An ounce of protection is worth a bbl of cure

Oil prices remain near all-time highs and some oil companies are reporting record-breaking year-end 2007 profits. There are rumbles, but no immediate signs of lessening demand, and OPEC has announced it will keep production level. Most oil patch investors, lenders, and credit managers think they have it pretty easy.

Those doing business with large, well-financed entities are right to take life a bit easier. However, as the price and profit run-up of the last few years attracted eager money looking to cash-in on the oil boom, some of that money found homes with outfits that had more sizzle than steak.

As a result, many investors and creditors currently find themselves holding positions in companies that are in, or headed for, Chapter 11. Since June 2006, there have been at least two dozen outfits (counting affiliates) that have landed in Chapter 11 – some voluntarily, some involuntarily – in Texas bankruptcy courts alone. Bankruptcy cases for oil and gas or service companies have also been filed in other jurisdictions, including that hotbed of drilling activity, New York City. In a few non-bankruptcy situations, investors and creditors have filed suit over disputes ranging from unpaid bills to securities fraud.

Reasons for failure – the past is prologue

So who is failing and why? The most notable cases have been E&P companies, drilling contractors, and in one instance, a gathering system. Just as during past price run-ups, that giant sucking sound was not necessarily hydrocarbons rushing out of a newly perforated formation. More frequently it was capital rushing into the hands of promoters, managers, or others with a nifty idea of how to put that capital to work in the oil business, but with a less clear set of detailed plans or documents.

Reasons for failure range from over-ambitious drilling programs that failed to anticipate the possibility of a dry hole, operational problems, or a partner’s non-consent, to allegations of fraud. Regardless of the reason for failure, oilfield service vendors are trying to collect on liens, and working interest owners are getting school-of-hard knocks PhDs in the sad literature of the fate of unrecorded working interests in bankruptcy.

This is not a new story in the oil patch, and it’s likely to get worse. As noted above, OPEC announced at the beginning of February that it is going to keep production at current levels. But citing the cooling of the US economy, OPEC also signaled that it may cut production when it meets again.

As with any significant price decrease, the immediate casualties will come from the ranks of the marginal companies, many of which are late entrants to the game. As such, they have paid top dollar for leases and commenced drilling during a tight rig market.

On the services side, the next best market to jump into was leasing rigs. Except that there weren’t any available for sale, so why not build them? Several of the service company bankruptcies have been blamed on new, but poorly designed or manufactured rigs. Given the tight liquidity of some of these companies, any operational or pricing problems will accelerate the trend that has been developing.

Warning signs

Most of the cases are still in litigation, and the allegations in the more colorful cases are hotly contested. But there are enough fact patterns emerging to supply some common sense rules and warning flags for investors, lenders, and trade creditors.

Follow the money: who, what, where, when, and why

The most basic rule is one that applies to investors, secured lenders, and trade creditors. Before entering into a significant transaction, be sure you know:

• who you are dealing with;
• what you are getting in return;
• where the properties are;
• when operations will commence; and
• why the money is needed.

In several of the recently filed cases, investors and creditors claim to have been misled about where their money was going and what they would get in return. Investors should ensure that funds raised through investment vehicles such as stock in multi-tiered companies, whether public or private, be held in escrow and only dispersed to the proper entity upon satisfaction of the conditions to the investment. If the investment is for a specific asset or bundle of assets, investors should insist on disinterested third-party input as to whether the deal makes any sense if the pitch material is too general to analyze (a red flag in itself).

In a case pending in Midland, Tex., shareholder representative of pension funds claims that they were promised, in addition to equity interests in the parent company, junior liens on oil properties and either overrides or working interests in properties acquired by the operating subsidiary. Needless to say, the paperwork is less than blue chip.

While there may be brochures or offering memoranda addressing certain of these items, there are no recorded liens or mineral interests in favor of the investors who are complaining. On the face of things, it seems clear that the investors forked over significant amounts of cash. Whether they will end up with anything more than shares in the shell of an insolvent parent company remains to be seen.

