structure of the Obligation to Pay. The Operating Agreement and the
            2004 AIPN AP are set up to encourage a party to pay Joint Account
            charges and ask questions later. The duty of a party under Article 3.3 (c)
            and Article 8.1 (A) of the Operating Agreement and Section 1.6.9 of the
            2004 AIPN AP is to pay joint account billings or be declared a Defaulting



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                   Party. There is no provision for withholding disputed sums.6 If the party
                   wants to risk being declared to be in default but is confident of ultimately
                   prevailing against the Operator for an unauthorized charge, that party may
                   withhold payment of a Joint Interest billing. If the revision to Section 2
                   helps mitigate the possibility of questionable or unauthorized charges,
                   however, it will make it easier for parties to live with the current structure
                   of the Operating Agreement and the 2004 AIPN AP.7

V.         RECENT ACCOUNTING PROCEDURE ISSUES

       A search of cases involving issues arising under any AIPN accounting procedure
revealed only one case.8 That case contained a few passing references to an AIPN
accounting procedure but no provision of the form itself was at issue in the case. In
looking at relevant judicial precedents, however, there are a number of interesting
developments in connection with the accounting procedure published by the Council of
Petroleum Accountants Societies (COPAS) which has published model form accounting
procedures for use by the oil and gas industry in the U.S. for over 40 years.9 The most
widely used COPAS form for the last 20 years10 has been the 1984 Onshore form11 and
the 1986 Offshore form12. In April, 2005, COPAS published a new accounting
procedure, the 2005 COPAS form which was developed to replace the 1984 and 1986
forms.13 (The 1984 and 1986 COPAS forms will be referred to in this paper as the 1984
COPAS since they are very similar. The most recent COPAS form will be referred to as
the 2005 COPAS.)


6
  An interesting development is the 2005 COPAS. Under Section I.3.B of the 2005 COPAS, a Non-
Operator may withhold payment of joint interest billings if the Non-Operator is billed for (a) an incorrect
interest, (b) an unauthorized project, (c) a sold or transferred interest, or (d) charges outside the adjustment
period.
7
  See supra text accompanying note 24 for a similar discussion where the choice is to pay or make a
consent or non-consent election.
8
    Tri-Star Petroleum Co v. Tipperary Corp., 107 S.W.3d 607 (Tex.App.-El Paso 2003, pet. denied).
9
 Karla J. Bower, 2005 1984 COPAS-A comparison of Key Features of the 1984, 1986 and 2005
Procedures, 42 ROCKY MTN. MIN. L. INST. 421 (2005).
10
  Al E. McClellan and Mike Cougevan, The New COPAS 2005 Accounting Procedure, 51 LANDMAN 37
(May/June 2006).
11
   See COPAS Publications, Volume Four, COPAS Model Form Interpretation (MFI-17) which explains
the provisions of the 1984 Onshore COPAS and contains a copy of the form.
12
   See COPAS Publications, Volume Four, COPAS Model Form Interpretation (MFI-19) which explains
the provisions of the 1986 Offshore COPAS and contains a copy of the form.
13
  See COPAS Publications, Volume Five, COPAS Model Form Interpretation (MFI-51) which explains
the provisions of the 2005 COPAS and publishes a copy of the new form.


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       Most court opinions do not identify which COPAS form is being construed but
the provisions at issue in the cases that were found are identical to the provisions in the
1984 COPAS. No cases have been found to date construing the 2005 COPAS.

A.     Similarities Between AIPN and COPAS Forms. The 2004 AIPN AP and the 1984
       COPAS are similar in a number of ways.

