Oil And Gas Cos. Must Prepare For Counterparty Bankruptcies

By Keith Aurzada, Jorge Gutierrez, Gary Johnson and Lloyd Lim
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Law360 (April 7, 2020, 4:15 PM EDT) --
Keith Aurzada
Jorge Gutierrez
Gary Johnson
Lloyd Lim
It seems like a lifetime ago that the two greatest concerns of the oil and gas industry were the slowdown in the global economy and investor demand for free cash flow. The price of a barrel of West Texas Intermediate crude was stuck in the mid-$50 range, and natural gas hovered at $2.00 per million British thermal units (and lower) for an extended period of time.

The past few weeks' events serve as a reminder that we should be grateful for what we have, because things could always get worse. The massive economic shocks from the COVID-19 pandemic and the Saudi Arabia/Russia volume and price standoff (aka the war against American shale producers) have created an unhinged market downturn, and it is unclear when a sense of normalcy will return.

The magnitude of the downturn means many U.S. producers, their midstream company counterparts and related oil field service companies will not survive. Regardless of balance sheet strength, the upstream and midstream players must prepare now for counterparties that seek bankruptcy protection while at the same time getting creative to maintain their own liquidity.

Midstream Agreements as Covenants Running With The Land

Historically, the industry believed that agreements between producers and midstream companies under which midstream companies provided gathering, processing and treatment services for oil, gas and produced water were bankruptcy-proof (i.e., the agreements could not be rejected by a debtor in bankruptcy) — because, rather than create contracts with mutual performance obligation by the parties, they created real property interests in favor of the midstream companies.[1]

More specifically, producers dedicated their oil and gas reserves in a specified area to the underlying agreement, in exchange for the midstream company's long-term investment in the infrastructure used to gather, transport and/or process the reserves. The dedication of reserves was intended to create a covenant running with the land, and was thought to convey a real property interest.

From each party's perspective, structuring midstream agreements in this manner provided benefits. Midstream companies had some assurance that they would recover their investment in infrastructure over the life of the dedicated reserves. Producers, particularly in remote areas, were assured of a reliable way to deliver their reserves to market.

The industry's historical understanding, however, was upended in 2016, when the U.S. Bankruptcy Court for the Southern District of New York held, in Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings LLC, that a producer could reject its midstream agreements under Texas law because those agreements were executory contracts that did not create real property interests (i.e., covenants running with land). The producer, therefore, was free to reject its midstream contracts, including the dedication.[2]

The Sabine decision strengthened the bargaining position of other financially distressed producers in their negotiations with midstream companies, but because it was such a dramatic departure from longstanding precedent, it created uncertainty in the industry.

In recent months, two bankruptcy courts in other jurisdictions have disagreed with Sabine, holding that the midstream agreements governed by the laws of Oklahoma and Utah create covenants running with the producer/debtor's land. These holdings constitute a return to the industry's pre-Sabine perspective that midstream contracts are not executory contracts that are subject to rejection in a bankruptcy case.[3]

Despite the conflicts in their ultimate holdings, the courts in the all three of the above referenced decisions seem to agree that the issues of whether an agreement creates a covenant running with the land, or a real property interest, is a matter of state substantive law and subject to the tests used by courts in the applicable state. For example, the Badlands agreements were interpreted under Utah law, and the Alta Mesa agreements under Oklahoma law.

Since the Oklahoma and Texas tests are substantively similar, one can argue that at least the decision of the U.S. Bankruptcy Court for the Southern District of Texas in Alta Mesa Holdings LP v. Kingfisher Midstream LLC is in conflict with Sabine. Setting that aside, in each case, three issues were dispositive: (1) whether the agreement "touched and concerned" the land; (2) whether there was privity of estate between the parties; and (3) whether the parties intended to create a covenant running with the land.

With this commonality of issues in mind, both producers and midstream companies should review their existing agreements, and determine whether a bankruptcy court would enforce or allow rejection of those agreements. If amendments are negotiable, now is the time to negotiate. If not, then at least expectations have been reality-tested.

If a midstream company is trying to bolster its covenant with the land position, at the very least it should make sure that the agreements or memoranda of the agreements have been filed in the counties included in the dedicated area. This would likely bolster the argument that the agreements create real property interests.

