Legal Audit – A Perspective On The Oil Industry

Oil and Gas is an important import for our economy, many initiatives have been taken by the Ministry for increasing production and exploitation of all domestic petroleum resources to address the priorities like Energy Access, Energy Efficiency, Energy Sustainability and Energy Security.Several policies have been implemented to increase India’s Production of crude oil.In order to promote the usage of natural gas as a fuel/feedstock across the country and move towards a gas based economy, the development of additional 13500 km long gas pipeline is under way to complete the Natural Gas Grid (NGG). At present, the NGG in the country predominantly connects the western, northern and south-eastern gas markets with major gas sources. As a commitment to provide clean energy in the eastern part of the country, the Government has approved a capital grant of ` 5,176 crore (40 per cent of the estimated capital cost of `12,940 crore) under Pradhan MantriUrja Ganga. To make available natural gas to public at large, Government has put strong emphasis on expansion of City Gas Distribution (CGD) network coverage across the country. CGD networks ensures the supply of cleaner fuel (i.e. PNG) to households, Industrial & commercial units as well as transportation fuel (i.e. CNG) to vehicles.

​The evolvement of oil markets has resulted in various risk exposures. In the context of these developments and the progressive deregulation and liberalisation of the Indian oil sector, having in place effective risk management and internal control systems has become crucial to the conduct of oil business.

A soundlegal audit function plays an important role in contributing to the effectiveness of the internal control system. The audit function should provide high quality counsel to management on the effectiveness of risk management and internal controls including regulatory compliance by the oil companies. In the changing scenario there is a need for widening as well as redirecting the scope of legal audit to evaluate the adequacy and effectiveness of risk management procedures and internal control systems in the oil industry.

To achieve these objectives,  legalaudit, needs a focus shift from the present system of full-scale transaction testing to risk identification, prioritization of audit areas and allocation of audit resources in accordance with the risk assessment. Oil Industry will, therefore, need to develop a well defined policy, duly approved by the Board, for undertaking risk-based legal audit. The policy should include the risk assessment methodology for identifying the risk areas based on which the audit plan would be formulated. The policy should also lay down the maximum time period beyond which even the low risk business activities/locations should not remain unaudited. Further, the risk assessment should be an, as an independent activity. Failure to follow risk assessment implicitly will decrease the performance. Higher uncertainty will result in larger balance swings and biases may cause loss of revenue, regulatory compliance failures, and the potential for litigation. It is imperative to know where facility issues exist and the financial impact of potential improvements to do cost-benefits analyses. Auditing data is prudent business practice. The audit will provide a means of process improvement, through proper identification of deficiencies and a precise plan for corrective action.

Oil Industry Safety Directorate (OISD) is a technical directorate under the Ministry of Petroleum and Natural Gas and has been entrusted with the responsibility of formulating standards, overseeing its implementation through safety audits in petroleum industry to enhance safety levels and reduce risk inherent with this industry. OISD standards cover the entire activities pertaining to hydrocarbon sector i.e. exploration & production, refining, gas processing, storage, distribution, environment etc. which are implemented on self-regulatory basis by the Oil & Gas companies.

Any Exploration & Production project in India is governed by various acts, rules, and regulations set by Government at the national level and other regulatory agencies at the state and local level. Some of the acts applicable specifically to Oil and Gas sector are:

Petroleum Act, 1934 (Act no. 30 of 1934) and the rules made there under: An Act to consolidate and amend the law) relating to the import, transport, storage, production, refining and blending of petroleum [16th September, 1934] Whereas it is expedient to consolidate and amend the law relating to import, transport, storage, production, refining and blending of petroleum. Therefore, this Act was passed in 1934 to address operational issues covering the entire value chain of oil production.

The Oilfields (Regulation and Development) Act 1948 (53 of 1948): Following the Petroleum Act, the next major legislation was the Oilfields (Regulation and Development) Act of 1948. Under this Act, the central government was granted the power to make rules for regulating the authorization of mining leases (for offshore blocks). Further, the Act also empowers the central government to determine rates of royalty payable by the holder of the mining lease for onshore as well as the offshore blocks

The Petroleum pipelines (Acquisition of Right of User in land) Act, 1962 (50 of 1962): With regard to acquisition of user rights on a land where petroleum and/ 16 17 or mineral pipelines were to be laid, the Petroleum and Minerals Pipeline Act got passed in 1962. This Act has provisions relating to the acquisition and utilization of land for laying pipelines. The Central Government has been given the authority to acquire the land. Once the land has been acquired, the Central Government has the option of either keeping the acquired land or transferring it to either the state government or the corporation2 for which the land has been acquired. The Act also provides for compensation in case of any damage, loss or injury is sustained by any person interested in the land under which the pipeline is proposed to be, or is being, or has been laid. Further, the liability of paying the compensation lies with the concerned authority, i.e., the Central or State Governments or Corporation.

