Bankruptcy

Risky Business: Uncertain Outcomes for Application of Bankruptcy Code 365

Bankruptcy

Variations in How States Treat Oil & Gas Leases Make Dispositions Complicated

Ability of a debtor to assume, assign, or reject oil and gas “leases” under section 365 of the Bankruptcy Code

Section 365(a) of the Bankruptcy Code (11 U.S.C. § 365) provides that “the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.” On the face of the statute, it would appear an oil and gas lease may be rejected in bankruptcy as an “unexpired lease.” However, as one court has held, “[t]he term ‘oil and gas lease’ is a misnomer because the interest created by an oil and gas lease is not the same as an interest created by a lease governed by landlord and tenant law.” In re Topco, Inc., 894 F.2d 727, 740, n.17 (5th Cir. 1990).1 This “misnomer” used by the industry for oil and gas leases, along with inconsistent interpretation by the various states, has created issues regarding whether section 365 is applicable. And, even if the oil and gas lease is not considered a “lease” for purposes of section 365, it might in the alternative be considered an executory contract, and still subject to section 365. As discussed below, these questions are usually decided based on the property laws of the relevant state, with the answer oftentimes hinging on whether oil and gas leasehold interests are considered a vested fee interest in real property. If state law treats oil and gas leases as conveying a vested fee interest (also referred to as a “freehold interest”), it is unlikely they will be deemed an “executory contract or unexpired lease” subject to section 365. See Topco, Inc., 894 F.2d at 740.

Whether an agreement is an “executory contract” is a question of federal law. (see Cameron v. Pfaff Plumbing and Heating, Inc., 966 F.2d 414 (8th Cir.1992)), but is informed to a considerable extent by state law principles the bankruptcy court is bound to respect. In re Aurora Oil & Gas Corp., 439 B.R. 674 (Bankr. W.D. Mich. 2010). Specifically, state law governs the extent of a debtor’s interest in property. See Butner v. U.S., 440 U.S. 48 (1979). This includes the classification of oil and gas leases as freehold or leasehold, which is important in determining whether it may be set aside as an unexpired lease under section 365. See In re Topco, Inc., 894 F.2d at n.17 (stating that, in Texas, oil and gas leases do not constitute unexpired leases subject to section 365).

Are Oil and Gas Leases Unexpired Lease?

Oil and gas leases are usually entitled “Oil and Gas Lease” and the parties are referred to as “lessor” and “lessee,” with a reversionary interest in favor of the grantor. These factors support an argument that section 365 allows rejection of the “lease.” Nevertheless, the majority of state? courts that have addressed whether oil and gas leases are unexpired leases subject to section 365 have determined that they are not. For example, a bankruptcy court indicated that, with respect to oil and gas leases in Texas, they do not constitute unexpired leases subject to section 365 because they convey interests in real property. Matter of Topco, Inc., 894 F.2d 727, n.17 (5th Cir. 1990). An Illinois bankruptcy court likewise concluded the oil and gas lease in question did not constitute an “unexpired lease” within the meaning of section 365(d)(4), where an oil and gas lease grants a freehold estate under Illinois law, rather than leasehold. In re Hanson Oil Co., Inc., 97 B.R. 468, 472 (Bankr. S.D. Ill. 1989).

Interestingly, an Oklahoma bankruptcy court held that oil and gas leases are not unexpired leases subject to section 365 under the real property laws of Oklahoma, although based on slightly different reasoning. See In re Clark Res., Inc., 68 B.R. 358, 359 (Bankr. N.D. Okla. 1986). The court reasoned that an Oklahoma oil and gas agreement grants a profit à ‘prendre rather than a leasehold estate, and thus the unexpired lease portion of 11 U.S.C. section 365, does not apply to the Oklahoma oil and gas lease. “The interest created by an oil and gas lease in Oklahoma is not ‘real estate’ and conveys no interest in land itself, it is a chattel real, an incorporeal hereditament and a profit à ‘prendre which is in the nature of a license to explore by drilling and permits the lessee to capture oil and gas which is then treated as personalty.” Id.

A federal district court in Ohio also found the oil and gas leases in that case were not leases of nonresidential real property within the meaning of sections 365(d)(4) and 365(m), but nevertheless concluded that the bankruptcy court’s holding that the leases were forfeited under section 365(d)(4) was erroneous. In re Frederick Petroleum Corp., 98 B.R. 762, 767 (S.D. Ohio 1989). The court believed that “the Ohio courts, if given the opportunity to do so, would characterize the property interest involved as being like or similar to the interest recognized under Oklahoma law.” Id. at 766.

Conversely, the court in Aurora Oil & Gas Corp. considered oil and gas leases rental agreements to use real property and therefore “leases” within the meaning of section 365. The court emphasized the differences, citing state law:

Michigan treats a lessee’s interest as a leasehold or profit á prendre, but not a freehold estate. In this significant respect, Michigan departs from the law of Texas and several other oil and gas states that apparently regard a lessee’s interest under an oil and gas lease as a freehold or fee.

In re Aurora Oil & Gas Corp., 439 B.R. at 678.

Are Oil and Gas Leases Real Property Interests?

