Issues on the unilateral termination of subsoil use contracts

Issues on the unilateral termination of subsoil use contracts

Disputes in relation to the unilateral termination of subsoil use contracts (the ‘Contract’) form a substantial part of the litigated cases on the rights stipulated by the legislation on subsoil. 

This is our brief review of judicial practice established under the Law of the Republic of Kazakhstan No. 2828 ‘On Subsoil and Subsoil Use’ dated 27 January 1996 (hereinafter referred to as the ‘Old Law’), with the aim of providing an analysis of the specific interpretations and applications of the legislation of the Republic of Kazakhstan by the courts in adjudicating civil cases of this category, description of problems that lead to the litigated cases, and our own opinion concerning the legality and legitimacy of certain judicial decisions. At present, there is no judicial practice on disputes relating to the unilateral termination of Contracts established under the Law of the Republic of Kazakhstan No. 291-IV ‘On Subsoil and Subsoil Use’ dated 27 June 2010 (hereinafter referred to as the ‘New Law’), but we nevertheless hope that this review, given the experience gained by judicial practice under the Old Law, may provide the reader with an indication of the possible judicial approach on appealing the unilateral termination of contracts in future. It is also important to note that many contracts entered into prior to the operation of the New Law contain a clause allowing the competent body to terminate the contract on carrying out subsoil use operations on a unilateral basis, if subsoil user the commits a material breach of the obligations stipulated by the Contract and work programme. It is therefore possible to conclude that with regards to Contracts entered into before the New Law, in the case of a material breach of obligations by the subsoil user, the competent body taking the terms and conditions of the Contracts as the basis will terminate the Contracts obligations, which can be found in the Contracts and work programme and subsequently breached by the subsoil user.

Grounds and procedure of the unilateral termination of Contracts in accordance with practice formed during the operational period of the Old Law: choosing the applicable Law

In most cases, the Ministry of Energy and Mineral Resources of the Republic of Kazakhstan[1] (hereinafter referred to as the ‘Competent Body’) terminated the Contracts on the basis of Article 45-2.2.4 of the Old Law i.e. where the subsoil user material breached its obligations stipulated by the Contracts and work programme. In the subsoil legislation, the term ‘material breach of Contractual obligations’ is omitted, although Article 401.2 of the Civil Code of the Republic of Kazakhstan (hereinafter referred to as the ‘CC RK’) makes reference to the notion of a ‘material breach of contract’. The breach is considered to be a material breach of the contract not meeting the legitimate expectations that, to a significant extent, the other party had at the time of entering into the contract. Article 401.2 of the CC RK provides for the court procedure on the termination of the contract on the demand of one of the parties in case the contract is materially breached. On the other hand, Article 45-2.2 of the Old Law stipulated that the Competent Body had the right to unilateral termination of the Contracts thus enabling the Competent Body to unilaterally terminate the Contracts on the basis of its decision.

It is for this reason that, at the time of dispute resolutions in respect of the unilateral termination of Contracts by the Competent Body, the courts often consider whether or not the laws on civil legislation apply to legal relations involving subsoil use. They will have obviously referred to the articles of the CC RK and the Old Law, which differentiate between the application of the civil legislation and the application of the subsoil legislation.

In accordance with Article 4.3 of the Old Law, civil relations concerning the right to subsoil use are regulated by the civil law if they are not regulated by the Old Law. Similarly, Articles 1.1 and 1.3 of the CC RK provide: “the civil law applies to relations on the use of natural resources based on equality between the parties if such relations are not regulated by the law on the use of natural resources.” The New Law also contains a clause stating that civil relations in connection with the right to subsoil use are regulated by the civil legislation of the Republic of Kazakhstan if they have not been regulated by the New Law.

Further, Article 42-1 of the Old Law specifically states that the contract can be concluded, executed, changed, or terminated in accordance with the Law itself and the civil legislation of the Republic of Kazakhstan.

If relations arising from the conclusion, execution, change, or termination of the contract are not regulated by the legislation on subsoil and subsoil use, according to the Old Law, the civil legislation would have applied to such relations.

In accordance with the New Law, the conclusion, execution, change, or termination of the contract can be given effect, containing no reference to the application of the civil legislation.

It should be noted that judicial practice is not coherent in terms of the interrelation between the civil and subsoil legislation. For instance, the Astana city court in at least 4 of its decisions reasoned that since the law on subsoil use does not explain the concept of a material breach of Contracts, Article 401.2 of the CC RK explaining the term “material breach of a contract” is applicable. The court therefore accepted the simultaneous application of the civil legislation and the law on subsoil use to relations arising from the Contract where civil legislation was considered by the court to be an addition to the law on subsoil use.

The Board on Civil Cases of the Supreme Court of Kazakhstan, on the other hand, arrived at a different conclusion in several cases. If relations concerning subsoil use are regulated under the law on subsoil and subsoil use, then civil legislation does not apply at all to relations, even if it explains some concepts that are not explained in the law on subsoil and subsoil use.

