Due Diligence

Top Leases: Assessing (and Avoiding) the Risks of Novation

You only have three more months on the primary term of an oil and gas lease that was issued nearly five years ago with a 1/6th royalty.  A drilling permit should be issued any day now, and you anticipate commencing operations to drill a well in sufficient time to hold the lease.  You instruct your landman to obtain a top lease from the mineral owner just in case there is a hiccup and you can’t start operations in time to hold the existing lease. Your landman negotiates a new lease from the mineral owner covering the same lands but has to agree to a 3/16ths royalty in order to obtain the top lease.  But, the top lease fails to expressly state that it is a top lease to the existing lease and doesn’t contain any other language clarifying that the top lease will only be effective if and when the underlying existing lease expires.  Despite the precautionary top lease, the well permit is issued when expected and you are able to commence drilling a well in time to hold the prior existing lease.

After the well is drilled and completed, is there a risk that the mineral owner could successfully argue that the new top lease is a replacement of the existing lease and you are required to pay a 3/16ths royalty instead of a 1/6th royalty? In the oil and gas industry, you often hear landmen and attorneys frame the question as whether or not the top lease will be deemed a “novation” of the prior existing lease. But what is the standard to prove a novation? How likely is it that the mineral owner above could successfully argue that the top lease is a novation of the prior lease, even though the well was drilled in time to hold the prior existing lease? This article will provide a brief overview of the elements and burden of proof to establish a novation.

A recent 2015 case out of Pennsylvania provides an excellent overview and example of the novation analysis in the context of oil and gas leases. In Mason v. Range Resources-Appalachia LLC, 120 F. Supp. 3d 425, 433 (W.D. Pa. 2015), an oil and gas lease was issued in 1961 in Western Pennsylvania and was arguably held by gas storage operations on the property (and by the payment of rentals). Years later, during the Marcellus shale boom, a landman working for Range Resources obtained an oil and gas lease in 2007 from the same mineral owners and covering the same lands as the 1961 lease. Range Resources only later discovered that it already owned the existing 1961 lease. Testimony in the case indicated that the leasing environment at that time was “chaotic,” that Range Resources did not have a good process for evaluating lease validity, and that landmen were taking leases without conducting complete due diligence of possible existing leases. Range Resources did not drill a well within the term of the 2007 lease, and the mineral owners asserted that the 2007 lease was a novation of the 1961 lease (which had unique provisions allowing the lease to be held by rental payments for gas storage), and that the 2007 lease then expired.

The Pennsylvania court set forth four elements to show a novation, which elements are the same or similar in other jurisdictions that have undertaken a discussion of novation:

“(1) the displacement and extinction of a prior contract, (2) the substitution of a valid new contract for the prior contract, (3) sufficient legal consideration for the new contract, and (4) the consent of the parties.”1

The Pennsylvania court further stated that “whether a contract has the effect of a novation primarily depends upon the parties’ intent” and “the party claiming the existence of a novation bears the burden of demonstrating the parties had a meeting of the minds.” The court stated that evidence of the parties’ intent to enter in to a novation can be shown “by other writings, or by words, or by conduct, or by all three.” Courts in other states have similarly emphasized that a party claiming a novation has the burden of proof, and that the party asserting the claim of novation has the burden of proving all of the required elements for a novation.2 A novation is never presumed. Instead the presumption is that the new contract was taken conditionally or as additional security, absent evidence of intention to the contrary.3 In the Pennsylvania case, the court determined that the mineral owners continued to accept rentals under the 1961 lease even during the term of the 2007 lease, and there was no evidence that the parties expressly intended to replace the 1961 lease with the 2007 lease.

Returning to our example above, the case law suggests that a mineral owner attempting to argue that the top lease was a novation of the base lease would have a very challenging case. But there is still a risk of such a claim, even if the claim is ultimately for nuisance value only. How can an operator protect itself from novation claims? Obviously, the best approach is to always put language in any top lease that makes it clear that the lease will only go into effect if and when the base lease expires by its terms, and make that intent clear in any other written correspondence to a landowner (such as an initial offer letter).