       1.      General Comparison: A comparison of the basic structure of the two
               documents shows the similarity of purpose and organization:

       2004 AIPN ACCOUNTING                        COPAS ACCOUNTING PROCEDURE
               PROCEDURE
Section 1 General Provisions                      Section I. General Provisions
Section 2 Direct Charges                          Section II. Direct Charges
Section 3 Indirect Charges                        Section III. Overhead
Section 4 Acquisition of Material                 Section IV. Pricing of Joint Account
Section 5 Disposal of Materials                   Material Purchases, Transfers and
Section 6 Inventories                             Dispositions
                                                  Section V. Inventories

       2.      Similar Language. In some places, the two forms use almost identical
               language: Compare, for example, the provision on Adjustments in both
               documents. The following excerpt is a redline comparison of part of the
               current Section 1.7 on Adjustments in the 2004 AIPN with the comparable
               provision in the 1984 COPAS, Section I.4 on Adjustments:
                       Payments of any [such bills] advances or billings shall not
                       prejudice the right of any Non-Operator to protest or question the
                       correctness thereof; provided, however, all bills and statements
                       rendered to Non-Operators by Operator during any [c]Calendar
                       [y]Year shall conclusively be presumed to be true and correct after
                       [twenty-four (]24[)] months following the end of any such
                       [c]Calendar [y]Year, unless within the said [twenty-four (]24[)]
                       month period a Non-Operator takes written exception thereto and
                       makes claim on Operator for adjustment. No adjustment favorable
                       to Operator shall be made unless it is made within the same
                       prescribed period.
               (The bracketed provisions are those portions of the text unique to the 1984
               COPAS and the underlined provisions correspond to the text unique to the
               2004 AIPN.)

       3.      Applicability of Judicial Precedents. The similarities between the two
               forms suggests that judicial precedents construing the 1984 COPAS may
               very well be applicable to issues arising under the 2004 AIPN AP.




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B.          COPAS Cases Relevant to the 2004 AIPN AP The following is a brief summary
            of recent cases in the United States dealing with the 1984 COPAS which would
            also appear to be instructive in construing corresponding provisions of the 2004
            AIPN AP.

            1.      Statements and Billings - Requirements of a Billing.. The 1984 COPAS at
                    Section I.2 and the 2004 AIPN AP at Section 1.5.1 contain detailed
                    requirements of what a joint interest billing must contain. Section 1.7 of
                    the 2004 AIPN AP is premised on “bills and statements” being rendered to
                    Non-Operators. In one case the Operator had submitted to the Non-
                    Operator a Status of Account Summary which only included the amounts
                    owed for the two months in question by including them in the total amount
                    due. The court held that such a general statement did not constitute a
                    sufficient billing by the Operator to entitle it to the conclusive
                    presumption of Section I.4 of the 1984 COPAS.14

            2.      Payments and Advances - Compound Interest. The same case cited above
                    held that Section I.3.B of the COPAS Accounting Procedure requiring
                    interest on unpaid balances means compound interest.15 That issue will
                    not arise under the 2004 AIPN AP because Section 1.6.9 of that form
                    provides for unpaid balances to bear interest at the Agreed Interest Rate.
                    The Agreed Interest Rate is defined in Article 1.4 of the Operating
                    Agreement as interest compounded on a monthly basis.

            3.      Prior Payment Not Required. The first sentence of Section 1.7 of the 2004
                    AIPN AP provides that “Payment of any advances or billings” will not
                    prejudice the right of a Non-Operator to question the billing later if a
                    written exception is made within the prescribed 24-month period. It might
                    be thought from the structure of that sentence that the requirement to file a
                    written exception only applies to those charges which the Non-Operator
                    first paid. One case, however, held that the Non-Operator still had to file a
                    written exception even if it had never paid the disputed charge in the first
                    place.16 The court stated, “Contrary to Defendants’ contention, neither
                    Paragraph I.4 nor case law require payment by the Non-Operator as a
                    prerequisite to the application of Paragraph I.4.”17




14
     Exxon Corp. v. Crosby-Mississippi Res., Ltd., 40 F.3d 1474, 1488 (5th Cir. 1995).
15
     Id. at 1489. Also, the 2005 COPAS provides for interest compounded monthly at Section I.3.
16
  Exxon Corp. v. Crosby-Mississippi Res., Ltd., 775 F. Supp. 969, 974 (S.D. Miss. 1991), aff’d in part,
rev’d in part, 40 F.3d 1474 (5th Cir. 1995)
17
     Id. at 975.