State laws characterizing the nature of oil and gas leases can be analyzed to speculate whether a lease in any given state might be rejected in bankruptcy, but the answer is not clear in most instances. Many courts have addressed whether oil and gas leases are “real property” interests,2 and the Fifth Circuit in Matter of Topco, Inc., 894 F.2d 727, n.17 (5th Cir. 1990), indicated this classification would be determinative of whether the lease can be rejected in bankruptcy; however, the other bankruptcy courts cited above analyzed whether oil and gas leases are freehold real property interests (as opposed to leasehold interests which may also be considered a type of real property) – not simply whether or not an oil and gas lease is real property. While potentially helpful in guessing what a court might hold, we do not think classification as “real property” is necessarily determinative of whether a lease will be rejected under section 365; and, unfortunately, there is not a lot of caselaw addressing the freehold – leasehold dichotomy in the context of oil and gas leases.3 We note that in those states that have determined oil and gas leases are personal property, we believe there is an increased likelihood such leases would be rejected in bankruptcy under section 365.

Are Oil and Gas Leases Executory Contracts?

Those seeking to apply section 365 to an oil and gas leasehold interest may alternatively argue that the documents underlying the interest are executory contracts.4 “Though neither the Bankruptcy Code nor the predecessor Bankruptcy Act defines the term ‘executory contract,’ many courts have adopted the Countryman definition [being that an executory contract is one under which the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete perform would constitute a material breach excusing the performance of the other],5 or some variation of it.”6 Id. “However, because [the oil and gas lessor] often has nothing more to do than ‘sit back and collect royalty payments’ or wait for the reversion to occur by operation of law, the Countryman definition typically prevents finding conveying documents to be executory contracts.” See id. (citations omitted).

Courts in some jurisdictions have concluded that oil and gas leases are executory contracts,7 while other courts have determined they are not.8 Interestingly, in interpreting Louisiana law which classifies an oil and gas lease as real property, the bankruptcy court in Texaco Inc. v. Louisiana Land and Exploration Co., 136 B.R. 658, 668 (M.D. La. 1992), states that while a mineral lease constitutes “real rights,” this court concludes that the Louisiana mineral lease is an “executory contract” within the meaning of section 365(a). Other courts have been critical of this decision. For example, another Louisiana bankruptcy court declined to follow Judge Parker’s interpretation of executory contracts in Texaco, holding that “the mineral leases at issue in the present case do not constitute ‘executory contracts’ within the Countryman definition as adopted by the 5th Circuit.” In re WRT Energy Corp., 202 B.R. 579, 584 (Bankr. W.D. La. 1996). The court in WRT Energy also concluded that oil, gas, and mineral leases vest the lessee with real rights, which “clearly supports a finding that the [oil, gas, and mineral lease] is not an unexpired lease within the meaning of section 365 of the Bankruptcy Code. Id.

Does Classification of an Oil and Gas Lease Hinge on Production?

A Pennsylvania bankruptcy court has concluded oil and gas leases are initially an executory contract, but that the classification changes once production is obtained. In re Powell, 482 B.R. 873 (Bankr. M.D. Pa. 2012), order vacated on other grounds in part, 2015 WL 6964549 (M.D. Pa. 2015).9 The court reasoned that if gas had been produced prior to the bankruptcy filing, then section 365 would not apply because at that point, the gas company would have been vested with a fee simple determinable interest (apparently, akin to a vested fee or freehold interest) in the oil and gas – so effectively the gas company would have been producing its own gas. Id. 10 Under this reasoning, the interest is characterized as a lease or an executory contract under section 365 is moot. Id. 11

The question about whether oil and gas leases are “executory contracts” has been decided, at least by one court, based on the moment in which the oil and gas lessee’s freehold estate vested, which is not necessarily the moment the lease is executed. This rationale presents a risk that courts may initially consider an oil and gas lease to be an executory contract. The Pennsylvania bankruptcy court’s decision is based on the characterization of oil and gas leases under Pennsylvania law. In this respect, the law in most states and cases we have reviewed do not indicate that vesting of oil and gas leasehold rights might be delayed. However, in Pennsylvania and West Virginia, which are the states that appear to have made such a determination, the oil and gas freehold estate vests at the time production begins, or at the time oil and gas is found.12

Conclusion

The risk that an oil and gas lease will be rejected in the event of a filing under section 365 of the Bankruptcy Code depends primarily on the relevant state’s property laws, so there is no certainty of outcome.. Debtors or potential purchasers of an oil and gas lease should thoroughly examine the property laws of the governing state and, if available, any relevant bankruptcy court decisions applying those respective state laws in the context of section 365 to properly assess the risk of rejection.

1But see Texaco Inc. v. Louisiana Land & Expl. Co., 136 B.R. 658, 665 (M.D. La. 1992), stating that the reasoning in Topco was dicta.

2Within the Tenth Circuit, the majority of courts have concluded that oil and gas leases are real property rights. See, e.g., Gaddis v. McDonald, 633 P.2d 1102 (Colo. App. 1981) (overriding royalty interest in respect to oil and gas leases is real property interest); Terry v. Humphreys, 1922-NMSC-013, 27 N.M. 564, 203 P. 539 (an oil and gas lease for a period of five years, or as long thereafter as oil and gas, or either of them, is produced from said land by the lessee, conveys “real property”); Dame v. Mileski, 80 Wyo. 156, 340 P.2d 205 (1959) (overriding royalty interest reserved by assignor of oil and gas lease was real property); Chase v. Morgan, 9 Utah 2d 125, 339 P.2d 1019, 1021 (1959) (oil and gas leases are real estate); c.f. First Nat. Bank v. Dunlap, 1927 OK 67, 122 Okla. 288, 254 P. 729 (interest of lessee under oil and gas lease is not “real estate”); High Plains Oil, Ltd. v. High Plains Drilling Program-1981, Ltd., 263 Kan. 1, 946 P.2d 1382 (1997) (Oil and gas leases are personal property).