In one of its Decrees, the Board stated:

“Since the termination of a Contract is specifically stipulated in Article 45-2 of the Law ‘On Subsoil and Subsoil Use’, Articles 401 and 402 of the CC RK do not apply to relations under this dispute.”

In another case the Board, in reviewing an appeal from a subsoil user, analysed a Contract that stated that it could be unilaterally terminated on grounds stipulated by legislative acts or contracts. The Board allowed the application of Article 42-2 of the Law ‘On Subsoil and Subsoil Use’ to the facts of this case without making reference to the term “material breach of contract” provided under Article 401 of the CC RK.

Only if there are sufficient grounds, may the Contract be unilaterally terminated

In resolving court disputes relating to the unilateral termination of contracts, the key fact is the existence of grounds for termination which, according to the Old Law, included a material breach of obligations arising from the Contract or work programme.

As practice shows, the decisions of the Competent body on the unilateral termination of Contracts have not always been taken on the basis of sufficient grounds. Unfortunately, in some cases, the unfounded position of the Competent Body has found support from the courts. We can demonstrate this using the following example.

A subsoil use company entered into a Contract on extracting hydrocarbon in July 2006. In December 2007, the Competent Body issued a decision to terminate the company’s Contract on the basis of a failure to perform its programme for 2007.

The company appealed the notice and decision of the Competent Body to the court.

During the court proceedings, the company produced evidence showing 96% performance of the 2006 programme and 101% performance of the 2007 programme. In 2007, some actions were completed that should have taken place in 2008. This was considered to be the reason why the claim was refused. The court explained that the execution of actions not planned for 2007 was a breach of the work programme. The company should have amended its 2007 programme before taking the actions. The court concluded that “the stated facts are material breaches of obligations stipulated by the work programme allowing the competent body to terminate the Contract on a unilateral basis”.

We believe the court did not explain its decision in full. In accordance with Article 45-2.2.4 of the Old Law, one of the grounds for termination of a Contract by the competent body on a unilateral basis was a material breach of obligations stipulated either by the Contract or the work programme. In this case, the competent body terminated the contract on the basis of this provision. The court, agreeing with the competent body, decided that taking actions unstipulated by the 2007 programme was a material breach. In its judgment however, the court did not address any specific incomplete works stipulated by the 2007 programme. The material breach of obligations found in the Contract or work programme was the ground for the unilateral termination of the Contract. The court however did not discuss whether or not the breach was in fact a material one even on the basis of the established practice – the percentage of the means spent to perform works in a specific calendar year divided by the volume of the means planned to spend in this year.

It shall be noted that the described case is an exception rather than a rule. The majority of cases related to the unilateral termination of contracts on the basis of a material breach by the subsoil user of its obligations arise when the subsoil user does not perform actions planned for the specific year.

In practice, in cases of unfinished works planned for a specific year, the works were included in the work programme for the following year. If the competent body issued a decision on the unilateral termination of the Contract, the subsoil user submitted the authorised programme to the court for confirmation that the transfer of works to the following year was agreed with the body on geology and subsoil use. Practice has shown that there is no consistency between the courts when considering this argument.

In one case, the court decided that the company’s argument was unsubstantiated, pointing out that including unfinished works in the programme for the following year did not constitute undoing the breaches of obligations stipulated by the previous work programme.

On the other hand, in another dispute the court decided that the notification on the termination of contract to the company was made on the basis that financial liabilities stipulated by the work programme for 2006 were performed for 30%. During the court proceedings, the company produced evidence showing 96% performance of the 2006 programme and 101% performance of the 2007 programme had been performed. In 2007, some actions were completed that should have taken place in 2008. This was considered to be the reason why the claim was refused. The court explained that the execution of actions not planned for 2007 was a breach of the work programme. The company should have amended its 2007 programme before taking the actions. The court concluded that “the stated facts are material breaches of obligations stipulated by the work programme allowing the competent body to terminate the Contract on a unilateral basis”.

We believe the court did not explain its decision in full. In accordance with Article 45-2.2.4 of the Old Law, one of the grounds for termination of a Contract by the competent body on a unilateral basis was a material breach of obligations stipulated either by the Contract or the work programme. In this case, the competent body terminated the contract on the basis of this article. The court, agreeing with the competent body, decided that taking actions unstipulated by the 2007 programme was a material breach of obligations. In its judgment however, the court did not address any incomplete works. The material breach of obligations under the Contract or work programme was the ground for the unilateral termination of the Contract. The court however did not discuss whether or not the breach was in fact a material one. In practice, the courts take the percentage of the means spent to perform works in a specific calendar year and divide that by the volume of the means planned to spend in this year.

It shall be noted that the described case is exceptional. The majority of cases related to the unilateral termination of contracts on the basis of a material breach by the subsoil user of its obligations arise when the subsoil user does not perform actions under the work programme for the specific year.