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            4.      Meaning of Rendered. The same case held that the conclusive
                    presumption requires that a billing from the Operator be “rendered” to the
                    Non-Operator and that the presumption does not operate on a billing that
                    was not actually received by the Non-Operator.18 That rule has not been
                    followed, however, in at least two cases where the Non-Operator had not
                    received any billing at all from the Operator. The next two cases
                    summarize those holdings.

            5.      Operator Reasonably Disposed of Records. In the first case, the working
                    interest owners in question in 1976 farmed in rights down to 4,493 feet
                    under the unitized lease in question. In 1981, the unit Operator drilled to
                    deeper horizons but failed to establish production and then came back up
                    hole and completed the well above 4,493 feet. The working interest
                    owners evidently did not become aware of the shallower completion until
                    the well was put on production in 1990. At that time, they offered to pay
                    their share of the cost of the well but demanded an audit of the Operator’s
                    records as to such costs. By that time, the Operator had long ago disposed
                    of supporting documentation. Even though the working interest owners
                    stated that they were never billed for their share of the costs of the well,
                    the court ruled that the unit Operator is reasonably required to retain
                    supporting documentation for a maximum of three years and that the
                    original charges were conclusively presumed to be correct.19 The holding
                    of the court seems to be more of a practical accommodation to normal
                    business practices under the particular facts of that case than a repudiation
                    of the principle that the conclusive presumption cannot operate on charges
                    never billed.

            6.      Convertible Overriding Royalty. In the second case, a farmor reserved a
                    2.5% overriding royalty convertible to a 50% working interest at payout.
                    The agreement of the parties provided that all costs incident to payout
                    were to be determined in accordance with the COPAS accounting
                    procedure. There was no evidence that the Operator ever sent the farmor
                    cost or payout statements. Farmor argued that receipt of such statements
                    was necessary to trigger running of the 24-month period against him. The
                    court ruled that the farmor could have requested an audit within the 24-
                    month period but failed to do so and was thus barred from challenging the
                    costs going into the calculation of payout.20 The court in this case may
                    have wanted to state a special rule for the holder of a convertible
                    overriding royalty interest who should know that production is ongoing
                    and must therefore request statements or file a written exception within the

18
     Id. at 978.
19
     Willard Pease Oil and Gas Co. v. Pioneer Oil and Gas Co., 899 P.2d 766, 774 (Utah 1995).
20
     Grynberg v. Dome Petroleum Corp., 599 N.W.2d 261, 268 (N.D. 1999).


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                    24 month period. If the overriding royalty owner requests and is denied
                    audit rights, that should go a long way to blunt any subsequent claim that
                    the overriding royalty owner was barred for failure to file a claim within
                    the requisite 24-month period. The problem could also be solved by the
                    farmor specifically reserving audit rights under the farmout agreement.21

           7.       Purpose of the Conclusive Presumption After 24 Months. One author has
                    stated in commenting on a prior COPAS form, (the 1968 version which
                    contains audit and adjustment provisions identical to the 1984 COPAS)
                    that the purpose of the 24-month period was to give the Non-Operator a
                    way to pay bills from the Operator on a timely basis without a detailed
                    analysis of their accuracy and yet preserve its rights to collect any over-
                    payment and that it implied a Statute of Limitations in providing for a
                    conclusive presumption after 24 months.22 That interpretation was
                    specifically approved by one court cited in the footnote.23 In other words,
                    pay and challenge later. The benefit is that the right to challenge the
                    charge is preserved until a written exception can be filed. That gives the
                    Non-Operator more leeway than in the analogous situation where the
                    Operator proposes an operation by AFE which the Non-Operator does not
                    believe the Operator is authorized to propose and require the Non-
                    Operator to consent or non-consent the operation. If the Non-Operator
                    goes nonconsent and challenges the authority of the Operator to propose
                    the operation but is not successful, the Non-Operator has lost the ability to
                    simply pay and avoid the non-consent penalty.24

           8.       Conclusive Presumption Rebuttable. Where the action of an Operator has
                    been fraudulent or constitutes a bad faith breach of the operating
                    agreement, the conclusive presumption that operates after the 24-month
                    period may be rebutted.25

