CHAPTER 5 Issues Unique to Oil and Gas Bankruptcies

• Jurisdiction: United States

CHAPTER 5 Issues Unique to Oil and Gas Bankruptcies

A. Title Issues²⁸³

As title issues plague the oil and gas industry outside of bankruptcy, it should be no surprise that title issues likewise present a host of issues inside of bankruptcy. As discussed in Chapter 1, the characterization of an oil and gas lease has consequences for its treatment in bankruptcy (e.g., as an executory contract, true lease or fee interest).

For various reasons, not the least of which is the "handshake deal" nature of many oil and gas transactions, many paid-for interests in oil and gas interests are not papered or, if they are papered, are not recorded. This presents a unique problem in a bankruptcy context under competing clauses in §§ 541(d) and 544(a)(3).

Section 541 of the Bankruptcy Code, as discussed in Chapter 2, defines the composition of the bankruptcy "estate," with § 541(a) defining what is "in" and § 541(d) defining what is "out." Section 541(d) of the Bankruptcy Code states:

Property in which the Debtor holds, as of the commencement of the case, only legal title and not an equitable interest ... becomes property of the estate ... only to the extent of the Debtor's legal title to such property but not to the extent of any equitable interest in such property that the Debtor does not hold.

Thus, the unfortunate equitable-interest owner without a recorded assignment can, and often does, argue that the interest was never part of the bankruptcy estate because the debtor held mere legal title to the interest.

Section 544(a)(3), on the other hand, puts a debtor in the position of being a bona fide purchaser (BFP) who bought the property from the debtor on the filing date and then simultaneously perfected the transfer by recording a deed. As such, the debtor has the power to avoid liens, encumbrances or conveyances that a BFP could avoid, under the applicable state law. Because a BFP can generally avoid unrecorded title, this section of the Bankruptcy Code appears to allow the debtor to avoid transfers of oil and gas interests that are not recorded. These two sections are in conflict with one another, and there is a circuit split as to the resolution of the problem.

The counter-argument is that it should not matter whether assignments (of leases, royalty interests, etc.) are recorded. The bankruptcy estate is comprised only of the debtor's true title, which is its legal and equitable title. If the debtor holds only legal title, then any equitable title is not part of the estate.²⁸⁴ Thus, the argument goes, the only question should be whether the assignment meets the applicable state law's standards, including meeting the statute of frauds and the assignee accepting delivery and paying the purchase price. Therefore, holders of unrecorded assignments of interests in oil and gas should own such property regardless of whether the assignor is in bankruptcy because the debtor does not have equitable title, and therefore, the interest is not property of the bankruptcy estate. Nonetheless, holders of unrecorded assignments have found themselves fighting an uphill battle to assert their rights when their assignor has filed for bankruptcy protection.²⁸⁵

Framing the issue is the interplay between that section of the Code defining what is property of the estate (§ 541(d)) and that giving the debtor avoidance powers as a bona fide purchaser for value (§ 544(a)(3)). In the Ninth Circuit, § 544(a)(3) prevails, and the unrecorded assignee is out of luck.²⁸⁶ The minority view is that the debtor's estate is comprised only of property to which the debtor holds legal title.²⁸⁷ However, the Fifth, Tenth and Eleventh Circuits have held that § 541(d) prevails over a competing § 544(a)(3) avoidance claim because "Congress did not mean to authorize a bankruptcy estate to benefit from property that the Debtor did not own."²⁸⁸

Woven into this analysis is the constructive trust doctrine, common to many states, under which one who has been unjustly enriched at another's expense is treated under state law much like a trustee, holding legal title for the injured party's benefit.²⁸⁹ Thus, it has been argued, to varying degrees of success, that the putative assignee of an unrecorded interest should have a constructive trust imposed to protect the assignee's interest and that the debtor simply cannot own the equitable interest that lies with the assign-ee.²⁹⁰ One author has theorized that putative assignees should instead argue for the remedy of a resulting trust, which requires only that the equitable owner made payment but failed to receive an assignment.²⁹¹

B. Lien Avoidance

In bankruptcy proceedings, junior creditors are incentivized to challenge (or threaten to challenge) the liens of senior secured creditors as a means of realizing assets/value for distribution to junior creditors and as a potential means of extracting value by delaying the chapter 11 case. Additionally, actual or threatened litigation can earn junior creditors a seat at the negotiating table, as the other parties in the case will want to receive releases pursuant to the chapter 11 plan (i.e., bankruptcy courts are more likely to approve releases in an uncontested plan). There are three general ways that junior creditors can challenge the liens of senior secured creditors: (1) avoidance of unperfected liens; (2) preference actions; and (3) fraudulent transfer actions.