The Oil Industry (Development) Act, 1974 (47 of 1974) and Rules 1975: The Oil Industry (Development) Act was passed in 1974 under which the Oil Industry Development Board (OIDB) was created at a time when the need to promote self-reliance in the oil and gas sector was realized. The mandate of the Board is to facilitate development of the sector. The Board is responsible for collecting the oil industry development cess on the blocks that have been awarded to upstream oil companies on a nomination basis. It also extends financial assistance to companies in the sector in the form of loans.

Like above there are several other Allied Acts regulating Oil and Gas Sector.APEX Body governing Oil industries is The Ministry of Petroleum and Natural Gas. It has several bodies working under its umbrella to exercise an administrative control over this key sector.These include:

a. The Directorate General of Hydrocarbons (Upstream)

b. The Petroleum and Natural Gas Regulatory Board (PNGRB) (Downstream)

In a Legal due diligence for the above industry some major of the most important factors that are generic practice are:Performing Land Due Diligence will help identify Title Defect . Performing Contract Due Diligence will additionally help in understanding the business regime and model such as Oil and Gas leases,Joint Ventures, Mergers and acquisitions, Consortium Agreements, Technology Transfer Agreement, Royalty/Profit sharing Agreements, Exploration and Production Sharing Agreements,Gas Transmission Agreements, Farm-in/ farm-out Agreements, LNG Supply Agreement, Pipeline Transportation Contracts, Operating agreements, Gas balancing agreements, Power Purchase Contracts, Fuel Supply Agreement,  Shipping and Bulk Carriage Contracts, Contracts for the Purchase and Leasing of Rigs and other drilling equipments,Natural Gas Gathering and Processing Agreements, Leasing agreements for mines etc, Communitization agreement, Storage agreements v Pooling and Unitization agreements, Due Diligence and legal, Master service agreements and other agreements between oil and gas producers and oilfield service companies,

Some of the most controversial topics regarding the oil and gas industry are environmental concerns and sustainability. Performing Environmental Due Diligence will help verify conformity with governing environmental laws, identify any hazards such as Assessing and mitigating environmental risks, Reduction in Green House Gas Emissions, Advising on Clean Development Mechanism (CDM) projects, Developing models to increase energy efficiency by energy saving measures, improved/enhanced oil recovery measures and reduction measures in gas flaring, Use of bio-fuel technology, Adoption of renewable energy such as solar energy, wind energy,

Lastly the Generic Audit will have subjects like : Intellectual Property, Schedule of domestic and foreign patents and patent applications, Schedule of trademark and trade names Schedule of copyrights, Description of important technical know-how, Description of methods used to protect trade secrets and know-how, Any “work for hire” agreements, Schedule and copies of all consulting agreements, agreements regarding inventions, and licenses or assignments of intellectual property to or from the Company,Any patent clearance documents, Schedule and summary of any claims or threatened claims by or against the Company regarding intellectual property, A description of all employee problems within the last three years, including alleged wrongful termination, harassment, and discrimination, A description of any labor disputes, requests for arbitration, or grievance procedures currently pending or settled within the last three years, A description of worker’s compensation claim history, A description of unemployment insurance claims history,The Company’s personnel handbook and a schedule of all employee benefits and holiday, vacation, and sick leave policies.

Summary plan descriptions of qualified and non-qualified retirement plans, A list and description of benefits of all employee health and welfare insurance policies or self-funded arrangements, Copies of collective bargaining agreements, if any Compensation arrangements, Copies of all stock option and stock purchase plans and a schedule of grants thereunder Legal and Related Matters, Litigation and Audits Criminal records, Court judgments, Legal disclosures Compensation, Pending lawsuits against the Company Pending lawsuits initiated by Company Description of environmental and employee safety issues and liabilities, List of material patents, copyrights, licenses, and trademarks, Summary of insurance coverage/any material exposures, Summary of material contacts History regulatory agency problem, if any Debarred or restricted parties lists etc.

Hence it is of utmost importance that such industries undergo legal audits to stay complaint of the laws.

Author: Vibhor Gupta, Senior Associate, at Khurana & Khurana, Advocates and IP Attorneys.  In case of any queries please contact/write back to us at vibhor@khuranaandkhurana.com.

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