           9.       Pleadings as Written Exception and Claim. If no formal written exception
                    to a billing has been made by the Non-Operator within the 24-month
                    period but the parties are engaged in litigation, do pleadings answering the


21
  The 2005 COPAS at Section I.5.A now provides “Any Party that is subject to payout accounting under
the [Operating] Agreement shall have the right to audit the accounts and records of the Party responsible
for preparing the payout statements, or of the Party furnishing information to the Party responsible for
preparing payout statements.”
22
  Dutton, Accounting Procedures: Contracts or Controversies?, 19 ROCKY MTN. MIN. L. INST. 117, 123
(1974).
23
     Woods Petroleum Corp. v. Hummel, 784 P.2d 242, 244 (Wyo. 1989).
24
     See Abraxas Petroleum Corp. v. Hornburg, 20 S.W.3d 741, 758 (Tex.App.-El Paso 2000, no pet.).
25
     See Exxon Corp., v. Crosby-Mississippi Res., 775 F. Supp. at 969.


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                     complaint and answering interrogatories within the 24-months period
                     constitute a written exception in order to preserve a claim for an
                     adjustment? One court held that such pleadings do not constitute a written
                     exception.26 Do lengthy negotiations or communications over the 24-
                     month period constitute the requisite exception and claim for adjustment?
                     According to another court, not if they lack sufficient specificity.27

            10.      Time For Making a Written Exception and Claim. The time for making a
                     written exception is not extended beyond the 24-month period by
                     commencing an audit.28 Section I.5.A on Audits of the 1984 COPAS
                     specifically states that but Section 1.8.1 on Audits of the 2004 AIPN AP
                     does not. The result, however, should be the same since the 2004 AIPN
                     AP at Section 1.7 requires that claims be filed within the 24-month period.

            11.      Effect of 24-Month Period On Applicable Statute of Limitations. Does the
                     24-month period have the effect of shortening the applicable statute of
                     limitations which may provide for a longer period of time to challenge
                     incorrect charges under a contract? One court took the approach that the
                     24-month provision is not in conflict with the applicable statute of
                     limitations because it is a condition precedent that must be met for rights
                     to accrue.29 Another court simply recognized that the practical impact of
                     enforcing the 24-month period within which to challenge Joint Account
                     charges is that the challenge to disputed charges must be made sooner than
                     otherwise required under the applicable statute of limitations.30 The Texas
                     Civil Practice & Remedies Code at § 16.070 (a) provides:
                             Except as provided by Subsection (b),31 a person may not enter a
                             stipulation, contract, or agreement that purports to limit the time in
                             which to bring suit on the stipulation, contract, or agreement to a
                             period shorter than two years. A stipulation, contract, or
                             agreement that establishes a limitations period that is shorter than
                             two years is void in this state.”




26
  Exxon Corp., 40 F.3d at 1478 (interpreting Exxon Corp. v. Crosby-Mississippi Res., Ltd., 775 F. Supp.
969 (S.D. Miss. 1991)).
27
     Calpetco 1981 v. Marshall Exploration, Inc., 989 F.2d 1408, 1416 (5 th Cir. 1993).
28
     Id. at 1414.
29
     See Exxon Corp., 775 F. Supp. at 976.
30
  Armstrong Petroleum Corp. v. Tri-Valley Oil & Gas Co., 11 Cal. Rptr. 3d 412, 418 (Cal. Ct. App. 2004);
see supra note 14.
31
     Not applicable for purposes of this discussion.


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                    One Texas court referred to the 24-month period as a “two-year
                    contractual limitations period.”32 In any event, it would appear that the
                    24-month period, even if a limitation on the applicable statute of
                    limitations, i.e., the four year statute set out in Texas Civil Practice &
                    Remedies Code § 16.004, does not run afoul of the two year limit imposed
                    by §16.070 of the Texas Civil Practice & Remedies Code cited above. In
                    fact, given the way Section 1.7 of the 2004 AIPN AP is structured, it
                    seems likely that most claims will actually have more than two years
                    within which to be filed. The reason is that the 24 month period does not
                    begin to run until the end of the calendar year in which the bill for those
                    charges is rendered. That means that a Non-Operator billed for a charge at
                    the beginning of the calendar year would have well over 24 months –
                    almost 36 months, in which to request an adjustment of the charge.