But what if an operator accidentally obtains a standard lease with no top lease language when it already owns an existing lease? For drilling purposes, the mineral interest will be leased either way. But an operator should ideally take steps to address any ambiguity resulting from the top lease and clarify the intent of the parties. If the well is successfully completed in time to hold the existing lease, the best approach would be to have the mineral owner (and operator) sign and record a ratification document where the parties acknowledge that the base lease was held by the drilling of the well, and that the top lease will remain of record as a top lease only in the event the well ceases operations.

Another approach (with attendant risks) would be to send an informative letter to a landowner prior to drilling, informing them of the pending well, stating that the operator will deem the base lease as held by the drilling of the well. That would at least set up an estoppel argument, and the operator will know prior to drilling the well whether or not the landowner objects and claims a novation. Or, an operator may simply pay proceeds on the prior existing lease, see if the landowner accepts royalty payments under that lease, and simply run the risk of a future novation claim. There may also be facts that make an operator more confident that a novation argument will be unsuccessful that justifies a riskier wait-and-see approach.4

Each fact scenario will be different, and an oil and gas lessee must evaluate the facts and risks to determine what level of clarification and curative action it requires to address risks of novation claims when there are overlapping leases.

1 Another novation case in the oil and gas context, Warrior Drilling & Eng’g Co. v. King, 446 So. 2d 31, 33-34 (Ala. 1984), framed the elements as: “[T]o establish a novation there must be: (1) a previous valid obligation, (2) an agreement of the parties thereto to a new contract or obligation, (3) an agreement that is an extinguishment of the old contract or obligation, and (4) the new contract or obligation must be a valid one between the parties thereto.”
2 In re United Display & Box, Inc., 198 B.R. 829, 831 (Bankr. M.D. Fla. 1996). See also Fusco v. City of Union City, 618 A.2d 914 (App. Div. 1993); Alexander v. Angel, 236 P.2d 561 (1951); Scott v. Bank of Coushatta, 512 So. 2d 356 (La. 1987); Credit Bureaus Adjustment Dep’t, Inc. v. Cox Bros., 295 P.2d 1107 (1956).
3 For example, a Utah court conducting a novation analysis stated: “The burden of proof as to a novation by the transaction in question rests upon the party who asserts it; … an intention to effect a novation will not be presumed; … in the absence of evidence indicating a contrary intention, it will be presumed, prima facie, that the new obligation was accepted merely as additional or collateral security, or conditionally, subject to the payment thereof; and the intention to effect a novation must be clearly shown.” First Am. Commerce v. Washington Mut., 743 P.2d 1193 (Utah 1987); see also Tri-State Oil Tool Indus., Inc. v. EMC Energies, Inc., 561 P.2d 714, 716 (Wyo. 1977).
4 For example, if the existing lease covers multiple parcels in several drilling units, and the new lease only covers one parcel, that may make an argument for a novation more difficult. Also, if there are unrecorded documents that evidence clear intent that the second lease was intended only as a top lease, that fact may make an operator more confident that a novation claim would be unsuccessful.

Unitizing the Lessor’s Interest: No, It’s Not the Same as Pooling

The terms “pooling” and “unitization” are often used interchangeably, but they have different meanings. Pooling is “the bringing together of small tracts sufficient for the granting of a well permit under applicable spacing rules,” while unitization is “the joint operation of all or some portion of a producing reservoir.”[1] While pooling and unitization are both used to prevent waste and protect correlative rights,[2] unitization works on a much larger scale, allowing an operator to maximize the amount of resources extracted from an entire field or reservoir, without regard to lease or property boundaries. Generally, the lessee of a fee (private) oil and gas lease is free to commit its working interest to the unit agreement, but the lessee can only commit the lessor’s interest through voluntary ratification, compulsory unitization, or a unitization clause. This article will focus specifically on the third option: the unitization clause in fee leases.

Unitization clauses (if included at all) generally follow two patterns. First, the unitization clause may be interwoven into the pooling clause. Second, the unitization clause may appear separately, often immediately following the pooling clause (we believe this to be the preferred method). There are typically four parts to a “standard” unitization clause.

Part One – When can the lessee unitize the lessor’s interest?

