CHAPTER 11 ISSUES WHEN A FELLOW WORKING INTEREST OWNER FILES FOR BANKRUPTCY
| Jurisdiction | United States |
ISSUES WHEN A FELLOW WORKING INTEREST OWNER FILES FOR BANKRUPTCY
Madeline Tansey
Thompson & Knight LLP
Houston, TX
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DEMETRA LIGGINS is a partner at Thompson & Knight in Houston and New York. She has nearly two decades of experience in business finance and restructuring for a variety of large and small public and private companies. As a trusted business advisor, Demetra partners with her clients to identify and achieve their goals in the bankruptcy process, navigating through complex corporate reorganizations and distressed acquisitions. She has led many of Thompson & Knight's representations of bankruptcy clients, working on both in-court and out-of-court restructurings. A thoughtful and creative problem solver, she is highly regarded for her ability to quickly and efficiently help clients assess the effects of a bankruptcy on their corporate and financial transactions. Demetra works with her clients to purchase and sell assets in distressed situations, secure financing, and negotiate structure and implement cash collateral orders and debtor-in-possession financing agreements.
Introduction
Joint operating agreements, like all commercial relationships, involve the risk that an obligor or counterparty may become insolvent. Taking steps to minimize such risks when interacting with a financially-distressed entity is of particular importance in today's current energy market. The key to successful mitigation of risks is in anticipating potential issues resulting from troubled financial times and addressing those problems as proactively as possible. As detailed herein, there are several ways to avoid undesirable consequences through various means both inside and outside of the bankruptcy process.
Discussion
I. The Identity of the Debtor
In the oil and gas industry, having more than one party have an interest in a lease is common and this situation gives rise to the need for a defined set of rights and obligations for all parties involved. One of the most common agreement to address these rights is a joint operating agreement ("JOA"), which is a contract between two or more mineral interests that describes the proportionate costs to be shared by parties to the agreement and allocates the liabilities between the parties.1 One entity is classified as the operator and is responsible for the exploration and production activities under a lease. The other entities are typically classified as non-operators and are still associated with the operator, but they do not engage directly in E&P activities.
Because a JOA is an "agreement between or among interested parties for the operation of a tract or leasehold for oil, gas and other minerals," by which "[t]he parties to the agreement share in the expenses of the operations and in the proceeds of development,"2 noting that "the agreement normally is not intended to affect the ownership of the minerals or the rights to produce."3 Thus, the JOA does not create a separate entity distinct from the non-operators or working interest owners who are also parties to the agreement.4 Consequently, working interest owners must include provisions in the JOA that allocate drilling and production risks among themselves. This allocation of risks may be disturbed if one of the working interest owners is the subject of bankruptcy proceedings. Accordingly, a party to a JOA should protect against working interest owner credit risk by obtaining and perfecting a security interest or a party to the JOA may also have protection through setoff and recoupment.
II. JOA Characterization
The characterization of a JOA and other oil and gas agreements under state law directs their treatment in bankruptcy and means to minimize their associated risks.5 Therefore, awareness of how the mineral law of the governing state characterizes rights under oil and gas agreements is important. For example, bankruptcy courts generally consider joint operating agreements to be executory contracts subject to
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assumption or rejection by the bankruptcy party pursuant to Section 365 of the Bankruptcy Code. An oil and gas lease, however, may either be a real property interest or an executory contract or unexpired lease. This determination depending on the applicable state law. Joint operating agreements are generally considered executory contracts and, thus, like any rights created under an executory contract, a party's rights under a JOA are at risk in the event of a bankruptcy filing.6
Consequently, determining the identity of the debtor—whether operator or non-operator—is crucial for understanding the relative rights of the parties when a fellow working interest owner files for bankruptcy.