            12.     Resolution of a Claim Within the Statute of Limitations. If the matter
                    subject of a written exception resulting from an audit is filed within the
                    24-month period but is not resolved by the time the applicable statute of
                    limitations has run, is the claim nevertheless barred? The answer, in short,
                    is yes.33 In the case cited in the footnote, the court ruled that the audit
                    process is not a condition precedent to the commencement of a lawsuit and
                    since the lawsuit was not instituted within the applicable five year statute
                    of limitations in Oklahoma, it was barred.34 In other words, even if a Non-
                    Operator files a timely written exception within the 24 month period, it
                    still has to resolve the matter or file suit to preserve the claim before the
                    statute of limitations runs.

            13.     Meaning of the Word Adjustment. Is the word “adjustment” as used in
                    Section 1.7 of the 2004 AIPN ambiguous? Does a party escape the
                    requirement to file a written exception within the 24-month period by
                    stating that it is not seeking an adjustment but something else such as a
                    reimbursement for incorrect charges? That evidently will not work. The
                    word “adjustment” has been defined broadly to mean “A settlement of a
                    claim or debt in a case in which the amount involved is uncertain or in
                    which full payment is not made.”35

            14.     Adjustments Favorable to Operator. Section 1.7 of the 2004 AIPN AP and
                    Section I.4 of the 1984 COPAS allow adjustments in favor of the Operator


32
  XCO Prod. Co. v. Bruce L. Jamison and B. L. Jamison Family Ltd. P’ship, 194 S.W.3d 622, (Tex. App.-
Houston [14th Dist.] 2006, pet. filed).
33
     Meridian Oil Prod., Inc. v. Universal Res. Corp., 1992 U.S. APP. LEXIS 28932, at *3 (10th Cir. 1992).
34
     Id. at *4.
35
     See Woods Petroleum Corp., 784 P.2d at 243-244.


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                    as well as a Non-Operator. In one case the Operator under billed a Non-
                    Operator but waited 36 months after the year in which the last incorrect
                    billing was sent out to try and submit a corrected bill to the Non-Operator.
                    The court held that the Operator was contractually barred from trying to
                    collect the correct amount by the requirement to file within the 24-month
                    period.36

            15.     Effect of Other Agreements.. One of the problems an Operator may have
                    in making direct charges under any accounting procedure is the effect of
                    other agreements entered into at the same time as the Operating
                    Agreement. In one case, the Operator made direct charges to the Joint
                    Account for shore base facilities which were also used to service other
                    operations of the Operator. Those charges were made under an offshore
                    operating agreement with a COPAS accounting procedure attached. A
                    separate services agreement entered into at the same time as the operating
                    agreement provided that Operator would be solely responsible for its own
                    operations and also provided that in the event of a conflict between the
                    services agreement and the operating agreement, the services agreement
                    would prevail. The court held there was a conflict between the two
                    agreements and that the services agreement disallowed the charges to the
                    Joint Account.37 The point here is that other agreements outside the
                    Operating Agreement and the accounting procedure may directly impact
                    what can be charged under the accounting procedure without even making
                    specific reference to the accounting procedure.

            16.     Indirect Charges, Section 3. It does not violate the terms of the accounting
                    procedure to charge different overhead rates to different Non-Operators if
                    the accounting procedure has been amended as to one party and not the
                    other.38 The only limitation is that the Non-Operator cannot be charged
                    more than its proportionate share of the costs,39 which in the case of the
                    Operating Agreement is provided for at Article 3.3(C) requiring each party
                    to pay its participating interest share of Joint Account expenses. In other
                    words, if the higher rate paid by one party was still within its