In at least three pending E&P cases, parties in various positions claimed to own part of the mineral interests (i.e., working interest) that the debtors claimed was property of the bankruptcy estate. Two of those cases are still being litigated while the third ended in a complicated settlement in which each party gave up valuable rights.

In many of the E&P cases, trade vendors are left with large unpaid invoices, often on multiple properties. In one case, a drilling contractor was threatened with a lawsuit from a lessor they had never heard of as a result of the customer that had a rig under a 12-month lease, “lending” the rig to an industry contact that had a prospect to drill. The drilling contractor moved on location, drilled as requested, and only after problems arose learned that the lease that had been drilled did not belong to its customer but to the third-party friend of the customer.

In a rig case playing out in bankruptcy court in Dallas and a related federal district court lawsuit, investors in a drilling rig company claimed to have been solicited by the chairman of the company to lend money to the company for the acquisition of drilling rigs that could be put to work immediately in the Barnett shale. The investors say that the money was paid, but title to the rigs was acquired in another company organized by the chairman in which the old investors have no ownership interest.

Worse yet, the rigs are subject to a first lien claim by a large commercial lender. To top it off, the Chinese-manufactured rigs appear to be of an old, inefficient design, and too large for the typical Barnett shale drilling project. Not surprisingly, the recently formed, second drilling company finds itself ensconced in Chapter 11. The investors from the first company have sued their old pal, and the lawyers and consultants are lining up for an extended slugfest.

Most of these problems could have been avoided or minimized by better due diligence and documentation. Suggestions appear below for ways to protect your interests in oil and gas transactions.

Get a recordable interest – and record it

Parties who “invest in oil deals” often have a less than clear understanding of what they are getting for the investment. In part, the confusion arises from the many hybrid forms of oil and gas investments that have developed over the years.

From an investor’s standpoint, the safest way to acquire an interest in an oil and gas venture is to have a separate, recordable working interest, and then to record it. Even investors who receive recordable working interests frequently do not record them. This can occur through oversight or ignorance as easily as fraud.

Many buyers of “participations” simply don’t think about filing the assignment in the title records of the county, or assume that the promoter will file it for them without ever asking or checking. This can be a serious mistake. Mineral interests in Texas, as in most states, are treated as interests in real property, and to be enforceable, must be recorded. Under real property law, if the seller has clear title to a piece of real property, and a good faith buyer innocently acquires that property, the buyer will be able to keep the property even if it is later discovered that a third party bought an interest in the property from the seller, but failed to record it.

One of the most important reasons for obtaining and recording a separate working interest is that if the operator or promoter ends up in a bankruptcy case, the investor’s recorded working interest is not property of the debtor’s bankruptcy case. If the working interest has not been recorded, then a party in the bankruptcy case can move to set aside the interest. This is done under the so-called “strong-arm” powers under the bankruptcy code.

Under those sections of the bankruptcy code, the bankruptcy estate has the same rights as a hypothetical bona fide purchaser for value would under state law. Additionally, the bankruptcy code provides that property of the bankruptcy estate can be sold along with the rights of a co-owner of the property that holds an undivided interest in the property, such as the holder of a joint tenancy or tenancy in common.

Because a debtor in bankruptcy, the trustee, or a subsequent creditors committee can take advantage of the “strong arm” powers, it can sell its mineral interests along with that of the unrecorded working interest owner. But since mineral interests are separate, recordable real property interests, if a working interest has been filed of record, it simply will not be treated as property of the bankruptcy estate and cannot be sold by a debtor or successor.

As far as recording goes, the closer in time to the purchase the recordation is made, the safer it is from subsequent challenge under other provisions of the bankruptcy code, such as avoidance as a preferential transfer or fraudulent conveyance.

Conversely, where the investment has been through a joint venture, partnership, drilling program, or other type of vehicle, the mineral interest is subject to sale if the partnership or entity that holds record title to the property files for bankruptcy protection.

