CHAPTER 9 EXECUTORY CONTRACTS AND UNEXPIRED LEASES IN OIL AND GAS BANKRUPTCIES
| Jurisdiction | United States |
EXECUTORY CONTRACTS AND UNEXPIRED LEASES IN OIL AND GAS BANKRUPTCIES
William S. Holste
Shearman & Sterling LLP
Dallas, TX
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IAN E. ROBERTS is a partner at Shearman & Sterling LLP, in the Financial Restructuring & Insolvency practice group. He advises clients on the many complex issues that arise in deleveraging a capital structure. With particularly deep experience in the energy sector, Ian counsels on highly leveraged special situations, distressed acquisitions, refinancing transactions, cross-border restructurings, and all manner of insolvency-related corporate finance and governance. He strives to maximize value for his clients, which have included debtors, purchasers, lenders, private equity and hedge funds, institutional investors, governmental agencies, and a labor union. Following law school, Ian served as a law clerk to the Honorable Hayden Head of the United States District Court for the Southern District of Texas. In 2014-2015, he served as in-house counsel for Hewlett Packard Enterprise, focusing on global turn-around initiatives.
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Table of Contents
I. Introduction
A. What is an Executory Contract?
B. Assumption by Motion or Plan
C. Typical Procedures
D. Application in a Chapter 11 Sale
E. Rejection
II. Oil and Gas Leases
A. Preserving Value and Complying with the Bankruptcy Code
B. Specific Challenges
C. State Law Governing the Status of Oil and Gas Leases
(1) "Ownership in Place" Jurisdictions
(2) "Rule of Capture" or "Non-Ownership" Jurisdictions
(3) Ambiguous Jurisdictions
III. Other Relevant Agreements in the Oil and Gas Context
A. Joint Operating Agreements
B. Surface Use Agreements/Leases
C. Farmout Agreements
D. Executory Service Agreements and the Potential for Administrative Claim Priority
IV. Midstream Agreements
A. Getting to Market
B. Prepetition Dealings
C. Postpetition Dealings
(1) Dedications and Running Covenants
(2) Implications of FERC Regulation of Midstream Agreements
V. Conclusion
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I. Introduction
Section 365 of the Bankruptcy Code1 gives the chapter 11 debtor in possession the power to assume or reject "executory contracts" and "unexpired leases of real property."2 This constitutes one of the most significant tools in the chapter 11 debtor's toolbox, as it allows for the retention of agreements that are a net value and the shedding of those that are not.
At the same time, the statutory provisions that govern the debtor's exercise of this right are in some respects ambiguous, and courts have parsed that ambiguity in applying the statute to a variety of unique situations. Moreover, the nature of parties' interests in executory contracts and leases is generally determined by state law, further complicating the jurisprudence. As one commentator has written,
Bankruptcy is that volume of the law that might have been written by Lewis Carroll, every conventional legal principle refracted through the prism of insolvency. In that fact lies much of its students' joy—and their frustration. In no chapter of that volume has the law become more psychedelic than in the one titled "executory contracts." 3
If the state of the law on executory contracts in general may fairly be termed "psychedelic," the application of section 365 in the oil and gas context truly is a step through the looking-glass. Words no longer have their expected meaning, as oil and gas "leases" turn out not to be leases at all, and seemingly straightforward service agreements become conveyances of real property. The confluence of state contract and property law as applied to the oil and gas industry intersects with the provisions of the Bankruptcy Code to create a kaleidoscope of often bewildering possibilities, among which lie many traps for the unwary practitioner. All the while, the debtor and fiduciaries of the estate must navigate complex business and regulatory realities in a volatile industry, where a single decision can eliminate substantial value, or a fortuitous turn in the markets can render a debtor solvent in the twinkling of an eye. This paper aims to serve as a guide through some of the more common issues that arise in oil and gas bankruptcies, while recognizing that every case is in some measure a journey through an uncharted land.