36
     Id. at 244.
37
  Torch Operating Co. v. Louis Dreyfus Reserves Corp., No. 93-2636, 1994 WL 117786 (E.D. La. March
30, 1994).
38
   Hondo Oil and Gas Co. v. Texas Crude Operator, Inc , 970 F.2d 1433 (5th Cir. 1992). An interesting side
note in this case is that the court held that the operating agreement had been amended by course of conduct
of the parties. The amendment, however, had not been reduced to writing. The court held that the
amendment was not required to be in writing under the Statute of Frauds because that statute does not apply
to an agreement that can be performed within one year. Since the operating agreement in question would
terminate upon cessation of production, the court held that it conceivably could be performed within one
year.
39
     Id. at 1439.

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            “proportionate share of the costs,” it could not complain about the lower
            rate being charged another party.

C.   Profit Sharing Payments as Direct Costs of Salaries, Wages and Related Costs .
     May an Operator charge the Joint Account with profit sharing payments to
     employees of the Operator as a direct cost of salaries, wages and related costs
     under Section 2.2 of the 2004 AIPN AP? While not the subject of a court case,
     the issue has been the subject of arbitration. The question depends on how a
     profit sharing law operates; the role of Work Programs and Budgets under the
     Operating Agreement; other provisions of the Operating Agreement and finally a
     determination of whether profit sharing laws are in effect a tax measured by the
     income of the Operator.

     1.     Profit Sharing Laws in South America . The following is a tabulation of
            profit sharing laws in various South American countries. The basic
            outlines of how a profit sharing law operates can be understood from a
            review of those provisions.

            Argentina: The Federal Constitution (Section 14 bis) provides that
                       implementing laws will ensure employees the right to
                       participate in the profits of the commercial enterprises.
                       Nevertheless, the constitutional provision has never been
                       implemented. Hence, in practice, employers are not required
                       to make an extra payment to employees based upon the
                       profits of the commercial enterprise.

            Bolivia:     The General Employment Law (Ley General del Trabajo –
                         Section 57) provides that any commercial enterprise that
                         obtains profits in any given fiscal year shall pay its
                         employees an extra lump sum equal to one-month’s salary as
                         a profit sharing bonus, provided that the total amount paid to
                         all the employees does not exceed 25% of the profits of the
                         company. The amounts paid to employees as profit sharing
                         bonus are deductible for Income Tax purposes.

            Brazil:      The Federal Constitution (Section 7, XI) provides that
                         employees are entitled to a profit sharing bonus, in addition
                         to the regular compensation, subject to the provisions of the
                         implementing regulation. This constitutional provision was
                         implemented by Law 10,101 (2000). Law 10,101 provides
                         that profit sharing schemes shall be negotiated between
                         employers and employees through individual or collective
                         bargaining agreements. Law 10,101 does not provide a
                         penalty for failure to agree. Hence, most employers have not
                         implemented profit sharing. The amounts paid to employees



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                       as profit sharing bonus are deductible for Income Tax
                       purposes.


           Chile:      The Employment Code (Código del Trabajo - Sections 42
                       and 47-52) provides that any commercial enterprise that
                       obtains profits in any given fiscal year shall pay each
                       employee: (a) a profit sharing bonus equal to said employee’s
                       proportional share of 30% of the profits of the company or
                       (b) a bonus equal to 25% of the total earnings of such
                       employee in any given fiscal year, up to an amount equal to
                       4.75 times one-month’s minimum salary as determined by
                       law. The amounts paid to employees as profit sharing are
                       deductible for Income Tax purposes.

           Colombia:   Employers are not required to make an extra payment to
                       employees based upon the profits of the commercial
                       enterprise.

           Ecuador:    The Constitution of the Republic of Ecuador (Section 35.8)
                       provides that employees are entitled to a profit sharing bonus,
                       subject to the provisions of the implementing regulation. In
                       this regard, the Employment Code (Código del Trabajo –
                       Section 97) provides that the employer shall distribute to its
                       employees 15% of the net profits of the commercial
                       enterprise up to the amount of U$ 4,000 per employee. The
                       difference between the 15% of net profits and the amount
                       paid to the employees, if any, shall be paid to the Federal
                       State by the employer as Additional Income Tax. The
                       amounts paid to the employees as profit sharing bonus are
                       deductible for Income Tax purposes.

