Debtor Fails in Attempt to Use Bankruptcy for Fracking Profits

Natural Gas & Electricity | Volume 31, Number 1 | August 2014

THE MONTHLY JOURNAL FOR PRODUCERS, MARKETERS, PIPELINES, DISTRIBUTORS, AND END-USERS

Anthony Michael Sabino

Prof. Anthony Michael Sabino, partner, Sabino & Sabino, P.C. (anthony.sabino@sabinolaw.com), New York, specializes in complex business litigation in the federal courts, including oil and gas law and bankruptcy matters. He is also a professor of law in the Tobin College of Business at St. John’s University, and a special adjunct professor of law at St. John’s School of Law, both in New York. Professor Sabino also serves on the board of the Nassau County (New York) Public Utility Agency.

Lately, we have, quite naturally, devoted a great deal of our writing to the paramount issue of fracking, as it resides on the cutting edge of the natural gas industry.

Today, we return to the more prosaic arena of developments in industry-related litigation, particularly in the matter of oil and gas leases. Ironically, we shall not stray too far from fracking, because it is the financial bonanza that clearly precipitated this otherwise garden-variety bankruptcy case. The case is called Tayfur v. SWEPI LP (In re Tayfur),1 and it presents a number of noteworthy facets that make it worthy of the attention of industry players.

We shall not stray too far from fracking, because it is the financial bonanza that clearly precipitated this . . . case.

We will go over just a few facts to start the ball rolling. The debtor was an individual, residing in western Pennsylvania. Pending before the court was his petition for Chapter 13 bankruptcy. The cornerstone of his insolvency case was an oil and gas lease that he had entered into nearly a decade earlier. SWEPI was the current lessee, having lawfully succeeded to the legal interests of predecessor exploration and production concerns. While it appears that the leasehold had been generally unproductive for the string of lessees, the debtor had nonetheless enjoyed various “delay rentals” and similar payments for quite some time. It appeared the debtor intended to repay his creditors with the monies coming due under the oil-and-gas (O&G) lease with SWEPI.

The debtor’s land sat astride the Marcellus Shale.

Enter fracking. As you might have guessed by now, the debtor’s land sat astride the Marcellus Shale. He apparently came to the conclusion that his current lease with SWEPI, entered into before the fracking boom, was horribly below market. It is unclear as to what other financial difficulties, if indeed any, compelled him to enter into a bankruptcy proceeding, but this much is certain: he wanted out of the SWEPI lease, so he could enter into a new accord with a lessee at current fracking-driven prices. And he chose the bankruptcy law as his means to that end.

He wanted out of the SWEPI lease…… And he chose the bankruptcy law as his means to that

end.

In order to understand what law the debtor sought to employ in his quest, a cogent primer on a few key legal niceties is our next order of business.

Chapter 13 — Reorganization for the Common Man

Industry players are nauseatingly familiar with Chapter 11 of the modern Bankruptcy Code: Enron, Dynegy, and the narrowly averted insolvency of mammoth BP, just to name a few.2 Yet the instant case presents a debtor filing under Chapter 13. Because in all likelihood this proviso is quite unfamiliar to even this sophisticated readership, a few words of explanation are in order.

Chapter 13 is the functional equivalent of Chapter 11, but its availability is strictly limited to individuals.3 Whereas businesses seek to reorganize pursuant to Chapter 11, men and women seek to do much the same in the refuge of Chapter 13. In essence, Chapter 13 is a glorified budget plan whereby individuals agree to devote the bulk of their income for a number of years to paying off their debts to a significant percentage.

Chapter 13 is a glorified budget plan whereby individuals agree to devote the bulk of their income for a number of years to paying off their debts.

Working with what is akin to a court-supervised installment plan, the debtor pays a set amount of his wages into court, and this is periodically disbursed among his creditors in order to pay down his debts. Chapter 13 is therefore best known as the “wage earner” or “regular income” chapter, signifying one of its key fundamentals: only a person earning wages or having regular income qualifies for relief under this process, and this distinguishing feature is what excludes businesses from the chapter’s province.

Applying that rubric to the current case, this debtor first qualified for Chapter 13 because he was filing bankruptcy for himself and not a business. Second, although the court’s decision is notably bereft of any mention of this debtor being a wage earner, we can presume that he intended to fund his installment payments into court with his regular income, as anticipated from the current O&G lease or its replacement.

This set of distinctions from Chapter 11 is simple enough but is critical for the reader to understand the basic functioning of Chapter 13. After all, it cannot be denied that the vast bulk of O&G lessors are regular folks, and, should they have trouble paying a bill, they are far more likely to try to leverage their monthly royalties into a successful Chapter 13 debt repayment plan than suffer an out-and-out liquidation pursuant to Chapter 7 of the Bankruptcy Code.