III. The Automatic Stay
Parties face several challenges when their contract counterparty files for bankruptcy relief. A key risk under any kind of agreement is that one party will file for bankruptcy and the automatic stay will prevent the exercise of the other party's rights. Specifically, upon a debtor's bankruptcy filing, the automatic stay - a statutory injunction imposed by the Bankruptcy Code - prohibits non-debtor parties from taking any action to collect a pre-bankruptcy debt or to exercise control over the debtor's property, including the exercise of remedies under contracts with the debtor.7
A. Claims under the JOA as Unperfected Security Interests
Additionally, the automatic stay prevents the holder of an unperfected lien or security interest from perfecting that interest.8 This prohibition is significant for non-operators who have liens on a share of the operator's production or proceeds because it determines how much the non-operator is able to recoup from the operator in case of bankruptcy and the likelihood of the recovery. For example, the JOA between the operator and non-operators dictates the division "in the expenses of the operations and in the proceeds of development" and will give the non-operators an unsecured claim for their share of production.9 Once bankruptcy is filed, however, unperfected liens and security interests retain little value because a debtor in bankruptcy has sweeping "strong arm" powers that enable the trustee to avoid unperfected interests.10 If an unperfected security interest is avoided, then the creditor (the non-operator in this case) becomes a general unsecured creditor whose recovery, if any, is reduced based on the payment priorities set forth under the Bankruptcy Code.11
Moreover, under the general rule, corporate formalities are recognized in bankruptcy, and each affiliated debtor will file its own bankruptcy case with each debtor being treated as separate for purposes of, among other things, distributions to creditors.12 Therefore, a lien or a security agreement that was originally given by an entity that did not actually hold an interest in the property will typically mean that the purported security interest is treated as a nullity and that the holder of the security agreement is a general
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unsecured creditor. Thus, in obtaining a lien or security interest, the counterparty must ensure that, at a minimum, the record owner of the property in question enters into the security agreement that will give rise to the attendant lien or security interest.
Operators faced with the bankruptcy of an non-operator will encounter similar concerns, though their focus will center on the non-operator's ability to pay its proportionate share of costs under the JOA, rather than the allocation of proceeds. For example, in Wilson v. TXO Prod. Corp., when a non-operator stopped paying its share of expenses, the operator began applying the non-operator's share of the proceeds to the unpaid expenses.13 Later, after the non-operator filed for bankruptcy, the operator set aside proceeds payable to the non-operator, claiming it had liens on the funds under the JOA.14 The court noted that to the extent that the operator had "possession, prepetition, of proceeds of production related to [non-operator's] working interest, [operator] was a secured party in possession of the collateral. As the secured party in possession of collateral, it was entitled to apply those proceeds to [non-operator's] obligations for operating expenses."15 The court concluded, however, that it could not allow setoff power against prepetition royalties because royalty payments are a "distinct right" of the non-operator, and so the setoff requirement of mutuality would be missing.16
B. Rights to Setoff
A right to setoff under the Bankruptcy Code arises when counterparties have reciprocal debts and obligations, as non-operators and operators do under a JOA, and is analogous to a security interest.17 This right does not originate in the Bankruptcy Code; instead, setoff rights are created under non-bankruptcy law and then are preserved to the extent that the obligations set forth under section 553 have been satisfied.18 Significantly, the automatic stay will prohibit a non-debtor, whether that is the operator or non-operator, from offsetting any amounts without the approval of the bankruptcy court, though the party seeking to exercise a right to setoff may request termination of the automatic stay.19
One important requirement for setoff is that of "mutuality," in that parties may offset only those debts between the same parties standing in the same capacity if the debt arose before the commencement of the bankruptcy proceedings.20 Thus, to the extent that operators and non-operators have reciprocal obligations,
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such as the allocation of production proceeds and payments of costs, the parties can work to offset these obligations when one of the parties files for bankruptcy.21 When the right to payment is an individualized right belonging to only one of the parties, on the other hand, the setoff requirement of mutuality is missing and setoff is therefore not...
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