           Peru:       Legislative Decree No. 677 (Decreto Legislativo No. 677)
                       provides that profit sharing costs are incurred by a company
                       if it has more than 20 employees and has net income. The
                       amounts paid to employees as profit sharing bonus are
                       deductible for Income Tax purposes.

           Venezuela   The Employment Law (Ley Orgánica del Trabajo - Sections
                       174-184) provides that a commercial enterprise (with some
                       exceptions for enterprises with minimum investment capital)
                       shall distribute to its employees at least 15% of its net profits
                       in any given year, with a minimum per employee equal to
                       fifteen-days’ salary and a maximum per employee equal to
                       four-month’s salary. The amounts paid to employees as profit
                       sharing bonus are deductible for Income Tax purposes.


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     2.    Work Program and Budget . The typical Work Program and Budget does
           not give much guidance for determining whether profit sharing costs are
           included under one or more general categories that usually appear in such
           a document. Personnel costs may be shown in the typical Work Program
           and Budget under any of the following general budget entries: Employee
           Salaries, Employee Benefits, Company Labor and Services or Payroll.
           Payroll is usually divided into Salaries and Wages; Government Social
           Benefits and Bonuses. Experience indicates that it is unlikely that profit
           sharing costs are broken out specifically under any of the above
           categories.

     3.    Other Applicable Provisions of the Operating Agreement and 2004 AIPN
           AP . After looking at the nature of the profit sharing charge, it also needs
           to be looked at in the context of other provisions of the Operating
           Agreement and the 2004 AIPN AP. See for example, Article 4.2(B)(9) of
           the Operating Agreement which provides as follows:
           (B)     In the conduct of Joint Operations Operator shall:

                   (9)    pay to the Government for the Joint Account, within the
                          periods and in the manner prescribed by the Contract and
                          the Laws / Regulations, all periodic payments, royalties,
                          taxes, fees and other payments pertaining to Joint
                          Operations but excluding any taxes measured by the
                          incomes of the Parties;

           Similarly, Section 2.11 of the 2004 AIPN AP provides that chargeable
           costs and expenditures may include:

                  2.11    Taxes and Duties.
                          All taxes, duties, assessments and governmental charges, of
                          every kind and nature, assessed or levied upon or in
                          connection with the Joint Operations, other than any that
                          are measured by or based upon the revenues, income and
                          net worth of a Party.

           In short, taxes measured by the income of a party are not appropriate
           charges to the Joint Account.

     4.    Is Mandatory Profit Sharing a Tax Measured by Income? Even if profit
           sharing is not strictly speaking a tax, the question remains whether the
           basic nature of the charge shares enough characteristics with a tax to fall
           within the problem that Article 4.2(B)(9) of the Operating Agreement and
           Section 2.11 of the 2004 AIPN AP are trying to solve and are therefore
           within the prohibition of those provisions. Look for example at Conlen
           Grain and Mercantile, Inc. v. Texas Grain Sorghum Producers Boards,
           519 S.W.2d 620 (Tex. 1975). In that case, the Supreme Court of Texas

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             held that an assessment on grain producers by the Grain Sorghum
             Producers Board which (i) was not paid into the State Treasury, (ii) did not
             become part of the general revenues of the state and (iii) was not subject to
             appropriation by the legislature, was nevertheless a tax for purposes of the
             state constitutional prohibition of an occupation tax on agricultural
             pursuits. The reason for the holding of the court was that the assessment
             was a burden or charge which the legislature required processors of grain
             to collect from producers and was thus imposed by legislative power upon
             persons or property to raise money and that as such, it was a tax. Based on
             that reasoning, it would appear that profit sharing payments are a tax
             measured by income and as a result not an appropriate charge to the Joint
             Account.