Having highlighted the differences between Chapter 13 and its more popular sibling, the corporate reorganization chapter, we can now explore a crucial similarity between the two.

Section 365 — Lease Rejection

Section 365 is one of the most frequently employed provisions of the modern Bankruptcy Code.4 It is found in Chapter 3 (which is why its first digit is a “3”), and thus it is one of the many statutory “tools” found in the “toolbox” of the law’s preliminary chapters.5 It has universal applicability to Chapter 7 liquidations, Chapter 11 business reorganizations, and, as we will see here, Chapter 13 individual “wage earner” cases. That being said, just what does Section 365 do?

Section 365 is one of the most frequently employed provisions of the modern Bankruptcy Code.

Section 365 hands the debtor a powerful tool to sort out its debtor-creditor relationships. It permits a debtor to seek court approval to reject, assume, or assign any “executory contract” or unexpired lease. For sake of completeness, an executory contract is an accord existing on the date of bankruptcy that has yet to be fulfilled. Our focus today is the law’s coverage of unexpired leases, which is quite self-explanatory, especially in the instant case. Thus, we will restrict the following discussion to unexpired leases, but what we are about to say is equally correct when one side to an accord files for bankruptcy and its existing contracts have yet to run their course.

Having identified what falls within Section 365’s dominion, exactly what power is bestowed upon the debtor in this regard? As a first option, a debtor can reject the unexpired lease — in sum, rid itself of a burdensome arrangement. Previewing what the debtor was attempting in the case under review, an O&G lessor can jettison a below-market lease and strike a more lucrative deal with a new lessee.

An O&G; lessor can jettison a below-market lease and strike a more lucrative deal with a new lessee.

Likewise, as a second option, a debtor can assume an unexpired lease (i.e., keep the accord in force). This tactic is the counterpoint to lease rejection: here, if you have an existing O&G lease that pays you more than you could possibly get in the current market, you keep it. That ability is lease assumption in a nutshell.

The debtor’s third option pursuant to Section 365 is to assign the unexpired lease. If you have an unexpired lease with economic value but you cannot keep it (say, you plan to close down that aspect of your operations), then you assign, that is to say, sell, the lease to another who has use for it and is willing to pay you to obtain its rights. It is an asset sale, pure and simple. Of course, the proceeds are used to pay down debt in the bankruptcy case.

Soon enough, we will see that the debtor in this case was concerned with only the first of the three options set forth above. He wished to invoke Section 365 to expressly reject the existing lease with SWEPI. The debtor proclaimed that, once freed of this below-market lease, he could enter into a new accord more accurately reflecting the higher payouts now available to lessors sitting astride the Marcellus Shale.

We have one final parameter we need to explain in order to fully appreciate the workings of Section 365. Any of these choices — rejection, assumption, or assignment — require the express approval of the bankruptcy court overseeing the debtor’s case.6 While not precisely articulated in the statute itself, it has become axiomatic that bankruptcy judges shall be guided by a standard of what is in the best interest of the debtor’s estate, typically, what shall benefit creditors most, as a gauge for bestowing court approval upon the debtor’s proposed course of action.7 As we shall see, this requirement of just cause was to play a determinative role in the instant case.

Any of these choices . . . require the express approval of the bankruptcy court.

We are almost at the point of delving into the precise contours of the court decision at hand, yet we have one last legal topic to outline. Notably, it is from a distinctly non-bankruptcy domain, but, as such, it is of possibly even greater utility to this audience.

Statute of Frauds, AKA Get It In Writing

The Statute of Frauds is one of the oldest and most sacred laws in our shared Anglo-American jurisprudence. It predates the existence of the United States itself, as it came into existence in 1677. It was originally known by a far more descriptive appellation: “A Statute Designed to Prevent Frauds and Perjuries.” (We paraphrase slightly.)

Its modern progeny are the law of the land in every one of the states.

Businesspeople may be unaware of its precise moniker within their jurisdiction, but they surely know of the law’s impact upon the conduct of everyday business. The Statute of Frauds is that law that demands the prudent and circumspect “get it in writing,” specifically for commercial deals over a de minimis sum; contracts that take more than one year to perform; and, again, vital to this case’s analysis, any contract to sell or convey an interest in real property. It is axiomatic that an oil and gas lease conveys an interest in the minerals beneath the owner’s land.

An oil and gas lease conveys an interest in the minerals beneath the owner’s land. Accordingly, such leases naturally fall well within the requirement for a signed writing.