Example: Lessee shall have the right to unitize, pool, or combine all or any part of the leased premises with other lands in the same general area by entering into a cooperative or unit plan of development approved by any governmental authority.

The unitization clause should expressly grant to the lessee the authority to unitize the leased premises under a cooperative or unit plan of development. Depending on the type of unit being formed (for example, a federal exploratory unit or a state voluntary unit), the language should be broad enough to cover the proposed plan of development. Because the lessee may not know its future unitization plans at the time it negotiates a lease, the lessee should ensure that the unitization clause is broad enough to cover all forms of unitization.[3]

Even with a unitization clause, the lessee has an implied duty of good faith and fair dealing when pooling or unitizing a fee oil and gas lease.[4] This means that the lessee should be careful when attempting to commit a lease that is about to expire or includes non-productive lands, or when the lessee’s economic interests are not aligned with those of the lessor. However, if the unit plan of development is approved by a governmental entity (such as the BLM or the state conservation commission), courts will generally defer to the government’s approval in determining whether the lessee acted in good faith.[5]

Unfortunately, when describing how the leased premises can be unitized with other lands, it is not uncommon to find combined pooling/unitization clauses where the lessee mistakenly used pooling language (such as “into a drilling or spacing unit in conformance with a state drilling or spacing order”) instead of replacing it with unitization language (such as “to one or more unit plans or agreements for the cooperative development or operation of one or more oil and/or gas reservoirs or portions thereof”).

Properly drafted unitization clauses should cover the development of a field or reservoir as opposed to just those lands within a single drilling or spacing unit.

Part Two – How will the terms of the lease be affected?

Example: When such a commitment is made, this lease shall be subject to the terms and conditions of the unit plan or agreement and this lease shall not terminate or expire during the life of such plan or agreement.

To effectively extend the lease under the unit plan of development, the lease terms should be amended to conform to those of the unit agreement. This can be done either by having the lessor ratify the unit agreement or by including express language to that effect (such as described above) in the unitization clause. This will ensure that the lease won’t expire while the operator of the unit is actively engaged in drilling operations under the unit agreement.

Conforming the lease to the unit agreement may not be the end of the analysis in terms of lease extension. Specifically, all or a portion of the leased premises could still expire if the lease contains a severance provision in the unitization clause or a separate Pugh clause. A severance provision in a unitization clause could result in lease expiration as to any non-unitized lands at the end of the primary term. For example:

Anything in this lease to the contrary notwithstanding, actual drilling on, or production from, any unit or units (formed by private agreement or by any State or Federal governmental authority, or otherwise) embracing both lands herein leased and other land, shall maintain this lease in force only as to that portion of Lessor’s land included in such unit or units, whether or not said drilling or production is on or from the leased premises.

Similarly, a Pugh clause could result in lease expiration as to any non-producing lands at the end of the primary term. For example:

Notwithstanding any provision to the contrary, this lease shall terminate at the end of the primary term or any extended term, as to all the leased land except those lands within a production or spacing unit prescribed by law or administrative authority on which is located a well producing or capable of producing oil and/or gas or lands on which Lessee is engaged in drilling or reworking operations.

The threat posed by either of these provisions requires careful review of the lease as a whole. Oftentimes, Pugh clauses are negotiated independently of the general lease terms and ultimately included on an addendum attached to the lease. As a result, they are not always consistent with the other terms of the lease. To avoid ambiguity, when negotiating a fee oil and gas lease, it is prudent to review any included Pugh clause (and all other lease terms) and consider how it will reconcile with the unitization clause. Ideally, the Pugh clause should only result in lease expiration as to those lands outside of an approved unit. However, at a minimum, the Pugh clause should be drafted (or amended) so as to not sever the lands within a unit production area (for example, a participating area in a federal exploratory unit).

Part Three – How will the lessor’s royalty interest be calculated?

Example: Where there is production on any particular tract of land covered by such plan, it shall be regarded as having been produced from the particular tract of land to which it is allocated and not to any other tract of land and the Lessor’s royalty interest shall be based upon production only as so allocated.