Consensual Liens

Producers and midstream companies also should review their material agreements to determine whether those agreements create beneficial consensual liens for them as creditors. Under a consensual lien arrangement, the debtor, by written agreement, grants a lien in favor of its creditor.

The most obvious example of a consensual lien is one granted pursuant to a deed of trust for a loan secured by real property as the collateral. Less obvious, but still common and useful, is a consensual lien granted pursuant to a master service agreement between a producer or midstream company and an oil field service company. The master service agreement may provide that the producer/midstream company grants a lien on specified assets to secure its promise to pay the service company for services rendered.

Another consensual lien is one granted under a joint operating agreement, where each working interest owner grants a lien on its respective interest in the contract area in favor of the other owners. Although this lien is primarily for the benefit of the operator, it provides a form of protection for all parties, since the unpaid expenses of the defaulting party fall to the others in proportion to their interest, and in some cases, the operator itself is the one in default.

The agreement that grants the lien, be it a master service agreement or a joint operating agreement, must be supplemented by a recordable form of financing statement and a memorandum of the underlying agreement that is executed by the parties. Then the financing statement must be recorded with the appropriate secretary of state — and the memorandum must be recorded in the real property records of the county or counties where the underlying assets are located.

The lien-granting agreement creates the lien as between the parties, and the filing of the financing statement and memorandum perfects it for the benefit of the creditor, both as against the grantor and as against third party creditors. Given a consensual lien's nature, the creditor must get the debtor's written consent to the grant, and the grant and related perfection must occur prior to the events or services that give rise to an indebtedness.

Although these up-front steps are not overly burdensome, it is not uncommon for a creditor under a consensual lien arrangement to take all of the proper steps to realize its lien except file a memorandum or financing statement in the public records. That failure renders the lien unenforceable against the property of the debtor, and results in the creditor being unsecured, a bad result in a fight against third party creditors.

The party granting the consensual lien, e.g., a producer, should verify whether the grant of such a consensual lien is allowed under any previously existing credit facility with a bank lender. If it is not allowed under the terms of its credit agreement, it must secure consent from its lender prior to granting such a lien, or allowing a creditor to perfect the lien.

Judgment Liens

If a producer or midstream company, as creditor, is owed money by a counterparty that has not sought bankruptcy protection, the creditor may seek to obtain a judgment lien against the debtor. To obtain a judgment lien, the creditor must first sue the debtor and obtain a judgment for the unpaid obligation.

The creditor can then record an abstract of judgment against the debtor in the county or counties where the debtor has property. Once filed, the abstract of judgment creates a lien on the nonexempt real property of the debtor located in that county.

In contrast to statutory mineral liens under Texas law, the judgment lien does not relate back in time to the inception of the work or the services provided for purposes of determining the lien's priority. Instead, the date that the judgment is abstracted determines its priority relative to other creditors of the debtor. Thus, a judgment lien will rank behind a secured creditor's lien that was properly filed before the judgment debtor recorded the abstract of judgment.

Nevertheless, the judgment lien provides the creditor with the potential to obtain a lien on a larger pool of the debtor's assets located in counties throughout the state. The potential additional protection provided by a perfected judgement lien, however, may not materialize if the debtor counterparty files for bankruptcy.

More specifically, if a bankruptcy case is filed within 90 days of the perfection of the judgment lien, the debtor or case trustee may be able to avoid such lien as a preferential transfer to the extent that the debtor is insolvent, and the lien enables the creditor to obtain a larger recovery from the debtor than it would have in a Chapter 7 liquidation without the benefit of the lien.[4]

Accordingly, a creditor is best served by perfecting a judgment lien as soon as possible after obtaining a judgment against the debtor, to start the clock on the 90-day preference period — in the hope that such preference period expires prior to the debtor counterparty filing for bankruptcy.

Mineral Liens

The property code of most mineral-producing states provides for statutory liens for the benefit of persons who provide labor or perform services related to "mineral activities." Generally, mineral liens are utilized for the benefit of service companies providing a service to a producer.

Depending on the circumstances, a midstream company also may be entitled to perfect a mineral lien. Since the substantive law of each state varies, practitioners and clients must consult the law in the relevant state to determine the client's rights.