Section 544(a) of the Bankruptcy Code (known as the "strong-arm" powers) allows the debtor to initiate adversary proceedings to avoid any unperfected security interest in estate property. Unsecured creditors may seek standing to prosecute and settle strong-arm claims on behalf of the debtor's estate. To the extent that any purported liens on estate property are ultimately proved to be un-perfected or otherwise defective, the purported lienholder will be demoted to the status of an unsecured creditor.

A junior unsecured creditor could also seek (or threaten to seek) standing to avoid a senior secured creditor's lien on the basis of a preferential transfer. As discussed in Chapter 2, under §§ 547 and 550 of the Bankruptcy Code, the debtor has the power to avoid preferential transfers and recover for the benefit of the estate certain payments or other transfers the debtor made to (or for the benefit of) any creditors within the three months preceding the bankruptcy case (one year with respect to insiders). The term "transfers" is defined broadly in the Bankruptcy Code and includes, among other things, the creation or perfection of a lien.²⁹² A preference cause of action requires that the debtor was insolvent when the transfer was made and that the creditor received more than it would have in a chapter 7 liquidation.²⁹³ Nonetheless, if a lender realizes they are undercollateralized and able to perfect liens 90 days before a bankruptcy filing, these liens are not at risk of being clawed back as a preference under § 547 of the Bankruptcy Code.

Similarly, as also discussed in Chapter 2, §§ 548 and 550 of the Bankruptcy Code give the debtor the power to avoid transfers of interests in property made, or obligations incurred (e.g., liens granted to senior secured creditors), within two years preceding the bankruptcy that unfairly or improperly deplete the debtor's assets or dilute the claims against those assets because they are either (1) actually fraudulent or (2) involve constructive fraud, in that a financially impaired debtor received less than an even exchange of value.

C. Is an Oil and Gas Lease Subject to § 365?

Section 365 of the Bankruptcy Code deals with bankruptcy treatment of executory contracts and unexpired leases. Although the determination of whether an oil and gas lease is an executory contract is a question of federal law, the classification of the real property interest is determined by state law.²⁹⁴ Thus, the analysis of whether an oil and gas lease is subject to § 365 depends on the character of the estate conveyed or created in the particular state in which the property is located. On one end of the spectrum is the characterization of oil and gas leases as real property interests in oil and gas in-place states, such as Texas (fee simple determinable), Colorado (fee simple real property interest) and Oklahoma (incorporeal hereditament or profit a prendre), that are therefore not subject to § 365.²⁹⁵ Although there has been a historical split in authority,²⁹⁶ recent Ohio case law and statutory authority suggests that Ohio will follow the view that oil and gas leases create real property interests that are not subject to § 365.²⁹⁷In the middle are the cases in which courts have recognized mineral leases as "incorporeal immovable," such as in Louisiana, and though most courts note that these are not of the type of "contracts" contemplated by § 365, the case law is conflicting, both as to executory contract status and as to whether an oil and gas lease is an unexpired lease.²⁹⁸ Also in the middle is the treatment of outer continental shelf (OCS) leases, the status of which is likewise ambiguous.²⁹⁹ On the other extreme of the spectrum are those states, such as Kansas, where oil and gas leases are not considered interests in real property, and as personal property they are executory contracts.³⁰⁰ Pennsylvania courts have adopted the view that the terms of the instrument will determine the nature of the interest conveyed, and therefore, whether § 365 applies.³⁰¹ However, under Pennsylvania law, if the interest is held by production, a fee simple determinable has been conveyed, so § 365 does not apply.³⁰²

The significance an oil and gas lease being subject to § 365 is (1) the debtor's ability to accept or reject, and the requisite timing; (2) the debtor's need to cure pre-petition defaults if assumed; and (3) what damages the debtor will be required to pay if rejected. If an oil and gas lease is subject to § 365 as an unexpired real property lease, but not as an executory contract, then it must be assumed within 120...