Within the Fifth Circuit, courts have generally concluded that oil and gas leases convey real property rights. See, e.g., In re WRT Energy Corp., 202 B.R. 579, 137 O.G.R. 315 (Bankr. W.D. La. 1996) (holding that oil and gas interests in Louisiana grant “real rights,” rather than “personal rights,” thereby preventing their characterization as unexpired leases); Rogers v. Ricane Enterprises, Inc., 772 S.W.2d 76 (Tex. 1989) (an oil and gas lease conveys an interest in real property as does an assignment of all or a portion thereof); Nygaard v. Getty Oil Co., 918 So. 2d 1237, 1241 (Miss. 2005) (indicating that Mississippi would follow Texas law in interpreting the nature of oil and gas leasehold rights).

States within the Eighth Circuit have likewise have generally determined that oil and gas leases are interests in real property. See Coral Prod. Corp. v. Cent. Res., Inc., 273 Neb. 379, 730 N.W.2d 357 (2007) (an interest in an oil and gas lease is an interest in real property to the extent that it grants the lessee the right to remove minerals from the land); ANR W. Coal Dev. Co. v. Basin Elec. Power Co-op., 276 F.3d 957, 965 (8th Cir. 2002) (overriding royalty holders have an interest that is a form of real property under North Dakota law); Greene Cty. v. Smith, 148 Ark. 33, 228 S.W. 738 (1921) (indicating oil and gas leases are real property, which is defined as including not only the land itself but also buildings and all rights and privileges appertaining thereto). We note that we are not aware of any state cases in South Dakota, Iowa, Minnesota, or Missouri that clearly address this question.

3We are aware of the following cases addressing this issue: Cravens v. Hubble, 375 Ill. 51, 52, 30 N.E.2d 622, 623 (1940) (“An oil and gas lease which remains in force as long as oil and gas are produced, involves a freehold”); Alphonzo E. Bell Corp. v. Listle, 74 Cal. App. 2d 638, 646, 169 P.2d 462, 467 (1946) (referring to an oil and gas lease, the court stated “She was thereby immediately vested with a present interest in the land, an estate tantamount to a freehold”); In re Clark Res., Inc., 68 B.R. 358, 359 (Bankr. N.D. Okla. 1986) (Oklahoma oil and gas agreement grants a profit à ‘prendre rather than a leasehold estate); In re Aurora Oil & Gas Corp., 439 B.R. at 678 (Michigan treats a lessee’s interest as a leasehold or profit á prendre). Ralston v. Thacker, 932 S.W.2d 384, 387 (Ky. Ct. App. 1996) (“An oil and gas lease is an interest in real estate generally termed a ‘chattel real’ and is an estate less than freehold or fee-simple interest. “); Pearson v. Black, 120 S.W.2d 1075 (Tex. Civ. App. 1938) (title to all gas, coal and other minerals granted by oil and gas lease constituted a “freehold estate” in lands being a “determinable fee estate”); Somont Oil Co. v. A & G Drilling, Inc., 2002 MT 141, 310 Mont. 221, 49 P.3d 598 (appearing to treat the lessee as acquiring a fee simple determinable estate) (overruled on other grounds). See also infra note 12, indicating oil and gas leases include a freehold estate under Pennsylvania law, but that the vesting of this estate is delayed until production is obtained. However, if oil or gas is produced, a fee simple determinable is created in the lessee. See Sabella v. Appalachian Dev. Corp., 2014 PA Super 237, 103 A.3d 83, 101 (2014).

4See Oil and Gas Interests, Commercial Bankruptcy Litigation § 8:45.

5See, e.g., In re Kemeta, LLC, 470 B.R. 304 (Bankr. D. Del. 2012); In re Midwest Portland Cement Co., 174 Fed. Appx. 34, 46 Bankr. Ct. Dec. (CRR) 45 (3d Cir. 2006); In re Grand Chevrolet, Inc., 26 F.3d 130 (9th Cir. 1994); In re Sunterra Corp., 361 F.3d 257, 42 Bankr. Ct. Dec. (CRR) 222, 51 Collier Bankr. Cas. 2d (MB) 1276, Bankr. L. Rep. (CCH) P 80068 (4th Cir. 2004); Matter of Chicago, R. I. & P. R. Co., 604 F.2d 1002, 1004, 5 Bankr. Ct. Dec. (CRR) 618, 21 C.B.C. 305, Bankr. L. Rep. (CCH) P 67225 (7th Cir. 1979) (Bankruptcy Act case); Jenson v. Continental Financial Corp., 591 F.2d 477, 481, Bankr. L. Rep. (CCH) P 67051 (8th Cir. 1979) (Bankruptcy Act case). See also, In re Ravenswood Apartments, Ltd., 338 B.R. 307, 46 Bankr. Ct. Dec. (CRR) 16, Bankr. L. Rep. (CCH) P 80455, 2006 FED App. 0002P (B.A.P. 6th Cir. 2006); Dollar Development I, LLC v. Village Green Properties, Ltd., 2006 WL 572709 (W.D. Mich. 2006); In re Helm, 335 B.R. 528, 45 Bankr. Ct. Dec. (CRR) 281, 55 Collier Bankr. Cas. 2d (MB) 817 (Bankr. S.D. N.Y. 2006); In re FV Steel and Wire Co., 331 B.R. 385, 45 Bankr. Ct. Dec. (CRR) 119, 61 Env’t. Rep. Cas. (BNA) 1566, 35 Envtl. L. Rep. 20196 (Bankr. E.D. Wis. 2005); In re Nickels Midway Pier, LLC, 332 B.R. 262, 45 Bankr. Ct. Dec. (CRR) 163, 55 Collier Bankr. Cas. 2d (MB) 236 (Bankr. D. N.J. 2005), aff’d in part, rev’d on other grounds in part and remanded, 341 B.R. 486, 46 Bankr. Ct. Dec. (CRR) 126, 55 Collier Bankr. Cas. 2d (MB) 1854 (D.N.J. 2006), order aff’d, 255 Fed. Appx. 633, 49 Bankr. Ct. Dec. (CRR) 35 (3d Cir. 2007).