Generally, a pooling clause will allow the leased premises to be combined with other lands to form a drilling unit, wherein proceeds from production anywhere on the drilling unit are allocated according to the percentage of the acreage of each tract divided by the total acreage of the drilling unit. However, because units are concerned with the development of a field or reservoir, the unitization clause should provide that proceeds from production should only be allocated to that tract included in a unit production area (such as a participating area in a federal exploratory unit). In other words, if the lessor’s interest is properly committed to a cooperative or unit plan of development, production anywhere on the unit will hold the lease, but the lessor will only receive proceeds from production if its tract is included in a unit production area containing a producing well (not the drilling or spacing unit that would exist if the well was drilled outside of the unit).

So what happens if the lessee’s working interest is committed to the unit agreement, but the lessor’s royalty interest is not? While the lessee will be allocated proceeds according to its proportionate share of the unit production area, the lessor will be allocated proceeds on a leasehold basis. This can result in a windfall either for the lessor or the lessee (compare the allocation of proceeds from the 1H and 2H wells in the diagram to the right, assuming 320 acre standup spacing units).

Part Four – How can the lessee commit the lessor’s interest?

Example: Lessor shall formally express Lessor’s consent to any cooperative or unit plan of development by executing the same upon request of Lessee.

The mechanism for the lessee to commit the lessor’s interest to a cooperative or unit plan of development varies depending on the unitization clause. Many unitization clauses allow the lessee to unilaterally commit the lessor’s interest by executing the unit agreement. In some cases, such unitization clauses require the lessee to record a memorandum of the unit agreement. Other unitization clauses, such as the example above, require the lessor to formally consent to the unit plan of development when requested by the lessee. This is typically done by executing a ratification of the unit agreement. In any event, the agency administering the unit (for example, the BLM for a federal exploratory unit) may need to confirm the commitment status of the fee lessor. As such, and to avoid a potential dispute down the road, the lessee may decide to obtain the lessor’s ratification of the unit agreement, even if the terms of the lease do not require it.

Unitization Clause Checklist:

  • ✓ Is there a unitization clause?
  • ✓ Does the unitization clause cover the proposed type of unit?
  • ✓ Does the unitization clause allow the leased premises to be combined with other lands for the development of a field or reservoir (as opposed to a single drilling unit)?
  • ✓ Does the unitization clause amend the lease terms to those of the unit agreement?
  • ✓ If there is a severance provision in the unitization clause, will it impact the proposed operations?
  • ✓ If the lease contains a Pugh clause, is it consistent with the unitization clause? Will it impact the proposed operations?
  • ✓ Does the unitization clause allocate proceeds from production within the unit production area (as opposed to a drilling or spacing unit)?
  • ✓ Will the proposed unitization plan be exercised in good faith?
  • ✓ If required, did the lessor execute a ratification of the unit agreement? Was it recorded?

[1] Williams & Meyers, The Law of Oil and Gas, § 8-U.
[2] In Utah, for example, correlative rights are defined as “the opportunity of each owner in a pool to produce his just and equitable share of the oil and gas in the pool without waste.” Utah Code Ann. § 40-6-2(2).
[3] See, e.g., Trans-Western Petroleum, Inc. v. U.S. Gypsum Co., 584 F.3d 988 (10th Cir. 2009).
[4] See, generally, Williams & Meyers, The Law of Pooling and Unitization § 8.06.
[5] See Amoco Prod. Co. v. Heimann, 904 F.2d 1405 (10th Cir. 1990).

David Hatch and Andrew LeMieux

Utilizing Online Resources to Save Time: A Primer for Landmen and Title Examiners

Advances in technology save everyone time. We all look to technology to organize and inform our daily lives in both professional and personal settings. How can technology be used to save time when dealing with common title issues? Something as simple as knowing where to obtain a patent or how to determine potential heirs can save a landman time and avoid unnecessary questions and research.

There is a vast amount of title information available online, but knowing where to find it is half the battle. This article provides a brief summary of some of the best online resources available to landmen. These websites1 provide materials ranging from oil and gas plats to well production records, which can be used to form a more complete and accurate picture of the land and title issues being examined.

