Minimizing Counterparty Bankruptcy Risk

Minimizing Counterparty Bankruptcy Risk Mitchell E. Ayer  TABLE OF CONTENTS Introduction .................................................................................. 864 I. Priority of “Claims” in Bankruptcy .............................................. 866 II. Sales Contracts For Oil and Gas Production ................................ 867 III. Joint Operating Agreements ......................................................... 871 A. Mitigating Credit Risk by Obtaining and Perfecting a Security Interest or Lien ......................................................... 872 1. Avoiding Common Pitfalls When Perfecting a Security Interest or Lien .................................................. 872 a. Failure to Perfect a Security Interest or Lien ............ 873 b. Perfecting a Security Interest or Lien Against the Wrong Counterparty ............................................ 873 c Failure to Perfect a Security Interest or Lien as Soon as Possible ................................................... 874 2. Perfecting Oil and Gas Liens ........................................... 875 B. Mitigating Risk Through Setoff and Recoupment ................. 877 Copyright 2016, by MITCHELL E. AYER. * Mitchell Ayer is an attorney with the law firm of Thompson & Knight LLP in Houston, Texas. His practice includes disputes with royalty owners, working interest owners, and a variety of oil and gas bankruptcy matters. He represented Davis Petroleum Corp. in a pre-packaged bankruptcy that was confirmed within 96 hours of filing the bankruptcy petition. Mr. Ayer is Board Certified in Oil, Gas, and Mineral Law by the Texas Board of Legal Specialization and Board Certified in Business Bankruptcy Law by the American Board of Certification. He has served as past chair of the Houston Bar Association Oil, Gas & Mineral Law Section. He is a member of the American Bankruptcy Institute and American Inns of Court. Additionally, Mr. Ayer has been named to Texas Super Lawyers in the Bankruptcy & Creditor/Debtor Rights and Energy & Natural Resources areas, and is the author of numerous publications and presentations. He has a B.A. from Wittenberg University, an M.B.A. from Cleveland State University, and a J.D. magna cum laude from the University of Houston Law Center (first in class). He served on board the legendary Coast Guard Cutter Bibb from 1971 through 1974. The Author wishes to thank Steve Levitt, Cassandra Shoemaker, and Ayo Shittu for their research assistance as well as acknowledge the advice of David Bennett and Rhett Campbell. 864 LOUISIANA LAW REVIEW [Vol. 76 IV. Treatment of Executory Contracts and Oil and Gas Leases ............ 879 A. Characterization of Oil and Gas Leases ................................. 879 B. Assumption and Assignment of Oil and Gas Leases ............. 881 V. Purchase and Sale Agreements ..................................................... 882 VI. Mitigating Risks Related to Farmouts and Production Payments .................................................................... 883 VII. Include Bad Boy Guaranties in the “Credit Toolkit” When Conducting Oil and Gas Deals. .................................................... 884 VIII. Mitigating Regulatory Risks ................................................................ 886 Conclusion .................................................................................... 887 INTRODUCTION 1 In 2014, price shocks sent waves of financial distress throughout the oil and gas industry, as the price of crude oil plummeted from a high of $100.36/bbl in June to a low of $31.62/bbl by the beginning of February. 2 This drop in prices hit many American producers especially hard because a growing share of production in the United States has been sourced from “unconventional” deposits with limited permeability, which involve higher production costs relative to traditional sources of petroleum. 3 Consequently, there is growing concern over bankruptcy in the industry, with prices continuing to be suppressed over a year after their initial fall. 4 1. This Article is based on a presentation by our firm at the 2014 Texas Bench Bar Conference titled “Today’s Oil and Gas Market: Managing and Mitigating Bankruptcy Risk.” David M. Bennett, Today’s Oil and Gas Market: Managing and Mitigating Bankruptcy Risks (2014) (unpublished manuscript), available at http://www.tklaw.com/files/Publication/6bd977c5-ad04-4a0a-a4a3-575e4dd4b242/Presentation/PublicationAttachment/ab5898d2-0fca-455f-a285-5a b58228cd3e/Today's%20Oil%20and%20Gas%20Market%3B%20Managing%20a nd%20Mitigating%20Bankruptcy%20Risks.pdf. 2. Crude Oil , NASDAQ, http://www.nasdaq.com/markets/crude-oil.aspx (last visited Feb. 2, 2016). 3. Ed Crooks, US Shale Industry Braced for Bankruptcy , FIN. TIMES (Sept. 6, 2015, 1:37 PM), www.ft.com/cms/s/0/5974a3ce-52e0-11e5-b029-b9d50a74fd14.html#axzz3wSuE689J; see also Jennifer Cruz, Peter W. Smith & Sara Stanely, The Marcellus Shale Gas Boom in Pennsylvania: Employment and Wage Trends (U.S. Bureau of Statistics Monthly Labor Report, Feb. 2014); U.S. GOV’T ACCOUNTABILITY OFFICE, REP. NO. GAO-12-732, OIL AND GAS: INFORMATION ON SHALE RESOURCES, DEVELOPMENT, AND ENVIRONMENTAL AND PUBLIC HEALTH RISKS (2012). 