In practice, in cases of unfinished works, such works were included in the work programme for the following year. If the competent body issued a decision on the unilateral termination of the Contract, the subsoil user submitted the authorised programme to the court to confirm that the transfer of works to the following year was agreed with the bodies on geology and subsoil use. Practice has shown that there is no consistency between the courts in relation to this practice.

In one case, the court decided that the company’s argument was unsubstantiated, pointing out that including unfinished works in the programme for the following year did not constitute undoing the breaches of obligations stipulated by the previous work programme.

On the other hand, in another dispute the court decided that the notification on the termination of the contract to the company was made on the basis that financial liabilities stipulated by the work programme for 2006 were performed for 30%. In the beginning of 2007 however, the Contract and work programme contained amendments, as a result of which the liabilities of the company in 2007 were discharged by 70%. The court took the latter point into consideration and the company’s request to reject the notice and decision to terminate the Contract was satisfied.

For subsoil users who had failed to perform the work programme and included unfinished works in the programme for the following year, there was a risk that the Competent Body would issue a decision to terminate the Contract on a unilateral basis. Usually such decisions were issued not at the end of the year, but at some point later so that at the time of its issuance, the subsoil user incurred expenses. In such situations, the subsoil user engaging in exploration suffered the most as it incurred expenses at this time whilst using subsoil, but did not earn anything.

We are of the opinion that if unfinished works were included in a work programme for the following year and were finished within the framework of the programme, then the prolongation of the programme, not the failure to perform, constitutes a breach of the programme. In assessing the character of the breach (i.e. whether or not the breach was material), in our opinion the fact that the prolongation of the programme has a lesser impact on the interests of the State than a failure to perform the programme needs to be taken into consideration.

In one of the court cases, the Competent Body, relying on Article 401.2 of the CC RK, was required to prove that as a result of including unfinished works in a work programme for the following year, the State did not obtain what it had expected to obtain when it entered into the Contract. As mentioned above, the argument that Articles 401-404 of the CC RK could be relied upon in deciding whether a work programme was breached did not receive support in the High Court of the Republic of Kazakhstan. In our opinion, the ‘gravity’ of a breach of contract and work programme shall depend on the actual damage to the interests of the State. It is for this reason that the assessment of a breach should not be limited to establishing a correlation between the volume of planned and finished works. It should take into account the results of the preventative works performed prior to the termination of the Contract, as well as the extent to which a failure to perform a work programme for a specific year may impact the performance of the Contract and work programme as a whole.

We can illustrate the latter point using the following example.

In resolving one of the disputes apart from other arguments about the absence of a material breach of the Contract and work programme, the court took the following fact into account. The work programme of the subsoil user was estimated to be for 6 years of exploration. At the moment of issuing a decision to terminate the Contract, the breach was for two years. The failure to perform the work programme for the second year was the ground for the decision to terminate the Contract. At the moment of resolving the dispute however, half of the volume of means planned for the 6 years was realised. In our opinion, this is why the court gave a correct judgment, namely that the breach that occurred in the second year was not material since it did not pose a threat to the performance of the entire work programme and Contract.

Another case in judicial practice concerned the following. At the end of November 2007, the Competent Body issued a decision to terminate the Contract on the basis of a failure to perform the previous year’s work programme for 2007, which included unfinished works from 2006. The notice on the termination of Contract was however received by the company at the beginning of January 2008. In court, the company argued that the works done in the fourth quarter of 2007 should be included in the list of finished works for 2007. In turn, the Competent body argued that the works finished in the fourth quarter could not be included into the work programme for 2007 because they were performed after the Contract had been terminated. The court however came to the following decision: since the subsoil user received the notice no earlier than January 2008, the company performed and was obliged to perform its obligations arising from the Contract. Further, the term of the work programme for 2007 expired on 31 December of that year, hence all of the works finished prior to the date should be regarded as completed within the set term. It is for this reason that the Competent body should have included all works and expenses stipulated by this programme that were performed throughout the whole year of 2007.                                                                                                                                                                                                 

Taking into account the above, we would like to point out that in accordance with the New Law, the Competent body has a right to unilaterally terminate the subsoil use contract if the subsoil user does not remedy the breached within the term mentioned in the notification of the Competent body containing more than two breaches of obligations under subsoil use contract or project documents. The New Law does not contain any condition on the degree of a breach (material or immaterial), which may lead to difficulties and negative consequences for subsoil users.

Conclusion

There is no doubt that breaches of obligations should be stopped, including the means of coercive actions stipulated by the legislation up to the termination of the contract. At the same time, the proper performance of obligations facilitates the socio-economic development of the Republic of Kazakhstan and any obstacles shall be removed at a legislative level. For this, it is necessary that the company be able to defend its own interests properly using all of the legal means stipulated by the legislation. We do hope that the fervour with which companies defend their legal interests will facilitate stability, business protection from undue infringement, and the development of our country’s economy as a whole.