Because mineral liens are creatures of state statutes, the process of determining whether a creditor is entitled to such a lien and the procedure for perfecting it varies, and many times the regimes are complex. The threshold question typically is whether the creditor is a "mineral contractor" or "mineral subcontractor," since the mineral lien statutes target those categories of beneficiaries.

The applicable statutes typically define both terms, but it may be necessary to refer to case law to determine the creditor's status as a contractor or subcontractor. In addition, the nature of the work or labor performed must be in relation to the statutorily-defined term "mineral activities," which in Texas means "digging, drilling, torpedoing, operating, completing, maintaining, or repairing an oil, gas, or water well, an oil or gas pipeline, or a mine or quarry."[5]

This definition is so broad, that in most cases there will be no question that the services at issue constitute mineral activities. The general proposition is that the materials and labor must facilitate the potential production of oil and gas.

Once a creditor has determined that it is a mineral contractor or subcontractor, and that the nature of the work it performed related to mineral activities, the creditor can then undertake the statutorily-prescribed procedures to perfect its mineral lien.[6] This includes the contents of the required notice and affidavits that must be given to the debtor or the property owner (in the context of mineral subcontractors), and the deadlines for delivering same.

Failure to follow these procedures may result in the lien being unenforceable both in and outside of bankruptcy court. Should a bankruptcy be filed, lienholders may file liens after the filing of the bankruptcy under certain circumstances.

For example, if the interest in real property arose prior to the petition date, then liens may be perfected post-petition. This is a state-specific analysis, but is generally authorized by Section 546(b)(1) of the Bankruptcy Code.

Additional Practical Considerations

In the case of consensual liens, mineral liens and judgment liens, the applicable creditor should confirm whether it has taken all the actions necessary to obtain and perfect its lien. If necessary, this review should include a search of the public records to confirm that the appropriate instrument has been filed of record with the proper governmental authority.

With respect to midstream agreements, midstream companies should thoroughly analyze their contracts to determine if any revisions should be incorporated in amended agreements. Additionally, they should ensure that a memorandum of the underlying midstream agreement is filed in the public records of the county where the oil and gas interests are located.

A producer or midstream company that is owed money on an unsecured basis should promptly determine whether it wants to pursue a judgement lien, especially if it appears the debtor may seek bankruptcy protection. Given the time required to obtain a judgment against a defaulting debtor, the producer/midstream company creditor must quickly commence the litigation process, if it wants to improve the likelihood of converting its unsecured claim to a secured claim under a judgment lien.

Moreover, once a judgment is obtained, the creditor must move quickly to perfect its judgment lien, in order to minimize the possibility that such lien is avoided as a preferential transfer if the judgment debtor files for bankruptcy.

A mineral lien creditor must carefully analyze the standing of each party and the dates that services were performed. The outcome of that analysis will determine the detailed procedures the creditor must follow to perfect the lien.

Keith M. Aurzada, Jorge I. Gutierrez, Gary C. Johnson and Lloyd A. Lim are partners at Reed Smith LLP.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] See 11 U.S.C. § 365(a) (providing that a debtor may reject executory contracts); Alta Mesa Holdings LP v. Kingfisher Midstream LLC (In re Alta Mesa Res. Inc.) , Nos. 19-35133, 19-03609, 2019 Bankr. LEXIS 3859 (Bankr. S.D. Tex. 2019).

[2] Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings LLC (In re Sabine Oil & Gas Corp.) , 550 B.R. 59 (Bankr. S.D.N.Y. 2016).

[3] See In re Alta Mesa Res. Inc., 2019 Bankr. LEXIS 3859; Monarch Midstream LLC v. Badlands Prod. Co. (In re Badlands Energy Inc.) , 608 B.R. 854 (Bankr. D. Colo. 2019).

[4] See 11 U.S.C. § 547(b) (setting forth the elements a preferential transfer); Cullen Ctr. Bank & Trust v. Hensley (In re Criswell) , 102 F.3d 1411, 1415 (5th Cir. 1997) (holding that the perfection of a judgment lien within the 90 days period prior to the debtor filing for bankruptcy constituted a preference under Section 547 of the bankruptcy code).

[5] Tex. Prop. Code § 56.001(1).

[6] Tex. Prop. Code § 56.001 et seq.

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