6See Matter of C & S Grain Co., Inc., 47 F.3d 233, 26 Bankr. Ct. Dec. (CRR) 939, Bankr. L. Rep. (CCH) P 76395 (7th Cir. 1995) (“For purposes of the Bankruptcy Code, an executory contract is one in which the obligations of each party remain substantially unperformed.”); In re Mirant Corp., 440 F.3d 238, 46 Bankr. Ct. Dec. (CRR) 13, 55 Collier Bankr. Cas. 2d (MB) 1050, Bankr. L. Rep. (CCH) P 80453 (5th Cir. 2006) (holding that Congress intended the term “executory contract” in the Bankruptcy Code to refer to a contract on which performance remains due to some extent on both sides); Cameron v. Pfaff Plumbing and Heating, Inc., 966 F.2d 414 (8th Cir. 1992) (holding that “performance remains due to some extent,” as a definition of an “executory contract,” is equivalent to the Countryman definition); Turner v. Avery, 947 F.2d 772, 22 Bankr. Ct. Dec. (CRR) 495, Bankr. L. Rep. (CCH) P 74349 (5th Cir. 1991) (holding that an attorney’s contingent fee contract is executory if further legal services must be performed by the attorney before the matter may be brought to a conclusion); Gibson v. Resolution Trust Corp., 51 F.3d 1016, 26 U.C.C. Rep. Serv. 2d 547 (11th Cir. 1995) (recognizing that courts have characterized executory contracts as those with “remaining reciprocal obligations”); cf. In re Becknell & Crace Coal Co., Inc., 761 F.2d 319, 322 (6th Cir. 1985) (“[E]xecutory contracts involve obligations which continue into the future…. They include leases, employment contracts and agreements to buy or sell in the future.”) (quoting source omitted); In re General Development Corp., 84 F.3d 1364 (11th Cir. 1996) (approving the use of the “functional approach,” under which “the question of whether a contract is executory is determined by the benefits that assumption or rejection would produce for the estate”).

7See Texaco Inc. v. Louisiana Land and Exploration Co., 136 B.R. 658, 668 (M.D. La. 1992).

8See Laugharn v. Bank of America Nat. Trust & Savings Ass’n, 88 F.2d 551 (9th Cir.1937).

An Oklahoma bankruptcy court, held that oil and gas leases are not executory contracts subject to section 365, based on Oklahoma property law related to oil and gas leases. See supra In re Clark Resources, Inc., 68 B.R. 358 (Bkrtcy. N.D. Okl. 1986). Where the lessee’s only remaining obligation was payment of money and the lessor’s only remaining obligation is to defend their title and not interfere with lessee’s operations, the court apparently concluded this would not satisfy the Countryman definition pertaining to executory contracts, as neither party is “saddled with complex obligations to perform” and “[b]reach of these duties by the lessor or lessee would not excuse performance by the party not in breach, but would merely abate the obligation of the non-breaching party for as long as the breaching party was in breach.” See id. at 359-360.

9The Court apparently rejected the Bankruptcy Court’s determination that an oil and gas lease conveys as a matter of law, up until the point of production, an inchoate right that is subject to rejection under section 365– instead, one must look to the terms of the instrument to determine what interest has been conveyed.

10The court references the Pennsylvania Supreme Court’s decision in T.W. Phillips Gas and Oil Co. v. Jedlicka, 615 Pa. 199, 42 A.3d 261 (2012), which constructed a special interpretation of an oil and gas lease as conveying a title that is inchoate and allowing exploration only until oil or gas is found, regardless of the linguistics used in the lease. “If development during the agreed upon primary term is unsuccessful, no estate vests in the lessee. If, however, oil or gas is produced, a fee simple determinable is created in the lessee, and the lessee’s right to extract the oil or gas becomes vested.” Id. at 267.

11But oil and gas had not been produced at the time of the bankruptcy filing. Instead of analyzing whether the oil and gas lease was an executory contract, the In re Powell court concluded that the lease was an “unexpired lease” agreement “to use real property” and was subject to section 365(m) of the Bankruptcy Code. See also In re Tayfur, 505 B.R. 673, 682–83 (Bankr. W.D. Pa.), aff’d, 513 B.R. 282 (W.D. Pa. 2014), aff’d, 599 F. App’x 44 (3d Cir. 2015).

12E.g., In re Powell, 482 B.R. 873, 175 O.G.R. 187 (Bankr. M.D. Pa. 2012), order vacated on other grounds in part, 2015 WL 6964549 (M.D. Pa. 2015) (“Until oil or gas is produced, no freehold estate vests in the lessee.”); Hutchinson v. McCue, 101 F.2d 111 (C.C.A. 4th Cir. 1939)(under West Virginia law, lessee under oil and gas lease for fixed term and as long thereafter as oil shall be produced and rentals paid acquires in the first instance a mere license or inchoate right to go on the land and explore for oil and gas, but after oil or gas is found, the lessee acquires a vested interest therein); Headley v. Hoopengarner, 60 W. Va. 626, 55 S.E. 744 (1906) (the lessee has no vested estate therein until it is discovered).