Because most land ownership in the Western United States originated with the federal government, a good place to start is with the Bureau of Land Management (“BLM”) website2, regardless of the current ownership of the land. The BLM website provides land patents, surveys, master title and oil and gas plats, and historical indices for a select group of states:

  • Official BLM Patents are particularly useful to confirm federal reservations.
  • Survey plats can be used to track changes in legal descriptions.
  • Plats provide a visual representation and depict the current uses on those lands in a given township and range.
  • Historical indices provide a ledger-like record of all uses that have occurred in a given township and range.

However, land status records for a few of the Western states are maintained separately on the respective BLM state office’s website.3 See the BLM website for more information regarding the availability of these records.

In addition, geographic reports with accompanying serial register pages are available through the Bureau of Land Management Land & Mineral Legacy Rehost 2000 System (“LR-2000”) website4. These reports can be obtained by searching lands by township, range, and section. Geographic reports provide a list of all uses, including mining claims, federal leases, right-of-ways, and communitization agreements for a designated geographic area and will provide the BLM internal serial number for each use. Once you have the serial number, an accompanying serial register page which is available for both inactive and active uses provides more detailed information pertaining to each use.

The next source of valuable information is the state entity tasked with regulating oil and gas. Various oil and gas records can be found on state oil and gas commission websites:

Unfortunately, most states have unique websites that require a little patience to navigate. Also, some states do not provide older production records online. Although it is easier to search in some states than others, most states also provide spacing and pooling orders. These records are helpful to find detailed information on a well or to determine whether a lease has been properly held by production.

Individual county resources available online can vary greatly. Fortunately, more and more counties are providing online parcel viewers, often with aerial maps, which can be used to give a visual representation of the land, surface parcel boundaries, parcel acreage, roads, railroads, utilities, and bodies of water. Most county websites at least provide the status of property taxes which can help confirm surface ownership, while other counties provide additional resources through a paid subscription service.

You may also need to research corporate status or history of an entity. Every state has an entity that regulates the corporations registered in the state5 with a range of information that can be obtained regarding a business entity including (but not limited to) officers, addresses, and formation dates. One type of data that is typically available from these Secretary of State sites, but often requires a fee, is the corporate succession. However, there are other online resources that are free and easier to use. For example, the BLM Wyoming website offers the Corporate Name Change & Mergers Index6 and the National Association of Division Order Analysts maintains a mergers and acquisitions database as well.7 In the event a landman is faced with a gap in title between two entities, these resources particularly helpful to confirm whether an entity has merged or changed its name.

In addition to government sponsored websites, there are also some private sites that can be useful, especially in the area of genealogy. Genealogical research may be required for various title curative issues that may arise, including determining potential heirs, or confirming the death of a join tenant. There are many helpful resources online to troubleshoot these issues, including GenealogyBank.com8, a subscription-based service with a database of 6,500 newspapers which can aide in the search for an obituary or death notice. In addition, Ancestry.com9 can be used for a more intense, subscription-based genealogical search for census records, birth and death certificates, and other historical documents like military and marriage records.

These easy to access records can save time and money when dealing with basic title issues that arise at the outset of many, often time-sensitive, title projects.

1Many of these online resources limit their liability regarding the accuracy of the information provided.
3For example, Nevada and Wyoming.
5Colorado, Delaware, Montana, New Mexico, North Dakota, Utah, Wyoming.
6 http://www.blm.gov/wy/st/en/resources/public_room/corporate_list.html.

Exercising Rights to Setoff and Recoupment in Bankruptcy

Current market conditions are straining business relationships in the oil and gas industry. In a growing number of cases, distressed companies are seeking chapter 11 bankruptcy protection. In that event, a creditor-debtor relationship is formed between the bankrupt company and the performing partner. For example, in the context of a joint operating agreement, an operator (the performing partner) may seek to recapture drilling costs from a non-operator (the bankrupt company). In these bankruptcy cases, the performing partner should consider its ability to offset debts with the bankrupt company through “setoff” or “recoupment”.

