CHAPTER 6 OPERATIONAL AGREEMENTS IN THE SHADOW OF BANKRUPTCY--WHAT CAN BE DONE TO STRUCTURE AGREEMENTS IN ORDER TO MINIMIZE THE PROBLEMS OF A PARTY THAT LATER GOES BANKRUPT

• Jurisdiction: United States

Problems and Opportunities During Hard Times in the Minerals Industry
(May 1986)
CHAPTER 6
OPERATIONAL AGREEMENTS IN THE SHADOW OF BANKRUPTCY--WHAT CAN BE DONE TO STRUCTURE AGREEMENTS IN ORDER TO MINIMIZE THE PROBLEMS OF A PARTY THAT LATER GOES BANKRUPT
James C.T. Hardwick
Hall, Estill, Hardwick, Gable, Collinsworth & Nelson
Tulsa, Oklahoma

TABLE OF CONTENTS

SYNOPSIS

Page

I. INTRODUCTION

II. OVERVIEW: SOME LEGAL ISSUES

Strong-arm and Executory Contract Provisions of Bankruptcy Code

Joint or Joint and Several Liability by Contract

Joint and Several Liability: Mining Partnership and Joint Venture

III. OPERATING AGREEMENTS

Applicability of Code § 544 and § 365 to The Operating Agreement

Failure As A Title Document

Failure of Non-Consent Provisions

Failure of Security Provisions

Interference With Gas Balancing Provisions

Mining Partnership and Joing Venture Liability

Prepayments and Letters of Credit

Operator's Bankruptcy and Removal of Operator

IV. FARMOUT AGREEMENTS

Recording Problems

Executory Contract Issues

V. FARMOUT PARTICIPATION ARRANGEMENTS

VI. GAS PURCHASE AND SALE CONTRACTS

Need For Recordation

Executory Contract Issues

Joint Seller Issue

VII. DRILLING CONTRACTS

VIII. ENFORCEMENT OF RELINQUISHMENT PROVISIONS

IX. PREVENTING THE DEBTOR/TRUSTEE FROM RETRADING THE DEAL: USE OF PARTNERSHIPS

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I. INTRODUCTION

This paper will consider some aspects of the impact on the operational agreements more commonly encountered in the oil and gas industry of the bankruptcy of a party and will make some drafting and structural suggestions to minimize those results.

Mining industry operational agreements are not individually considered. However, much of the discussion of oil and gas operational agreements will be applicable to the corresponding mining industry agreements.

II. OVERVIEW: SOME LEGAL ISSUES

Strong-arm and Executory Contract

Provisions of Bankrupty Code

The two provisions of the Bankruptcy Code¹ which present the most serious threat to the performance of operational agreements are the provisions regarding executory contracts and the so-called "strong-arm" provisions. The strong-arm provisions of the Code are contained in §544 and provide that the bankruptcy trustee² may avoid any transfer of property that is voidable by:

"...a bona fide purchaser of real property from the debtor, against whom applicable law permits such transfer to be perfected, that obtains the status of a bona fide purchaser at the time of the commencement of the case, whether or not such a purchaser exists."³

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Thus, a trustee can avoid or set aside any unrecorded conveyance or other instrument effecting real property if, under state law, that instrument was ineffective as against a bona fide purchaser. It is generally held under this section that a trustee may set aside and ignore unrecorded instruments effecting real estate.⁴ Similar avoidance rights are afforded the trustee against unperfected security interests under §544(a)(1) of the Code. The transferee of an avoided transaction will have a claim against the debtor's estate for the damages.⁵ In some instances, the transferee will have a lien on property recovered by the trustee for the cost of improvements to and increase in value of such property.⁶

In addition to his strong-arm powers, the trustee may, with the court's approval, assume or reject any executory contract or unexpired lease of the debtor under §365(a) of the Code. The Code does not define an executory contract and definitions are not entirely uniform among the circuits.