No JOA, That’s OK: Practical Solutions For Operators in A Cotenancy Relationship

Bankruptcy, , , ,

“The panic appears to be over. Now is the time to get worried.”
William Keegan (1938–), British author and journalist

A signed and recorded joint operating agreement (JOA) is often the first line of defense for an operator dealing with distressed partners.  For example, a JOA generally grants an operator a lien upon the oil and gas rights of a non-operator in default and may establish certain penalties that can be assessed against a party who does not pay their share of development.  But what happens when there is no JOA?

In short, the rules of cotenancy govern.  Cotenants have an equal and coextensive right to occupy the premises so long as they do not exclude the other cotenant(s) from their equal right of access.  An occupying cotenant must account to the non-occupying cotenants for all profits, but can recover the expenses that the occupying cotenant incurred to generate such profits.  In most oil producing states, this means that one owner may develop minerals without the consent or joinder of its co-owners, but must proportionately share the proceeds of development minus the costs of development and production.  If oil and gas operations are unsuccessful, however, the entire burden falls upon the developing concurrent owner.

Unfortunately, these general rules do little to explain what an operator can do to recover the debts owed by a distressed partner for development costs.  So what tools does an operator have without a JOA?

What can an operator setoff?

One tool to collect debt owed by a distressed partner is the right to offset mutual debts.  The doctrine of setoff is generally broad enough to permit an operator to offset debts owing in one well with production in another well when there is no JOA explicitly establishing the right to do so.  This concept, known as the right of setoff, was recognized by the U.S. Supreme Court when it explained that “[t]he right of setoff (also called ‘offset’) allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding ‘the absurdity of making A pay B when B owes A.’”  Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18-19 (1995).

Generally, the doctrine of setoff will permit the offset of mutual debts on unrelated transactions, including the netting of obligations owed on unrelated wells.  Setoff can be a powerful tool because it affords an operator the opportunity to immediately collect 100% of the debt owed by a defaulting cotenant.  That said, although the doctrine is widely recognized, operators should be aware of a few precautions when deciding to exercise the right of setoff.

First, where possible, an agreement that expressly provides for the offset of mutual obligations should be sought.  This “best practice” will fortify the right of setoff and reduce the risk that a defaulting cotenant will challenge the setoff in the future.  Second, a company exercising the right of setoff must ensure that there is no preexisting contractual agreement or statutory obligation (such as a royalty obligation) which would prohibit or contravene setoff.  And third, although the doctrine of setoff is widely recognized, there is little case law specific to its use in the context of oil and gas cotenants.  The doctrine of setoff can be raised as an equitable defense in litigation, but the risk that a defaulting cotenant will challenge the setoff cannot be eliminated.

Ultimately, an operator must exercise its business judgment when setting off debts from unrelated wells.  In many cases, the immediate benefit of being able to collect a debt is well worth the risk that a defaulting party might challenge the setoff.

Can operators use state lien statutes?

State oil and gas lien statutes may provide an operator with additional remedies in the case of a defaulting cotenant.  Although lien statutes are most commonly used by oil and gas service providers, some courts have recognized that operators may also use these statutory liens.  John Carey Oil Co. v. W.C.P. Investments, 533 N.E. 2d 851 (Ill. 1988) (owner operator could attach statutory oil and gas lien upon interest of nonoperating co-owner under Illinois Oil and Gas Lien Act); Amarex v. El Paso Natural Gas Co., 772 P. 2d 905 (Okla. 1987); Kenmore Oil Co. v. Delacroix, 316 So. 2d 468, 469 (La. Ct. App. 1975).

When available, state lien statutes have specific procedures that must be closely followed in order to obtain a statutory oil and gas lien.  These statutes generally provide that the mineral lien must be perfected within a certain period of time from when the labor or services were last performed by filing information that defines the nature and amount of the lien with the appropriate state authority.  Individual state laws also differ regarding what property to which the lien extends.  For example, North Dakota’s lien statute states that the lien extends to the whole of the leasehold and includes the proceeds of production.  N.D.C.C. § 35-24-03.  But in Texas, the statute does not specifically reference proceeds of production as property subject to the lien, and Texas courts have held that mineral liens do not attach to the proceeds of production.  See e.g. In re Hess, 61 B.R. 977, 978 (N.D. Tex. 1986); Tex. E. Transmission Corp., 254 F.Supp.114, 118 (“in Texas the lien acquired by recording a judgment cannot attach to oil and gas after severance, or to proceeds resulting from its sale.”).  Although the scope and availability of lien rights varies from state to state, the filing of a lien can be a useful tool when dealing with distressed partners.

What about force pooling?

Finally, a force pooling order from the state regulatory agency may help an operator recover and in some states, secure the debts of a defaulting cotenant.  Most oil and gas producing states have a statutory provision allowing an operator to compel the integration of a non-participating working interest owner into a pooling arrangement.  After certain notice and hearing requirements are met, the state agency can integrate the owner into the pooled area and require the sharing of costs and revenues.  Force pooling may help an operator resolve outstanding debts with a cotenant in several ways.

First, the entry of a state force pooling order will clarify that an operator must pay a non-participating working interest owner only after the operator has deducted that owner’s share of drilling and completion costs.  Although this right already exists under the rules of cotenancy, legal disputes often arise about which costs are considered “reasonable and necessary.”  A force pooling order will define, by statute, what costs can be recovered by the operator.