VI.   ISSUES RELATED TO REVISION OF THE 2004 AIPN AP

A.    2004 AIPN AP Section 1.8.1.            Section 1.8.1 of the 2004 AIPN AP provides
      for the right of a Non-Operator to audit the Joint Accounts and records of
      Operator relating to any Calendar Year within the 24 month period following the
      end of the Calendar Year. It is provided that Non-Operators shall have reasonable
      access to Operator’s personnel and to the facilities, warehouses, and offices
      directly or indirectly serving Joint Operations. The cost of each such audit shall be
      borne by Non-Operators participating in the audit.

      Possible Revision Issue: Is it necessary to specify the right of the Non-Operators
      to copy audited books and records? Is it clear that each Non-Operator is only
      responsible for its own costs in conducting the audit?

B.    2004 AIPN AP Section 1.8.3. The following provision appears at the end of each
      alternative under Section 1.8.3 on audit of Affiliate books and records:

             “No amounts paid to an Affiliate of Operator, which the Non-Operator
             seeks to audit, may be charged to the Joint Account if the Affiliate of the
             Operator does not allow audit of such amounts as provided above.”

      Possible Revision Issues: Does the last paragraph literally mean the Operator
      cannot make an Affiliate charge to the Joint Account until it has the audit report?
      Does the audit report not come long after the charge is made to the Joint Account?

C.    2004 AIPN AP Section 1.8.4. Section 1.8.4 provides that any Party may audit the
      records of Operator’s Affiliate relating to charges by Operator Affiliates for
      purchasing services under Section 2.5.1, for services normally provided by third
      parties under Section 2.7.1 and for exclusively owned equipment under Section
      2.6 and that provisions of Section 1.8.3 on Affiliate audits will apply mutatis
      mutandis to such audits.




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       Possible Revision Issues: Should the three last paragraphs of Section 1.8.4 be
       consolidated into one? Should each section that would be applied mutatis
       mutandis be specifically mentioned?

D.     2004 AIPN AP Section 1.8.7. Section 1.8.7 provides that the parties conducting
       an audit will make a reasonable effort to prepare a written report to the Operator
       and all the Parties who participated in the audit as soon as possible and in any
       event within 90 Days after the conclusion of each audit. Operator is to make a
       reasonable effort to reply to the report in writing no later than 90 Days after
       receipt of the report. Should the Non-Operators consider that the report or reply
       requires further investigation as to any item, they may conduct a further
       investigation even if the 24 months may have expired.

       Possible Revision Issue: Is there a need to specifically prevent expanding the
       audit to anything except those items identified as requiring further investigation in
       the audit report?

E.     2004 AIPN AP Section 2.2.1. Section 2.2.1 provides that the salaries, wages and
       related costs of employees of Operator and its Affiliates temporarily or
       permanently assigned in the Country of Operations and directly engaged in Joint
       Operations shall be chargeable to the Joint Account.

       Possible Revision Issue: Is there a need to exclude stock options and deferred
       compensation charges to the Joint Account?

F.     2004 AIPN AP Sections 2.2.2 and 2.2.7. Section 2.2.2 deals with direct charges
       for salaries, wages and related costs of employees of Affiliates assigned outside
       the country of operations and directly engaged in Joint Operations. Section 2.2.7
       deals with direct charges for the cost of services performed by Affiliates outside
       the Country of Operations.

       Possible Revision Issues: Are these two sections drafted in coordination with
       each other and is there a need to remove the requirement in Section 2.2.7 that the
       services must be rendered outside the country of operations?

G.     2004 AIPN AP Section 6, Inventories. Possible Revision Issue: Should a new Section
       6.3 be added to Section 6 which provides that the Operator will maintain a register of
       all Joint Account Property classifying the property into separate categories with
       all such assets being verified at least every 5 years? Should mobile and high risk
       assets be verified at least every 2 years?

VII.   CONCLUSION

        The substantive revisions made to the 2000 AIPN Accounting Procedure as
reflected in the 2004 AIPN AP help bring the form into closer alignment with current
practice. Resources available for using and understanding the 2004 AIPN AP include
recent court decisions construing the analogous 1984 COPAS. Some of the issues that
the AIPN committee will consider in revising the 2004 AIPN AP were reviewed.

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