It is said that an executory contract is a contract under which the obligations of both the debtor and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.⁷ In the Tenth Circuit, however, the definition of an executory contract appears to require only that neither party has completely performed and that the obligations remaining unperformed by each party are complex.⁸

In a Chapter 7 case, if the trustee does not assume or reject an executory contract within sixty (60) days after the order for relief or such additional time as the court for cause permits, then the contract is deemed to be rejected.⁹ In a

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Chapter 11 case, the trustee may assume or reject an executory contract at any time prior to confirmation of the plan. However, the court, upon request of any party to that contract, may order the trustee to assume or reject the contract at an earlier time.¹⁰

It is not the purpose of this paper to explore the Code's strong-arm or executory contract provisions. This has been done in detail by other speakers at this Institute. However, most of the operational agreements considered by this paper sufficiently relate to real property to be subject to attack under the strong-arm provisions and all these operational agreements at one time or another will be executory contracts and in fact, most of them remain executory throughout the periods of relevance. Thus, the impact of the Code's executory contract provisions and strong-arm provisions will be an important part of this paper.

Joint or Joint and Several

Liability By Contract

Operational agreements (such as farmouts and gas purchase and sale contracts) which call for a single performance by two or more parties to be given to another party or parties present special problems in the event of the bankruptcy of one of the persons whose performance is required. The solvent parties also bound to that performance may incur a substantially greater obligation than they bargained for. By illustration, consider a farmout agreement among A as farmor and B and C as farmee. Assume the farmout is not optional on the part of B and C but that they are obligated to drill a test well on A's lease in return for the assignment of an interest in that lease. Assume B and C have agreed among themselves that B will pay 80% of the cost for 80% of the interest earned and C will pay 20% for 20% of the interest earned. If B goes bankrupt, is C obligated to A to complete performance by drilling the well? As most farmout agreements are written, the answer is yes, and the same is true for other joint undertakings under operational agreements.

"Where two or more parties to a contract promise the same performance to the same promisee, each is bound for the whole performance thereof, whether his duty is joint, several, or joint and several".¹¹

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The significance of the rule is well illustrated by the case of Anderson v. Barnes,¹² wherein both defendants held title to certain property as joint tenants and entered into a contract to sell that property to the plaintiff. The contract required the seller to execute and deliver to the plaintiff a warranty deed conveying the property free of liens and encumbrances. Prior to closing, a judgment lien was recorded against the interest of one of the defendants rendering him unable to perform his obligation to convey free and clear. Plaintiff sued for specific performance. The issue on appeal was whether the defendants had each warranted title to the whole interest and thus whether the defendant whose interest was free and clear was liable for the breach of warranty on account of the other defendant's encumbered interest. The Colorado Court of Appeals held that because the defendants had signed one contract and the contract contained but one warranty, each was bound by the warranty for the entire interest subject to the contract.

Whether the parties intend to be bound jointly or jointly and severally for one performance or severally for separate performances is one of interpretation and depends upon the intention of the contracting parties as revealed by the language of the contract and the subject matter to which it refers.¹³ In Clayman v. Goodman Properties, Inc.,¹⁴ the court held that a contract whereunder the purchasers were listed as "Melvin Clayman, Stanley Clayman, and David Hillman, jointly hereinafter called 'Prospective Purchaser' or 'purchaser'" resulted in joint and several liable of the purchasers where the named parties were consistently referred to in the contract as the "purchaser" in the singular. The court noted that:

"Nowhere does the contract distinquish the three in any way, or separate the rights and obligations among them. On the contrary, the contract uniformally treats the three as a team, without so much as a whisper that they are to be differentiated in anywise for any purpose."¹⁵

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With respect to interpretation, the position of Restatement is:

"(1) Where two or more parties to a contract make a promise or promises to the same promisee, the manifest intention of the parties determines whether they promise that the same performance or separate performances shall be given.

(2) Unless a contrary intention is manifested, a promise by two or more promisors is a promise that the same performance shall be given."¹⁶

The significance of this is obviously that where one of the promisors which has made a joint promise or joint and several promise becomes bankrupt, the other promisor is liable for the entire performance and will thus incur a greater obligation than it bargained for.¹⁷

Joint and Several Liability:

Mining Partnership and Joint Venture

The previous subdivision explored how the structure of the contract could result in one party to an operational agreement becoming liable for obligations intended to be satisfied by another party to the agreement because insolvency or bankruptcy prevented performance by the intended obligor. A person's liability for the obligations contracted to be undertaken by

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another can also result if the arrangement among the parties is treated as a mining partnership or joint venture. This paper will not explore in any depth the law of mining partnership and joint...