Moreover, many states establish a “risk penalty” that, to compensate for the operator’s assumption of drilling risk, allows the operator to recover more than the non-participating owner’s proportionate share of costs.  In Colorado, for example, an operator may recover 200% of the force pooled owner’s share of drilling and completion costs.  C.R.S. § 34-60-116.  In these cases, a force pooling order is doubly helpful because it allows the operator to recover costs in excess of those actually expended.

Finally, in certain states, a force pooling order may authorize a lien on production to secure the debt of the non-participating cotenant.  In North Dakota, for example, the state force pooling statute provides that the operator has “a lien on the share of production from the spacing unit accruing to the interest of each of the other owners for the payment of his proportionate share of such expenses.”  N.D.C.C. § 38-08-08 (2015).  A similar provision exists in Oklahoma except that it provides that the operator “shall have a lien on the mineral leasehold estate or rights owned by the other owners therein and upon their shares of the production” until the operator is paid the amount due under the pooling order.  Okla. Stat. Ann. tit. 52, § 87.1 (2015).  In these states, upon executing the necessary steps to perfect a lien as provided by state statue, the operator will have a lien on production and/or the cotenant’s mineral estate until the cotenant’s share of costs has been recovered.

Even without a JOA, a savvy operator can do more than worry.  There are many effective legal tools that operators can use to recover and secure debts.  Those who take proactive steps to review these remedies now will be at an advantage later.

Co-Authors
Risa Wolf-Smith is a Partner at Holland & Hart and has in-depth experience in oil and gas business bankruptcy reorganizations and workouts.
Elizabeth Spencer is Of Counsel at Holland & Hart and specializes in regulatory and transactional work for oil and gas businesses.

Exercising Rights to Setoff and Recoupment in Bankruptcy

Bankruptcy, Due Diligence, Oil and Gas Agreements, , , ,

Current market conditions are straining business relationships in the oil and gas industry. In a growing number of cases, distressed companies are seeking chapter 11 bankruptcy protection. In that event, a creditor-debtor relationship is formed between the bankrupt company and the performing partner. For example, in the context of a joint operating agreement, an operator (the performing partner) may seek to recapture drilling costs from a non-operator (the bankrupt company). In these bankruptcy cases, the performing partner should consider its ability to offset debts with the bankrupt company through “setoff” or “recoupment”.

Setoff is simply a creditor’s right to offset mutual debts. Setoff is captured in Section 553(a) of the Bankruptcy Code, which preserves a creditor’s right to offset the mutual debts of the creditor and debtor provided that both debts (the debt owed by the creditor to the debtor and the debt owed by the debtor to the creditor) 1) arose before commencement of the bankruptcy case and 2) are mutual, meaning that both parties owe a debt to the other.1 The mutual debt need not, however, arise out of the same transaction in order for setoff to be available under the statute. 2 In fact, debts subject to setoff generally arise from different transactions.3

For example, A and B are jointly developing two wells and A is the operator of the wells. One well, called Boom, is producing, but the other, called Bust, is not. Boom generates $500,000 a month in revenue, but B owes A $1 million for B’s share of operating costs on Bust. In this case, setoff may allow A to withhold B’s share of revenue from Boom and credit it to B’s unpaid costs from Bust. This is because the purpose of setoff is to avoid “the absurdity of making A pay B when B owes A.”4

Setoff is limited in three ways. First, setoff is not a right created by the Bankruptcy Code.5 While Section 553(a) preserves a right to setoff, that right must first exist under “applicable non-bankruptcy law” (e.g. state law).6 Second, unlike recoupment (discussed below), a creditor can only offset pre-bankruptcy (pre-petition) debts. In other words, a creditor cannot use setoff to recover a pre-bankruptcy debt out of post-bankruptcy (post-petition) payments owed to the debtor.7 Third, a creditor’s right to setoff is automatically stayed (i.e. suspended) when a debtor files for bankruptcy protection.8 Creditors seeking to setoff must first obtain relief from the automatic stay imposed by Section 362(a) of the Bankruptcy Code and should consult bankruptcy counsel to assist in that effort.

Recoupment is similar to setoff in that it recognizes the basic inequities of allowing a debtor to enjoy the benefits of a transaction without also meeting its obligations.9 But, recoupment only permits a creditor to withhold funds to offset debts arising from the same transaction.10 Claims arise from the “same transaction” when both debts arise out of a single, integrated contract or similar transaction, such as a joint operating agreement.11

For example, A operates a well and B is a non-operator with an obligation to reimburse A for 25% of the drilling costs. A incurs $1,000,000 in costs and B fails to pay its $250,000 share. If B files for bankruptcy protection, then A has a $250,000 claim against the bankruptcy estate. In this case, recoupment may allow A to withhold B’s revenues from the well and credit the revenues against the costs incurred by A. This example illustrates how recoupment functions like a security interest in that it grants priority to a creditor’s claim in the bankruptcy estate, provided that the estate has a claim against the creditor arising from the “same transaction” as the creditor’s claim.12

Recoupment has certain benefits that are unavailable under setoff. First, a creditor can exercise its right to recoupment without regard to the timing and other requirements of Section 553 of the Bankruptcy Code.13 Second, recoupment allows a creditor to recover a pre-bankruptcy debt out of post-bankruptcy payments owed to the debtor.14 Third, a creditor who properly exercises its right to recoupment will not violate the automatic stay imposed by Section 362(a) of the Bankruptcy Code.15 However, a creditor may wish to seek relief from stay to clarify its right to exercise recoupment and to avoid any uncertainty about the amount the creditor can recoup. Bankruptcy counsel can help a creditor analyze its right of recoupment and assist in seeking relief from the automatic stay.

