Oil and gas price volatility is as much a part of the energy business as drill bits. Few predicted that the current down-cycle would be as long or as deep as it is proving to be. While global events could turn and prices improve, lower prices seem to be a reality for now. Lower prices impact the finances of everyone in the energy industry. Insolvencies, business failures, and bankruptcies are inevitable in this environment; and when they occur, they affect everyone, at all levels and in all aspects of the industry. Though industry participants can’t change the price of oil, they can protect their interests in other ways. In times like this, fortune favors the prepared.

Bankruptcy Starts a Whole New Game

Bankruptcy effectively creates a new entity at the time the petition is filed — the bankruptcy estate. The bankruptcy filing freezes the debtor’s estate and sets the board for the rest of the game. Bankruptcy rules create priorities for who gets the best treatment from the limited resources of the bankruptcy estate. While the rules are complex, in general they strongly favor parties,(debtors and creditors), who take the necessary steps to protect and perfect their interests prior to the time bankruptcy is filed. Conversely, they severely penalize the complacent.

The following are a few basic rules unique to the bankruptcy game and strategies to help you come out on top.

Rules of the Bankruptcy Game

Automatic Stay

The filing of a bankruptcy petition automatically “stays” actions against the debtor, the property of the debtor, or the property of the estate. 11 U.S.C. § 362. The stay bars virtually all creditor activity against the debtor, including obtaining, perfecting or enforcing liens. It generally applies until the bankruptcy case terminates or until the Court enters an order granting a creditor’s motion to lift the stay as to particular action by a particular creditor. To obtain an order lifting the stay, the creditor must prove a ground for doing so under the Bankruptcy Code. With limited exceptions actions that violate the automatic stay are voidable and may subject the violator to actual and punitive damages.

Preferential and Fraudulent Transfer Avoidance

A trustee in bankruptcy has power to undo actions taken before the filing of the bankruptcy petition including preferential or fraudulent transfers. If you have received money or property under circumstances that constitute a preference or fraudulent transfer, you may be required to pay that money back to the bankruptcy estate. Preferential transfers include certain payments or transfers of property to creditors, while fraudulent transfers are those transfers made with the intent to hide assets or for less than fair market value.

Preferential Transfers

A transfer is preferential if it is (i) to or for the benefit of a creditor;

(ii) on account of an antecedent debt; (iii) made while the debtor is insolvent; (iv) made on or within ninety days of the petition date or within one year if the creditor at the time of the transfer was an insider; and (v) allows the creditor to receive more than the creditor would receive in liquidation.

Fraudulent Transfers

Fraudulent transfers include those that are actually fraudulent — made with “actual intent to hinder, delay or defraud” creditors and in some cases those that are constructively fraudulent if the debtor received less than “reasonably equivalent value” in exchange and was either actually insolvent on the date that such transfer was made or became insolvent as a result of such transfer. The trustee may avoid fraudulent transfers occurring up to two years prior to the filing of bankruptcy. The trustee can also apply State law, such as the Uniform Fraudulent Transfers Act or the Uniform Fraudulent Conveyances Act, to avoid certain transfers occurring even earlier.

Executory Contracts

Executory contracts, those requiring continuing performance such as JOA’s and Joint Development Agreements, can be assumed or rejected by a bankruptcy trustee. Effectively, the debtor is allowed to reject burdensome executory contracts and assume those that are to its benefit. Further, an executory contract is not enforceable against a debtor prior to its assumption, but is enforceable by the debtor. If a debtor elects to assume the benefits of an executory contract, it is required to perform all of its obligations — including remedying any unfulfilled obligations.

Winning Game Strategy

Record & Perfect Liens Early

Properly perfecting security interests should be a top priority since a secured creditor collects payment before unsecured creditors. Proper perfection of a security interest depends on state law and the type of lien and property. In most jurisdictions this includes recording an executed and acknowledged memorandum of the interest that meets state law requirements to perfect the liens and security interests; is filed in the public records of the county where the property is located; and filing a properly completed financing statement with the appropriate U.C.C. filing office. Failure to strictly follow the applicable perfection requirements may result in loss of the creditor’s secured status. Once a petition in bankruptcy is filed, the automatic stay applies to prevent perfection. A party should not wait until the eve of bankruptcy to perfect its security interest, however, since the date of a transfer for purposes of preferential avoidance will be the date of perfection. In addition to the usual routine steps taken to perfect security interests and liens, it makes sense to have your documents and filings reviewed for sufficiency at the earliest indication that the other party may have financial concerns ahead. If there is a problem, it may be possible to repair it if you act early enough.

Be Aware of Preference Periods

As simple as this sounds, stay current in accounts when dealing with a party in the zone of insolvency. As an account becomes non-current (antecedent), payments made within the preference period become subject to avoidance. Current accounts generally do not.

Setoff Early and Consider Recoupment

The right of setoff (also called “offset”) allows entities that owe each other money to apply their mutual debts against each other and avoid “the absurdity of making A pay B when B owes A.” For setoff to be available, the debts must be “mutual” (between the same parties, standing in the same capacity) and must have arisen prior to the commencement of the bankruptcy case. Setoff rights are not unlimited. If a party chooses to offset within ninety days before the date of the petition, the offset may be subject to avoidance in part and once a bankruptcy petition is filed, the automatic stay prevents a counter party from off-setting without court permission. While setoff may be unavailable post-petition, when the debts arise out of the same agreement, a counter party may be able to equitably recoup its debt. The right of recoupment is narrower than setoff rights and will depend on the facts of the case.

Withhold to Protect Against Lien Exposure

Laborers or vendors involved in the drilling, operation, or maintenance of a well generally have statutory or constitutional lien protection for the services and goods they furnish. The lien attaches to the property involved. Though a non-operator does not have a contractual relationship with a service provider or a vendor, Texas law may allow service providers, as subcontractors, to attach a mineral lien against the non-operator’s leasehold interest. However, a non-operator’s liability to the laborer is limited to the amount that the non-operator owes the operator when the notice is received. Consequently, when a non-operator receives notice of vendor or subcontractor claims, the non-operator should consider withholding payment to the operator “in the amount claimed until the debt on which the lien is based is settled or determined to be not owed.”

Remove Operator/Take-over Operations

If an operator is approaching insolvency, the non-operators may desire to step in to continue to preserve production and avoid adverse consequences. Most JOAs provide for situations, such as an operator’s inability to continue operations, under which parties to a JOA can elect a replacement. Since a JOA is an executory contract, effecting removal pre-petition will avoid significant complication in bankruptcy.

Keys to Reducing Risk

Forethought and preparation are key to successful outcomes in bankruptcy. The time to prepare for bankruptcy is before it becomes inevitable.

If bankruptcy is filed, counsel should be notified immediately. Bankruptcy cases can move very quickly with unexpected adverse consequences for creditors.