Law360, New York (April 19, 2016, 11:28 AM ET) -- The crash in oil prices has reverberated throughout the industry and is widely expected to lead to a wave of bankruptcies among oil and gas producers (particularly the small to midsize companies that have played a major role in the boom in shale production in North America). Less well-recognized, until recently, is the prospect that these producer bankruptcies may soon affect oil pipeline companies that built new infrastructure, relying on long-term ship-or-pay contracts with the producers.

Over the past 10 years, oil pipelines have invested billions of dollars to reconfigure the pipeline network that carries crude oil from production areas to refining centers as well as petroleum products from refineries to end markets. Most of these projects have been secured by long-term transportation services agreements (TSAs) entered into by producers and marketers that commit themselves to ship a defined volume on the pipeline or else pay a deficiency fee for failing to ship the committed volume. To satisfy the regulatory policies of the Federal Energy Regulatory Commission, these TSAs are generally offered on standard terms through an open season process in which any interested party may participate. Typically, the key terms of the TSA are then approved by the FERC through issuance of a declaratory order. The FERC has repeatedly ruled that the shippers that sign TSAs are bound by the contract and therefore cannot argue for lower tariff rates on committed volumes that would be inconsistent with the terms of the TSA.

A risk exists, however, that if a shipper (such as an oil producer) goes into bankruptcy, it may attempt to reject the TSA on a prospective basis, thus depriving the pipeline of the assured stream of revenue represented by the TSA. Section 365(a) of the Bankruptcy Code generally allows a bankrupt debtor to disavow or “reject” any existing contract that calls for future performance by both the debtor and its counterparty — an “executory” contract. The code deems such a rejection to be a breach of the contract and allows the counterparty a claim for damages. But, unless the counterparty has prebankruptcy security, this is a mere unsecured claim that will generally entitle the counterparty to pennies on the dollar.

Ordinarily, when the debtor in a bankruptcy proceeding files a motion to reject an executory contract, the debtor is simply seeking to renegotiate the contract on more favorable terms. The counterparty is typically willing to renegotiate as well, since the alternative is to have no contract at all and be left with an inadequate unsecured claim. However, the special status of TSAs at the FERC may change this typical scenario.

The FERC has repeatedly held that TSAs that offer special tariff rates and access terms to contract shippers do not violate the anti-discrimination rules in the Interstate Commerce Act because those rates and terms are available to any interested party through the open season. A corollary of that policy is that the pipeline cannot amend the terms offered in the open season after the fact to make them materially more favorable for the shippers that signed TSAs during the open season. Doing so would deny the more favorable terms to shippers that might have participated in the open season if they had known those more favorable terms would be available.

Courts have held that the Federal Power Act (which governs FERC-regulated electric companies) does not totally preempt a bankruptcy court’s jurisdiction in a bankruptcy proceeding to authorize the rejection of an executory contract subject to FERC regulation. See In reMirant Corp., 378 F. 3d 511, 522 (5th Cir. 2004); In re Calpine Corp., 337 B.R. 27, 35 (Bankr. S.D.N.Y. 2006); Cf. In re Sabine Oil & Gas Corp., Case No. 15-11835 (SCC) at 9 (Bankr. S.D.N.Y. March 8, 2016) (opining that § 365(a) rejection of TSA for natural gas gathering system is appropriate, but without addressing filed rate doctrine). In doing so, however, the courts have been clear that a bankruptcy court may not approve a modification of rates in a FERC-jurisdictional electric power agreement without FERC approval. Mirant at 519; Calpine at 36. Indeed, one court has indicated that, if the purpose of rejection is to modify rates, rejection is not appropriate under §365(a). Calpine at 36-37.

These issues do not appear to have been tested with respect to oil pipelines governed by the Interstate Commerce Act. However, it seems likely that a similar result would apply in such cases — namely, that the debtor could reject an executory TSA but could not ask the bankruptcy court to approve the debtor’s assumption of a TSA with a lower tariff rate or other changes without prior FERC approval.

Thus, a result of FERC oil pipeline regulation is that the normal contract restructuring process does not seem possible without first seeking approval of the restructured TSA at the FERC. That is, the pipeline may not be able to settle its differences with the debtor by softening the terms of the TSA without creating undue discrimination issues at the FERC, because the new TSA would not be consistent with what other parties were offered in the open season. This issue has not been presented to the FERC to date, but it appears likely that it will arise eventually.

One vehicle for raising that issue could be a supplemental petition for declaratory order to ask the FERC to approve the restructuring of the TSA in the case of bankruptcy (or imminent bankruptcy) on the ground of special circumstances that would arguably make the resulting difference in contract terms not unduly discriminatory. Such a request could either be generic (to cover a range of possible restructurings) or specific (to approve a particular instance of contract restructuring), with the latter option having a greater likelihood of success because the FERC would have a defined set of facts before it. However, even on favorable facts, it is impossible at this point to predict with certainty how the FERC would rule on such a request.

In the meantime, oil pipeline companies can take some steps to mitigate the risks of shipper rejections. Many pipelines already require committed shippers to provide financial assurances to offset the damages that may arise if, among other things, the TSA is rejected by a shipper in bankruptcy. The pipelines that do not include such a requirement may wish to do so in future open seasons. Even the pipelines that already require significant financial assurances may want to consider imposing enhanced financial assurances in future open seasons. The stronger the financial assurances, the less tempting it will be for the debtor to reject the contract.

For contracts already in place, the pipeline should assure that existing financial assurance provisions are used proactively where the financial status of the shipper is in doubt. Because the grant of security may be subject to avoidance (or a "clawback") if the debtor files a bankruptcy petition within 90 days, the sooner the pipeline exercises its rights under the financial assurance provisions, the more likely it is that it will be allowed to retain the newly acquired security.

Where feasible (such as for gathering pipelines serving a particular producing field), a pipeline may consider using acreage dedication agreements that arguably “run with the land,” thereby potentially reducing the chance of contract rejection in bankruptcy. Agreements that properly run with the land are by their nature nonexecutory and not subject to rejection under the Bankruptcy Code. However, it is important that the contracts be truly nonexecutory, since bankruptcy courts are courts of equity that probe the substance of contracts to arrive at conclusions. See, e.g., In re Sabine at 7, 9-19 (stating in dicta that particular contracts were executory but holding that ultimate determination whether covenants run with the land requires full evidentiary adversary proceeding). Acreage dedication agreements also have limitations because they may not apply in all situations and they may carry other risks that must be weighed against any potential advantages in a bankruptcy context.

Finally, when considering restructuring of existing contracts either in the bankruptcy process or when it is imminent, the pipeline should carefully consider the terms of its specific TSA (for example, whether a most-favored-nations clause may be triggered by the restructuring of the TSA for the shipper in bankruptcy), as well as the bankruptcy and FERC regulatory consequences of any contract modifications or other dispute resolution alternatives.