111 U.S.C. § 553(a).
2In re Davidovich, 901 F.2d 1533, 1537 (10th Cir. 1990).
3Conoco, Inc. v. Styler (In re Peterson Distrib.), 82 F.3d 956, 959 (10th Cir. 1996).
4Citizens Bank v. Strumpf, 516 U.S. 16, 18 (1995).
5Id.
6Id.
7See 11 U.S.C. § 553(a).
811 U.S.C. § 362(a)(7).
9Peterson Distrib., 82 F.3d at 960.
10In re Adamic, 291 B.R. 175, 181-82 (Bankr. D. Colo. 2003).
11Davidovich, 901 F.2d at 1538.
12Peterson Distrib., 82 F.3d at 960.
13Davidovich, 901 F.2d at 1537.
14Beaumont v. VA (In re Beaumont), 586 F.3d 776, 780 (10th Cir. 2009).
15Id. at 777.

Fraudulent Transfer Risks in Oil and Gas Transactions

Bankruptcy, Due Diligence, , , ,

Over the past few months, the economics of the oil and gas industry have changed dramatically. As oil and gas prices have fallen, so too have profit margins and working capital. Many companies will weather this storm. A fortunate few will expand their positions and acquire additional assets, some of which will be purchased from distressed companies. In dealing with these distressed companies and their assets, landmen and other oil and gas industry professionals will need to have a working-knowledge of select bankruptcy-related laws and concepts to protect their company’s assets. In this article, we will discuss one aspect of relevant bankruptcy law: fraudulent transfers and how they may affect property transactions.1

What is a fraudulent transfer?

When a company files for bankruptcy, the bankruptcy trustee may avoid any fraudulent transfer of property made within four years of filing in most states, if certain conditions are met. Fraudulent transfers occur when: (1) there was an intent to hinder, delay, or defraud creditors; or (2) the debtor transfers property without receiving “reasonably equivalent value” in exchange for the transfer and is insolvent at the time of the transfer, becomes insolvent as a result of the transfer, or is left with an unreasonably small amount of capital to operate its business as a result of the transfer.2 If a transaction is deemed to be a fraudulent transfer, the bankruptcy trustee can recover the property or obtain a judgment for the value of the property.

The first type of fraudulent transfer involves an actual intent to defraud and is more easily identified. For example, in In re Tronox, a court found that a debtor transferred property with environmental liabilities with an intent to hinder, delay, or defraud creditors through a spinoff.3 In another case, In re ASARCO, a court found that the debtor hindered and delayed creditors by directing all of the consideration from a sale of a majority of a mining entity to one of the Debtor’s creditors, to the detriment of other creditors.4 These situations usually involve related parties.

The second type of fraudulent transfer, commonly referred to as a constructively fraudulent transfer, occurs when a company purchases an asset without paying reasonably equivalent value. This can occur when purchasing assets from a third party or, more commonly, when buying-out a partner to resolve a debt or other obligation. If the seller files for bankruptcy subsequent to the transaction, there is a risk that the bankruptcy trustee could seek to have the transaction declared to be a fraudulent transfer.

In determining “reasonably equivalent value” a bankruptcy court looks at the totality of the circumstances. Fraudulent transfer laws are designed to preserve the assets of the debtor for the benefit of creditors. When carrying out this intent, courts disregard the form of a transaction and look “instead to its substance.”5 Fraudulent conveyance law is “designed to protect creditors’ rights” and looks at transactions from “the perspective of creditors.” 6 Whether a purchaser paid reasonably equivalent value is a subjective question that depends on the facts of each individual situation.

What does this mean for landmen?

Oil and gas professionals should be aware of the risks of acquiring property from distressed companies. To avoid constructively fraudulent transfers, a purchaser should ensure that they are giving “reasonably equivalent value” for the asset. This can be difficult. Under certain circumstances, when the value of the property is enhanced by the buyer after the sale closes (through drilling or other development) the debtor may later contend that the buyer failed to pay reasonably equivalent value.

The best way to determine “reasonably equivalent value” when dealing with a distressed company is to obtain an appraisal from an independent third party. If an appraisal is not cost-effective or is impractical, the risk of a fraudulent transfer can be mitigated by conducting proper due diligence.

An awareness of the financial health of the companies you are doing business with is as important as ever. By evaluating the transaction now, you can avoid problems down the road.

1There are many tools that an oil and gas company can use to mitigate its exposure to bankruptcy risks. A full discussion of all the tools is beyond the scope of this article. If you have questions on how to mitigate bankruptcy risks, or if a business partner files for bankruptcy, we advise you to contact a bankruptcy expert immediately to protect your assets.
2 See 11 U.S.C. § 548.
3 In re Tronox Inc., 429 B.R. 73 (Bankr. S.D.N.Y. 2010).
4 See In re ASARCO, L.L.C, 702 F.3d 250 (5th Cir. 2012).
5 In re HBE Leasing Corp. v. Frank, 48 F.3d 623, 638 (2d Cir.1995) (construing the New York’s fraudulent conveyance statute).
6In re Crowthers McCall Pattern, Inc., 129 B.R. 992, 998 (S.D.N.Y.1991).