4. Crooks, supra note 3. 2016] MINIMIZING COUNTERPARTY BANKRUPTCY RISK 865 The recent price shock illustrates just one of the many threats to parties in an industry characterized by pervasive risk. 5 From natural disasters to human error, risk events may cause firms in the oil and gas industry to incur debilitating costs that render them insolvent. As a result, the threat of counterparty insolvency is always looming for parties to oil and gas contracts. Due to the omnipresent threat of counterparty insolvency, parties should actively manage counterparty credit risk. Long-term credit risk management in oil and gas contracts is challenging because production in some fields lasts many decades and a contract counterparty may change completely or suffer financial reverses. Accordingly, such long-term contracts should be written with the view that one’s counterparty will evade its debts and will be the subject of bankruptcy proceedings. Although the institution of bankruptcy proceedings normally suggests that many creditors will not be satisfied in full, there are a number of strategies that a party to an oil and gas contract can employ to increase its chances of satisfaction. These strategies should be considered before a potential party enters into an agreement. That party may consider a range of factors before determining whether to employ a particular strategy, especially the type of contractual relationship under consideration. This Article addresses five major contract relationships and furnishes advice to protect clients or companies in the event of bankruptcy. These relatively simple and inexpensive steps can save millions of dollars and protect clients and companies from the draconian “strong arm” powers given to a trustee or debtor-in-possession in bankruptcy. 6 Part I of this Article discusses the treatment of claims in bankruptcy proceedings generally as well as the significance of a creditor’s unsecured claims in particular, providing background information for discussions of the consequences of bankruptcy for specific contractual relationships. Parts II through VI discuss the consequences of bankruptcy for parties to sales contracts for oil and gas production, joint operating agreements, oil and gas leases, purchase and sale agreements, and farmout agreements, respectively, as well as furnish relevant, practical strategies. Part VII discusses a final strategy that can be applied to various types of relationships—“Bad Boy” guaranties. This Article concludes with a summary of advice for protecting a party to oil and gas contracts from the consequences of counterparty credit risk. 5. See generally ROBERTA BIGLIANI, REDUCING RISKS IN OIL AND GAS OPERATIONS (2013), available at http://www.emc.com/collateral/analyst-reports /minimizing-operational-risk-in-oil-gas-industry.pdf. 6. See 11 U.S.C. § 544 (2014). 866 LOUISIANA LAW REVIEW [Vol. 76 I. PRIORITY OF “CLAIMS” IN BANKRUPTCY The practical advice presented in this Article are responses to the treatment of “claims” in bankruptcy proceedings. Under the Bankruptcy Code, a “claim” is essentially defined as a “right to payment” or a “right to an equitable remedy for breach of performance if such breach gives rise to a right to payment.” 7 A claim is treated differently depending on its classification under the Bankruptcy Code, including whether it is, among other things, secured or unsecured. 8 The treatment of an unsecured claim in bankruptcy proceedings shows the importance of obtaining adequate security from a potential bankruptcy debtor. A claim is unsecured to the extent that the creditor has failed to obtain a valid lien or security interest to secure the value of the debtor’s obligation to the creditor. 9 In most cases, such claims will be practically worthless because there will be few assets of the debtor remaining after all higher priority claims are satisfied. 10 Claims are satisfied in accordance with a priority scheme provided by the Bankruptcy Code as supplemented by relevant state law. 11 The goal is to be at the top of the food chain, which is basically delineated as follows: 1. Owners are at the top because an ownership interest passes through bankruptcy. 12 It is best to own mineral interests or real property interests such as production payment, relinquished interest, working interest, or farmout interest. 2. Covenants running with the land are next. If the obligations can be characterized as covenant running with the land, the majority view is the counterparty cannot the reject contract in bankruptcy. 3. Generally, secured creditors (lien creditors) are entitled to the value of their collateral. 4. Administrative Claims (super-priority or general administrative) (20 day claims) are fourth. 5. Unsecured...