But here is a linchpin, one of several, about the required writing. In order to be enforceable in a court of law, the lease must not only be in writing, but it also must be signed by the “party to be charged.” And precisely who is that? If you are the one seeking to enforce the lease, it is not you; you are deemed the “proponent” of the writing, and therefore your signature is an unnecessary embellishment.

Put another way, the fact you are in court seeking to uphold the accord negates the need for your signature. Thus, it is now easy to see that the mythical “parties to be charged” are “the other guys.” Because you want to “charge,” that is to say, enforce, the lease against them, their signature must grace the document. If not, you have a worthless piece of paper that no US court will give credence to.

And there you have it, citizens, the legal predicates for the court decision under discussion. As point in fact, the foregoing points of law explain the bulk of what happened in this case, and so it is with ease that we apply the law to the specific facts at hand in Tayfur. To that task, we now turn.

As a first step, the bankruptcy court had to resolve a threshold question: did the purported O&G lease here pass muster under the Statute of Frauds? After all, if the writing was insufficient as a matter of law, then neither side could enforce any legal privileges under such an inadequate document. The pivot upon which this turned was, of course, whether SWEPI, as the party to be charged, had signed the document.

Here Chief Bankruptcy Judge Jeffery Deller revealed a stunning misconception in the debtor’s legal argument. The debtor harped on the fact that he purportedly never signed the relevant document with SWEPI’s predecessor lessee. That objection missed the mark entirely, noted the court.

The debtor harped on the fact that he purportedly never signed the relevant document with SWEPI’s predecessor lessee. That missed the mark entirely.

By his mere invocation of Section 365 of the Bankruptcy Code, the debtor had irretrievably positioned himself as the proponent of the unexpired lease. Therefore he rendered it irrelevant that he had allegedly never countersigned the document. However, SWEPI (or its antecedents) had signed the original O&G lease or its ancillary accords. As the party to be charged, SWEPI’s notation verified the arrangement as enforceable. In a word, the debtor did himself in on this point.

The debtor did himself in.

Yet a subdiscussion on the Statute of Frauds aspect of this case is also illustrative for this readership, in preparation for future controversies of their own. SWEPI had not one, but several interrelated documents that,

taken as a whole, comprised the totality of the O&G arrangement here. The bankruptcy court here pulled together a number of contract law axioms, and held, in sum, that the execution of one or more parts of the whole validated its entirety. Again, proof of, among other things, the useful maxim of “incorporation by reference” — in other words, the full signatures of all parties on the principal contract makes enforceable all of the primary document’s subparts. This part of the law is especially useful in this context, as many oil and gas leases incorporate by reference schedules, exhibits, and subagreements.

Now for the key question: because the debtor and SWEPI were parties to a legally enforceable, yet unexpired, lease, could the debtor reject it pursuant to Section 365? Here Chief Bankruptcy Judge Deller turned to the precise legal standard of Section 365 and applied that maxim to the facts before him.

As mentioned, a debtor’s choice of lease rejection is subject to the bankruptcy court’s permission, said approval to be premised upon what is in the best interests of the debtor’s estate. It is therefore incumbent upon the debtor to provide evidence that its proposed course of action would ultimately benefit its estate, and, hence, its creditors.

And it was here that the debtor was found lacking.

The judge looked to these hard facts. The debtor claimed he “saw” (whatever that means) a neighbor’s oil and gas lease, which provided for the payment of $3,250 per acre and 18 percent royalties to the lessor. A supposed expert provided similar numbers, but no documentation was put into the record.

The court found that the debtor possessed, at best, an insubstantial letter from a local land manager, sketching out some “possible” interest in the entering into a new O&G lease. Notably, the potential lessee invited the debtor to make a proposal. The sum and substance, as found by the court here, was that there was no substance. Chief Bankruptcy Judge Deller specifically found there was a distinct lack of written offers from either side, and, crucially, “there was no evidence introduced at trial that there was interest on the part of any entity beyond the discussion stage.”8

The court found that the debtor possessed, at best, an insubstantial letter from a local land manager, sketching out some “possible” interest.

Clearly, the debtor was found lacking in evidence that his choice of lease rejection would be beneficial. But things were about to get worse, much worse, for him. SWEPI had called to the stand its own land manager, who testified that the debtor’s property was literally surrounded on all sides by other landowners who had leased their mineral rights to SWEPI. This isolation of the debtor’s property would make his leasehold singularly unattractive to any exploration and production company other than SWEPI.

The debtor was found lacking in evidence that his choice of lease rejection would be beneficial.

Indeed, the very possibility of fracking on his property, which has apparently motivated the debtor to try to reject his current lease in the first place, ultimately proved to be his undoing. As this readership well knows, the essence of fracking is horizontal drilling. Yet this requires a proper drilling angle, acreage, and, of course, a latticework of pipelines. SWEPI propounded evidence that it would simply be impossible for a new lessee to be able to drill profitably on the debtor’s leasehold, given the relative lack of space and the isolation of his acreage.