Recording JOAs In the Face of Looming Bankruptcies: Better Now Than Never

Bankruptcy, Oil and Gas Agreements, ,

While the oil and gas industry has experienced a significant downturn as a result of the collapse of global and regional oil prices, it wasn’t so long ago that times were booming and wells were being drilled at a rapid pace. During the recent boom years, everyone in the industry was scrambling to keep ahead of the curve, and some tasks previously viewed as routine fell to the way side. One action item that has been increasingly overlooked in recent years is the recording of a joint operating agreement, or a memorandum thereof (generally herein, including the recording of a memorandum applicable, a “JOA”) to provide notice of the operator’s lien rights. Considering the current downturn, the failure to record a JOA could come back to bite operators as defaults and bankruptcies appear to be looming for many players in the industry. As an operator, there still may be time to repent and record those agreements in order to protect your rights and interests.

The most current 1989 A.A.P.L Model Form of Operating Agreement, and most other commonly used agreements for joint operations, contains provisions whereby each party to the JOA grants a lien upon any interest it owns or acquires in real or personal property in the contract area covered by the agreement to secure such party’s obligations under the JOA.1 The form JOA contains provisions allowing for the recording of a memorandum (or “recording supplement”) of the JOA, or the agreement itself, which is acceptable in most states, to perfect the liens granted in the agreement.

It is generally well known that recording the JOA acts to perfect the operator’s lien of record as to competing lienholders. For example, if a JOA is recorded and there is later recorded a judgment lien against a non-operator, the operator’s lien would be superior to the claims of the later judgment creditor. As the current industry slowdown continues, and the risks of bankruptcies of non-operators looms, what is the impact of the failure to record a JOA upon the filing of Chapter 11 bankruptcy by the non-operator?

Upon filing for bankruptcy under Chapter 11 of the bankruptcy code, the appointed bankruptcy trustee of the debtor has the authority to either accept or reject “executory contracts.” 11 U.S.C. 365. An executory contract is a contract wherein there are ongoing or unperformed obligations on both sides. It is generally held and expected that JOAs will most likely be deemed executory contracts under the bankruptcy code. If a bankruptcy trustee accepts an executory contract, that will mean that the debtor, as an ongoing concern, will cure past defaults under the contract, compensate for default damages or losses, and give assurances for future performance. However, a bankrupt debtor that is a non-operator under a JOA will often have an incentive to reject a JOA as an executory contract. If a JOA is rejected, then ongoing rights and obligations of operators and non-operators, including the non-operator debtor, will likely be governed by common law tenants-in-common principles. If a bankruptcy trustee rejects an executory contract, then that is treated as a breach of the contract and the creditor party to the executory contract is granted damages resulting from the default under the rejected contract. Whether a JOA is recorded or not will not impact whether a JOA is an executory contract, but it will impact whether or not the damages granted to the operator under the rejected JOA will be secured or unsecured. If a JOA was never recorded, then the operator will be deemed an unsecured creditor and join the pool of other unsecured creditors (which creditors will either not get paid at all or may get pennies on the dollar for outstanding debts). But if the JOA was properly placed of record to perfect lien rights, then the damages afforded to the operator upon rejection of the JOA as an executory contract will give the operator a secured lien.

Of course, just because a recorded JOA perfects an operator’s lien, that does not mean it is necessarily first in time and has a superior lien position. For example, a non-operator may have granted a prior recorded mortgage or deed of trust for the benefit of a bank, which first-recorded lien could trump a later-recorded JOA (or memorandum thereof). Ideally, operators should obtain subordinations to the JOA from holders of outstanding mortgages or deeds of trust (much like operators do for important oil and gas leases or surface use agreements), but in practice this rarely occurs. But certainly recording the JOA will perfect the operator’s lien as to subsequently recorded liens (and remove the operator from the general unsecured creditor pool in bankruptcy).

The question facing land departments now is: what if we didn’t record a JOA at the time of execution – is it too late? The answer, as most other answers offered by attorneys, is: it depends. Within 90 days of filing for bankruptcy, any payments made for prior debts by a debtor in bankruptcy to certain creditors, but not others, can be held to be preferential transfers under the bankruptcy code. A preferential transfer is most typically a payment made to and for the benefit of one creditor, to the detriment of other creditors, within 90 days of the bankruptcy filing. A Texas bankruptcy court has held that recording a JOA within 90 days prior to the bankruptcy filing was a preference that benefited a single creditor to the detriment of other creditors and was thus invalid.2 You cannot forecast if and when a non-operator will file for bankruptcy. But one thing is certain – it doesn’t hurt to record the JOA. If you record and a non-operator does file for bankruptcy within 90 days, the recording may be invalidated. But if the non-operator files for bankruptcy on the 91st day, you may have been fortunate enough to perfect your operator’s lien. Also, while you may have lost lien priority during any delay in failing to promptly record the JOA, you might still have time to perfect your lien as to other subsequent lien claimants down the road (and you may still have time to secure a first-position lien). Being a second position lienholder on oil and gas assets under a JOA behind the first lien of, for example, a non-operator/debtor’s bank, will still grant you certain advantages in terms of negotiating an acquisition of those assets or preserving some rights to proceeds (certainly over and above the rights of unsecured creditors).

So in the face of potential loan defaults, judgment liens, bankruptcies, and all the other unfortunate events that result from oil and gas downturn cycles, operators should act soon to record JOAs. Obviously, priority should be given to agreements where there are sizeable and mounting debts by certain non-operators. While there may be findings down the road that the late recording of a JOA fails to perfect lien rights, there are no good reasons not to simply record JOAs today.

1See Article VII.B of 1989 Model Form Operating Agreement.
2See In Re Wilson, 69 B.R. 960 (Bankr. N.D. Tex. 1987).