Setoff is simply a creditor’s right to offset mutual debts. Setoff is captured in Section 553(a) of the Bankruptcy Code, which preserves a creditor’s right to offset the mutual debts of the creditor and debtor provided that both debts (the debt owed by the creditor to the debtor and the debt owed by the debtor to the creditor) 1) arose before commencement of the bankruptcy case and 2) are mutual, meaning that both parties owe a debt to the other.1 The mutual debt need not, however, arise out of the same transaction in order for setoff to be available under the statute. 2 In fact, debts subject to setoff generally arise from different transactions.3

For example, A and B are jointly developing two wells and A is the operator of the wells. One well, called Boom, is producing, but the other, called Bust, is not. Boom generates $500,000 a month in revenue, but B owes A $1 million for B’s share of operating costs on Bust. In this case, setoff may allow A to withhold B’s share of revenue from Boom and credit it to B’s unpaid costs from Bust. This is because the purpose of setoff is to avoid “the absurdity of making A pay B when B owes A.”4

Setoff is limited in three ways. First, setoff is not a right created by the Bankruptcy Code.5 While Section 553(a) preserves a right to setoff, that right must first exist under “applicable non-bankruptcy law” (e.g. state law).6 Second, unlike recoupment (discussed below), a creditor can only offset pre-bankruptcy (pre-petition) debts. In other words, a creditor cannot use setoff to recover a pre-bankruptcy debt out of post-bankruptcy (post-petition) payments owed to the debtor.7 Third, a creditor’s right to setoff is automatically stayed (i.e. suspended) when a debtor files for bankruptcy protection.8 Creditors seeking to setoff must first obtain relief from the automatic stay imposed by Section 362(a) of the Bankruptcy Code and should consult bankruptcy counsel to assist in that effort.

Recoupment is similar to setoff in that it recognizes the basic inequities of allowing a debtor to enjoy the benefits of a transaction without also meeting its obligations.9 But, recoupment only permits a creditor to withhold funds to offset debts arising from the same transaction.10 Claims arise from the “same transaction” when both debts arise out of a single, integrated contract or similar transaction, such as a joint operating agreement.11

For example, A operates a well and B is a non-operator with an obligation to reimburse A for 25% of the drilling costs. A incurs $1,000,000 in costs and B fails to pay its $250,000 share. If B files for bankruptcy protection, then A has a $250,000 claim against the bankruptcy estate. In this case, recoupment may allow A to withhold B’s revenues from the well and credit the revenues against the costs incurred by A. This example illustrates how recoupment functions like a security interest in that it grants priority to a creditor’s claim in the bankruptcy estate, provided that the estate has a claim against the creditor arising from the “same transaction” as the creditor’s claim.12

Recoupment has certain benefits that are unavailable under setoff. First, a creditor can exercise its right to recoupment without regard to the timing and other requirements of Section 553 of the Bankruptcy Code.13 Second, recoupment allows a creditor to recover a pre-bankruptcy debt out of post-bankruptcy payments owed to the debtor.14 Third, a creditor who properly exercises its right to recoupment will not violate the automatic stay imposed by Section 362(a) of the Bankruptcy Code.15 However, a creditor may wish to seek relief from stay to clarify its right to exercise recoupment and to avoid any uncertainty about the amount the creditor can recoup. Bankruptcy counsel can help a creditor analyze its right of recoupment and assist in seeking relief from the automatic stay.

111 U.S.C. § 553(a).
2In re Davidovich, 901 F.2d 1533, 1537 (10th Cir. 1990).
3Conoco, Inc. v. Styler (In re Peterson Distrib.), 82 F.3d 956, 959 (10th Cir. 1996).
4Citizens Bank v. Strumpf, 516 U.S. 16, 18 (1995).
7See 11 U.S.C. § 553(a).
811 U.S.C. § 362(a)(7).
9Peterson Distrib., 82 F.3d at 960.
10In re Adamic, 291 B.R. 175, 181-82 (Bankr. D. Colo. 2003).
11Davidovich, 901 F.2d at 1538.
12Peterson Distrib., 82 F.3d at 960.
13Davidovich, 901 F.2d at 1537.
14Beaumont v. VA (In re Beaumont), 586 F.3d 776, 780 (10th Cir. 2009).
15Id. at 777.