It would simply be impossible for a new lessee to be able to drill profitably on the debtor’s leasehold, given the relative lack of space and the isolation of his acreage.

Given such, the outcome was preordained. The court ruled that the debtor had failed to meet his burden of showing the requested rejection of his lease would benefit the estate. With the debtor’s motion denied, his present accord with the current lessee would remain in force and effect.

Takeaways

In overviewing the case, we find this otherwise prosaic controversy imparting some valuable lessons for industry participants. We break down the most significant teachings as follows.

One, while most of the industry is familiar with major corporate players filing for Chapter 11, we find in Tayfur that its analog for personal debtors, Chapter 13, is not all that different in its operation. Again, we remind that while the industry is an overwhelmingly corporate domain, it derives most of its mineral rights from regular folks who are the actual landowners, and thereby become lessors. And because even regular people sometimes seek protection in the bankruptcy court, industry players should be prepared to see some of their lessees slip into Chapter 13 proceedings.

Two, the debtor in Tayfur clearly misapprehended the meaning of the Statute of Frauds. This venerable statute is purposed to make accords enforceable in a court of law but is premised upon having the counterparty affix its signature to the relevant document. The debtor was doomed to fail, because he contradicted himself in court, for his reason of sadly misconstruing how the Statute of Frauds works.

Once he came to court as a proponent of the very lease he sought to reject, he negated any need for his own signature. Both lessors and lessees need to take these lessons to heart: if you bring a lease into court, your lack of signature is now moot. But long before you head to the courthouse, make sure the counterparty has signed the document, or, as we saw here, have a convincing body of documentation that, when reviewed as a whole, makes for a clear and binding accord, willingly entered into by both parties.

If you bring a lease into court, your lack of signature is now moot.

For our third and last lesson, please note that Section 365 is nearly universal throughout the Bankruptcy Code. Chapter 7, 11, or 13 — it makes no difference. The debtor is in the driver’s seat as to making important decisions regarding the rejection, assumption, or assignment of any unexpired lease. And a pending O&G deal fits precisely within the statute’s bailiwick.

But remember that the debtor’s final hurdle is to obtain the imprimatur of court approval for his decision to exercise any of the three options. This debtor ultimately lost, and rightly so, because he was woefully unprepared to offer convincing proof that his choice of lease rejection would inure to the benefit of the bankruptcy estate.

Conversely, the lessee opposing the motion was quite well prepared and presented contrary evidence that more than overwhelmed the debtor. This lessee did its homework, and thus won the day.

The lessee did its homework, and thus won the day.

We began this article by stating it was not about fracking, and it is not. But in truth, in the current environment, where the potential paydays from fracking the Marcellus Shale and other formations are driving parties toseriously consider if they can get a better deal elsewhere, this plain little Chapter 13 case raises a number of points crucial not only to those reviewing their current lease deals, but also to all lessors and lessees contemplating entering into similar accords in the days to come.

NOTES

505 Bankruptcy Reporter (BR) 673 (Bankr. W.D. Pa. 2014).
See Sabino, A. M., & Sabino, M. A. (2010, August). Why BP will not go bankrupt. Natural Gas & Electricity, 27(1), 18–22.
11 U.S.C. Section 1301, et
11 U.S.C. Section 365(a), et
In brief, Chapters 1, 3, and 5 of the Bankruptcy Code contain the fundamental statutes to be put in use in all bankruptcy In essence, they tell you what to do, when and where to do it, and how to do it in the operative Chapters 7, 11, and 13; hence, our metaphor of the “toolbox.”
Sabino, A. M., & Sabino, M. J. C. (1988). Restoring the necessity of timely court approval for the assumption or rejection of unexpired leases under Bankruptcy Code section 365(d)(4). Duquesne Law Review, 27, 35, 47–48 (citing cases and explaining Section 365’s legislative history).
See L.R.B. v. Bildisco & Bildisco, 465 U.S. 513, 526 (1984) (where an executory contract or unexpired lease burdens the estate, and, after careful scrutiny, a balancing of the equities favors discarding the accord, good cause is shown to grant the debtor’s request to reject the agreement), cited by Sabino, A. M. (2007). “Sound collision”: Federal labor law and the Bankruptcy Code collide in this year’s airline bankruptcies. Norton Annual Survey of Bankruptcy Law, pp. 33, 37–38 (contrasting Section 365 with its offspring, Section 1113 of the Bankruptcy Code, and the latter’s specific provisions for rejecting labor contracts).
505 BR at