Apart from safeguarding the property from sale, additional monitoring of title needs to be made to ensure that the operator is paying its field expenses as those come due. Failure to pay mineral contractors on time can (and should) give rise to mineral contractors filing liens against the property. The following is the effect of these liens on third-party investors.

File your liens

Most services provided to a well site, pipeline, or pipeline right of way fall under the Texas Property Code definition of “mineral activities.” Persons (including companies, partnerships, or other entities) who perform labor or furnish or haul material, machinery, or supplies used in mineral activities under an express or implied contract with a mineral property owner or with a the mineral property owner’s agent are recognized as “mineral contractors” or “mineral subcontractors” depending upon what was being furnished and which party granted the contract.

A mineral lien arises automatically upon furnishing goods or services. As contractors’ bills are paid, the lien is extinguished. The lien remains in place for unpaid invoices. To be enforceable against the mineral owner and third parties who may also assert liens, mineral liens must be “perfected.”

Perfection is accomplished by filing an affidavit in the real property records of the county in which the property is located. The Property Code contains specific requirements for what must be included in the affidavit and time frames within which it must be filed. There are additional requirements for mineral subcontractors to serve written notice that the lien is claimed 10 days prior to filing the lien.

If the mineral owner has filed bankruptcy, normal collection efforts must stop. However the bankruptcy code contains an exception that permits holders of statutory liens to file their liens of record provided they are within the time afforded by state law. Thus, if the mineral owner has filed bankruptcy, it is advisable for the contractor or subcontractor to take the necessary steps to record their liens immediately.

The mineral lien attaches to any improvements, machinery, equipment, pipelines, wells, leases, or land for which services are rendered. The lien does not attach to proceeds of production, however. Thus, unless the lien holder is willing to wait until the property is sold, the effective remedy is to seek appointment of a receiver to prevent the property value from being diminished by production, or to seek foreclosure under the Texas Property Code. Note that the lien is junior to pre-existing liens, so if a secured lender is already in place, the mineral lien would be subordinate to that lender.

Other states have similar laws. In Louisiana, the mineral lien, known as a “privilege,” specifically attaches to proceeds of production. For liens arising for operations in the Outer Continental Shelf, the federal law looks to the law of the adjacent state. Thus, Gulf of Mexico operations are governed by whichever state’s law the lease is closest to.

Monitor activities

Working interest owners need to monitor the operator; operators need to monitor the contractors. One of the more unfortunate situations that arises with some frequency is that an operator will send out joint interest billings (JIBs) to the other working interest owners, collect the payments, and then fail to pay the mineral contractors. Or the contractors will fail to pay the sub-contractors. The result is that working interest owners who have paid their JIBs find their interests at risk because of a failure somewhere down the line.

The legal analysis can get messy arguing about whether the Operating Agreement made the operator the working interest owner’s agent for contracting purposes. An E&P bankruptcy case in Corpus Christi (Reichmann Petroleum) recently settled these, among other issues. The settlement may have been driven more by the practical economics of litigating murky issues with dozens of claimants than by pure legal analysis. The take-away point is to ensure payments sent up – or down – the chain get to the intended place.

Investors’ funds should be escrowed until closing is complete

Leaving aside the issue of “blank check companies,” recent bankruptcy cases repeatedly demonstrate that investors have plunked down cash expecting to acquire certain assets, only to find that what was delivered was not everything investors thought they were getting.

Investors should scrutinize offering memoranda and hold onto their wallets until they are satisfied that their funds will not be released until simultaneous delivery of the bundle of interests they believe they are buying, and that in the case of mineral interests, those interests are in recordable form, and steps are in place to record the interests.

Summary

Rising prices have masked many problems. As prices stabilize or decrease, these problems will come to light. To avoid financial loss, now is the time to take available steps to protect vulnerable positions.

About the author

John Melko [[email protected]] is a partner in the bankruptcy section in the Houston office of Gardere Wynne Sewell LLP.