The effect of bankruptcy on major oil and gas agreements
Shahid A. Ghauri, Jones Day, Houston Daniel P. Winikka and Paul M. Green, Jones Day, Dallas
Oil and gas companies, by the very nature of the high risk and cyclical business in which they are engaged, are prime candidates for financial restructuring.
The capital-intensive process of exploring and producing oil and gas coupled with the cyclical markets for these commodities mean that oil and gas companies often find themselves in need of restructuring their balance sheets, either through negotiations with creditors out of court or through a bankruptcy filing. Bankruptcy provides a debtor with powerful tools to restructure or free itself from burdensome contracts, so it's important for all parties involved in a financial restructuring of an oil and gas company, to understand what their rights in bankruptcy are as they relate to contracts.
Although the Bankruptcy Code contains special provisions that govern certain types of agreements, including some utilized in the oil and gas industry, most fall within the Bankruptcy Code's general treatment of "executory" contracts or unexpired leases. The Bankruptcy Code allows a debtor-in-possession to "assume" or "reject" executory contracts and unexpired leases. In fact, the ability to reject contracts is one of the key tools that the Bankruptcy Code provides a debtor to assist it in reorganizing. The Bankruptcy Code, however, fails to provide an express definition of "executory contract," leaving the courts to craft their own.
To determine whether a contract is executory, one must determine whether both parties have some performance remaining, and whether such remaining performance is material. If a contract is executory, the debtor has the option to assume, assume and assign, or reject the agreement. A debtor may assume an executory contract only with bankruptcy court approval. If there has been a monetary default under the contract, the debtor must cure the default and provide adequate assurance of future performance to the counterparty before assuming the contract.
Consistent with the overriding goal of facilitating a debtor's ability to maximize the value of its assets, the Bankruptcy Code also permits a debtor to assume an executory contract and assign the contract to a third party without the counterparty's consent, even if the contract prohibits such an assignment without consent. However, a debtor cannot assign such a contract without the counterparty's consent if applicable non-bankruptcy law would prohibit such an assignment.
Debtors also have the ability to reject executory contracts. Rejection is tantamount to an election by the debtor to cease further performance under the contract, and is treated as a breach immediately before bankruptcy filing. As a result, any damages arising from the breach are treated as a prepetition claim, which, along with all other prepetition claims, are compromised in the bankruptcy and often receive a recovery that may constitute only a small percentage of the amount owed. Additionally, as a general rule, a debtor must accept or reject a contract in full. This general rule is subject to state law, which under some state law may provide that an agreement is divisible and includes multiple contracts, allowing separate assumption and/or rejection of each severable agreement.
Many executory contracts contain clauses, commonly known as "ipso facto clauses," that permit the termination of the agreement upon the commencement of bankruptcy. Except for certain limited exceptions, ipso facto clauses are unenforceable in bankruptcy and will not prevent a debtor from assuming and assigning such agreements.
The Bankruptcy Code does not contain any special provisions that apply to joint operating agreements. Given that JOAs govern continuing operations and typically have substantial ongoing obligations yet to be performed by the operators and non-operators alike, courts have generally concluded that JOAs are executory contracts.
It is possible that a JOA is severable into multiple agreements. If a court determines a JOA is severable, there is the possibility that the court may find some of the severable agreements executory, while others have been fully performed and are no longer executory. In this situation, the debtor would only be allowed to reject, assume or assign the executory portions of the agreement.
Like JOAs, asset purchase agreements are not specifically addressed by the Bankruptcy Code, so the typical rules regarding executory contracts apply. In other words, APAs can be assumed, assumed and assigned, or rejected, but only if the court finds the failure of either party to complete performance would constitute a material breach of the contract. When an APA has not been fully performed, courts will generally find that the APA can be rejected or assigned as an executory contract.
As with JOAs and APAs, courts also typically find that partnership and joint venture agreements constitute executory contracts. However, such agreements may cease to be executory, when a partnership has dissolved or the agreement requires no continuing duties from the parties. Notably, based on anti-assignment provisions commonly found in state partnership and limited liability company statutes, debtors may lack the ability to actually assume and assign these agreements absent consent of their joint venture partners. Unlike JOAs and APAs, interests in mineral leases are generally considered interests in real property.