Fraudulent Transfer Risks in Oil and Gas Transactions

Over the past few months, the economics of the oil and gas industry have changed dramatically. As oil and gas prices have fallen, so too have profit margins and working capital. Many companies will weather this storm. A fortunate few will expand their positions and acquire additional assets, some of which will be purchased from distressed companies. In dealing with these distressed companies and their assets, landmen and other oil and gas industry professionals will need to have a working-knowledge of select bankruptcy-related laws and concepts to protect their company’s assets. In this article, we will discuss one aspect of relevant bankruptcy law: fraudulent transfers and how they may affect property transactions.1

What is a fraudulent transfer?

When a company files for bankruptcy, the bankruptcy trustee may avoid any fraudulent transfer of property made within four years of filing in most states, if certain conditions are met. Fraudulent transfers occur when: (1) there was an intent to hinder, delay, or defraud creditors; or (2) the debtor transfers property without receiving “reasonably equivalent value” in exchange for the transfer and is insolvent at the time of the transfer, becomes insolvent as a result of the transfer, or is left with an unreasonably small amount of capital to operate its business as a result of the transfer.2 If a transaction is deemed to be a fraudulent transfer, the bankruptcy trustee can recover the property or obtain a judgment for the value of the property.

The first type of fraudulent transfer involves an actual intent to defraud and is more easily identified. For example, in In re Tronox, a court found that a debtor transferred property with environmental liabilities with an intent to hinder, delay, or defraud creditors through a spinoff.3 In another case, In re ASARCO, a court found that the debtor hindered and delayed creditors by directing all of the consideration from a sale of a majority of a mining entity to one of the Debtor’s creditors, to the detriment of other creditors.4 These situations usually involve related parties.

The second type of fraudulent transfer, commonly referred to as a constructively fraudulent transfer, occurs when a company purchases an asset without paying reasonably equivalent value. This can occur when purchasing assets from a third party or, more commonly, when buying-out a partner to resolve a debt or other obligation. If the seller files for bankruptcy subsequent to the transaction, there is a risk that the bankruptcy trustee could seek to have the transaction declared to be a fraudulent transfer.

In determining “reasonably equivalent value” a bankruptcy court looks at the totality of the circumstances. Fraudulent transfer laws are designed to preserve the assets of the debtor for the benefit of creditors. When carrying out this intent, courts disregard the form of a transaction and look “instead to its substance.”5 Fraudulent conveyance law is “designed to protect creditors’ rights” and looks at transactions from “the perspective of creditors.” 6 Whether a purchaser paid reasonably equivalent value is a subjective question that depends on the facts of each individual situation.

What does this mean for landmen?

Oil and gas professionals should be aware of the risks of acquiring property from distressed companies. To avoid constructively fraudulent transfers, a purchaser should ensure that they are giving “reasonably equivalent value” for the asset. This can be difficult. Under certain circumstances, when the value of the property is enhanced by the buyer after the sale closes (through drilling or other development) the debtor may later contend that the buyer failed to pay reasonably equivalent value.

The best way to determine “reasonably equivalent value” when dealing with a distressed company is to obtain an appraisal from an independent third party. If an appraisal is not cost-effective or is impractical, the risk of a fraudulent transfer can be mitigated by conducting proper due diligence.

An awareness of the financial health of the companies you are doing business with is as important as ever. By evaluating the transaction now, you can avoid problems down the road.

1There are many tools that an oil and gas company can use to mitigate its exposure to bankruptcy risks. A full discussion of all the tools is beyond the scope of this article. If you have questions on how to mitigate bankruptcy risks, or if a business partner files for bankruptcy, we advise you to contact a bankruptcy expert immediately to protect your assets.
2 See 11 U.S.C. § 548.
3 In re Tronox Inc., 429 B.R. 73 (Bankr. S.D.N.Y. 2010).
4 See In re ASARCO, L.L.C, 702 F.3d 250 (5th Cir. 2012).
5 In re HBE Leasing Corp. v. Frank, 48 F.3d 623, 638 (2d Cir.1995) (construing the New York’s fraudulent conveyance statute).
6In re Crowthers McCall Pattern, Inc., 129 B.R. 992, 998 (S.D.N.Y.1991).