bankruptcy

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).