State law determines the nature and extent of a debtor's property rights in bankruptcy, including its interest in real property. Most state laws typically provide that mineral leases convey a real property interest or "working interest" from the lessor to the lessee—as opposed to creating a true leasehold. Thus, bankruptcy courts have typically found that mineral leases should not be afforded the treatment of an unexpired lease and thus cannot be rejected in bankruptcy. The rights and obligations under the lease form a part of the debtor's estate and are treated accordingly.
The interests of a debtor farmor in a farmout agreement are expressly excluded from the debtor farmor's estate. This exclusion protects the farmee, the party that acquired the right to drill and produce liquid or gaseous hydrocarbons, from a debtor-farmor rejecting the agreement and effectively reclaiming the property. The Bankruptcy Code prohibits the debtor-farmor from claiming that proceeds from a farmout agreement are property of the estate so long as the farmee complies with the agreement.
As part of the 1994 amendments to the Bankruptcy Code, Congress recognized that production payments are akin to transfers in real property, and it created special treatment for production payments to prevent debtors from rejecting the agreements as executory contracts. The Bankruptcy Code protects the buyers of production payments, as the sellers are unable to avoid or reject such payments in bankruptcy. Furthermore, since production payments are excluded from the property of the estate, the automatic stay will not prevent parties from enforcing any liens on any oil and gas properties subject to the production payments during the pendency of the debtor's bankruptcy case.
If an agreement falls within the Bankruptcy Code's definition of swap agreement, the bankruptcy of a counterparty generally will not limit the other party's ability to enforce its obligations under the agreement.
Swap agreements are defined by the Bankruptcy Code to include commodity forward agreements, but the term "commodity forward agreements" is not defined by the Bankruptcy Code, leaving courts to create their own definitions.
For an agreement to qualify as a commodity forward agreement, the Fourth Circuit found that some or all of the following factors should be present: (1) substantially all of the expected cost of performance must be attributable to an underlying commodity determined at the time of contracting; (2) payment must be for a commodity that is delivered more than two days after the date of the contract at a price that is fixed at the time of contracting; (3) quantity and time of delivery must be fixed at the time of contracting; and (4) the agreement itself need not be assignable or tradable. Certain of these elements, such as the requirement that price, quantity, and time of delivery be fixed at the time of contracting, but they are not present in the Bankruptcy Code and may pose challenges in determining whether a natural gas supply contract is, in fact, a commodity forward agreement.
Rights of first refusal can be found in a wide variety of agreements, including, for example, leases, joint operating agreements, partnership agreements, franchise agreements, shareholder agreements and deeds. With the possible exception of a deed, these agreements usually constitute executory contracts that can be assumed, assumed and assigned, or rejected.
When a debtor seeks to assume and assign an agreement that includes the right as part of a sale of assets, an issue can arise as to whether section 365(f) of the Bankruptcy Code renders the right of first refusal unenforceable.
Section 365(f)(1) of the Bankruptcy Code provides that, subject to certain exceptions, "notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection." Although the policy underlying this section is arguably solely to ensure that provisions that restrict or condition assignment do not operate to prevent the debtor from assigning the applicable contract, courts have interpreted Section 365(f) more expansively to fulfill the broader, fundamental bankruptcy policy to maximize the value of estate assets for the benefit of all creditors.
Most courts have looked to whether the right of first refusal imposes so heavy of a burden on the ability to assign the contract that it should be rendered unenforceable—a determination left to the discretion of the court. In some cases, courts have modified the rights. For instance, courts have sometimes required the holder of the right to participate in an auction and exercise its right to match the purchase price at each step of bidding. In another case, the court gave the winning bidder at a sale hearing another chance to raise its bid after the holder of the right of first refusal sought to exercise the right and tender the same purchase price to the trustee.
While courts have varied in their views as to what circumstances warrant the invocation of Section 365(f) to modify a right of first refusal or render it unenforceable, a debtor could potentially succeed in having the right modified or rendered unenforceable in any case where it can show that complying with the right will impose significant burdens and jeopardize the estate's ability to realize the maximum value for the assets to be sold.
The Bankruptcy Code provides a debtor with significant tools to free itself from, or maximize the value of, its contractual arrangements. In any financial restructuring or possible bankruptcy involving an oil and gas company, it is important to analyze the significant agreements that may be at issue to understand what impact a bankruptcy may have. Different types of agreements receive different treatment under the Bankruptcy Code, so understanding the implications of bankruptcy on each type of agreement can help prevent an unwelcome surprise. The foregoing discussion of the effects of bankruptcy on common agreements in the oil and gas industry is intended only to provide a general overview, and one should always refer to their own counsel for advice in a particular situation.
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