A. What is an Executory Contract?
The Bankruptcy Code does not define the term "executory contract," which contains inherent ambiguity. As Williston wrote, "[a]ll contracts to a greater or less extent are executory. When they cease to be so, they cease to be contracts."4 Theoretical imprecision aside, the Bankruptcy Code uses the term and invests it with some significance, leaving the courts to divine the nuances of its interpretation. The legislative history does gesture toward the intent of Congress with respect to its use of the term. "Though there is no precise definition of what contracts are
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executory, it generally includes contracts on which performance remains due to some extent on both sides."5 As the United States Supreme Court expressed it in the recent Tempnology case:
A contract is executory if 'performance remains due to some extent on both sides.' Such an agreement represents both an asset (the debtor's right to the counterparty's future performance) and a liability (the debtor's own obligations to perform). Section 365(a) enables the debtor (or its trustee), upon entering bankruptcy, to decide whether the contract is a good deal for the estate [and its successor] going forward." 6
Unfortunately, here Williston's point reasserts itself. A contract that does not have remaining performance due "to some extent" is no longer any sort of contract at all. The definition becomes so broad as to be unworkable. Harvard Law School Professor Vern Countryman addressed this problem in a highly influential 1973 article published in the Minnesota Law Review. "[T]hat expansive meaning," he wrote, "can hardly be given to the term as used" in the bankruptcy context. "The concept of the 'executory contract' in bankruptcy should be defined in the light of the purpose for which the trustee is given the option to assume or reject."7
Professor Countryman instead set forth the following definition, which most courts have adopted in the intervening decades:
a contract under which the obligation of both the bankrupt 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 the performance of the other. 8
This definition quickly leads to certain conclusions about which sorts of agreements do and do not constitute executory contracts for the purpose of section 365. If contracts under which both parties continue to owe material performance are deemed executory, agreements that are already substantially performed or that have expired by their own terms are not.9 Furthermore, if one of
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the parties has no continuing obligation other than the payment of money, that obligation is not understood to be outstanding material performance, and accordingly, such a contract is generally not deemed executory.10
The question sometimes arises as to whether the debtor must assume or reject an agreement in its entirety. While a line-item rejection would undoubtedly provide great advantages to the debtor in possession, the general rule is that the debtor may not assume some provisions and reject others. As the Third Circuit put it, "Section 365(f) requires a debtor to assume a contract subject to the benefits and burdens thereunder. 'The [debtor] . . . may not blow hot and cold. If he accepts the contract he accepts it cum onere. If he receives the benefits he must adopt the burdens. He cannot accept one and reject the other.' The cum onere rule 'prevents the [bankruptcy] estate from avoiding obligations that are an integral part of an assumed agreement.'"11 There are instances, however, where courts will find multiple agreements in a single writing.12 In such cases, the debtor may assume or reject each such agreement separately. Contrariwise, in cases where multiple documents constitute a single agreement, the debtor must assume or reject them together.13 "To decide whether a contract is divisible for assumption purposes, the [c]ourt should look to state law."14
B. Assumption by Motion or Plan
Assumption of an executory contract or unexpired lease requires court approval, which procedurally can be sought and obtained by motion or as part of a chapter 11 plan.15 In any case, the counterparty and other creditors must be given adequate notice and have the opportunity to object to the proposed assumption.16 Often—including with oil and gas leases—the motion that provides for the assumption (and assignment) of contracts and leases is part of a broader motion to sell assets under section 363 of the Bankruptcy Code. (see (D) infra).17 When a debtor pursues
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assumption of its contracts pursuant to a chapter 11 plan, assumption is typically approved by the bankruptcy court in connection with plan confirmation under section 1129 of the Bankruptcy Code.18 Assumption in that case becomes effective upon the consummation of the transactions contemplated by the plan (or the Debtor's emergence from chapter 11).
Finally, some courts have held that the debtor may assume or reject a contract through performance, i.e., "by clearly communicating in an unequivocal manner its intentions to either assume or reject to the lessor," though this remains a matter of some controversy.19 "The majority of courts faced with this issue have held that the effective date of rejection is the date of the bankruptcy court's order approving rejection, and that court approval is a condition precedent to effective rejection."20 Given the plain language of section 365(a), it is more prudent not to rely on the...
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