Lower oil prices have led to an increase in the number of energy companies seeking to sell or abandon interests in oil and gas assets in bankruptcy proceedings. Whether companies are seeking to sell assets or abandon them, concerns regarding the costs of plugging and abandoning or decommissioning those assets arise not just for the debtor and potential purchasers of the assets but also for the debtor's lessors, joint-interest holders, and predecessors in interest. Each of these parties bears potential liability for decommissioning costs that are not paid by the debtor's estate or assumed by a buyer of the debtor's interests.
A debtor's lessors, joint-interest holders, and predecessors in interest faced with potential abandonment will need to learn certain facts to allow them to assess the likelihood that they will have to pay any decommissioning or abandonment costs. What do the relevant lease, operating agreement, or assignment provisions say about such costs? Have decommissioning obligations already arisen, and if not, when are they likely to arise? Are there multiple options for accomplishing decommissioning and what are the costs of each? Are there bonds, trust funds, letters of credit, or escrowed funds set aside to pay for decommissioning, and if so, are those funds sufficient? What is the likelihood that the debtor's estate will have assets sufficient to pay any unfunded decommissioning costs? The answers to these questions, along with various business concerns, will drive decisions about how to proceed when faced with the possibility of having to cover a debtor's share of unfunded decommissioning costs.
There are a number of other legal issues that would also be relevant to anyone advising a company in this situation. A thorough examination of all these issues is beyond the scope of this article, but the following is an introduction to two legal questions often faced by lessors, joint-interest holders, and predecessors in interest confronted with abandonment.
Can the Debtor Abandon the Assets and Leave Unfunded Decommissioning Obligations?
A debtor seeking a discharge from liability for decommissioning costs in bankruptcy may seek to abandon those assets and reject any related executory contracts from which the decommissioning obligations arise. Section 554 of the U.S. Bankruptcy Code allows a debtor or trustee, subject to court approval, to abandon any property "that is burdensome to the estate or that is of inconsequential value and benefit to the estate." 11 U.S.C. § 554(a). Section 365 allows the debtor or trustee to "reject any executory contract or unexpired lease of the debtor." 11 U.S.C. § 365(a). Together, these provisions can allow a debtor to give up oil and gas interests that are no longer sufficiently valuable to cover expected decommissioning costs and to receive a discharge of any liability for those costs.
A debtor's lessors, joint-interest holders, and predecessors in interest that are potentially stuck footing the bill for unfunded decommissioning costs may want to intervene and force the debtor's estate to decommission the assets or at least pay for the debtor's share of any unfunded decommissioning costs from available assets.
The power to abandon assets pursuant to section 554 has certain limitations. A trustee cannot simply abandon any and all uneconomic interests in oil and gas assets. In Midlantic National Bank v. New Jersey Department of Environmental Protection, 474 U.S. 494 (1986), the U.S. Supreme Court held that a "Bankruptcy Court does not have the power to authorize an abandonment without formulating conditions that will adequately protect the public's health and safety." Id. at 507. In other words, the "trustee may not abandon property in contravention of a state statute or regulation that is reasonably designed to protect the public health or safety from identified hazards." Id. What Midlantic requires exactly is a matter of some debate, though.
A minority of courts have found that Midlantic prohibits the abandonment of property in violation of any applicable environmental laws. See In re Howard, 533 B.R. 532, 547 (Bankr. S.D. Miss. 2015). Under this view, any decommissioning obligations that are ripe would need to be met by a debtor before abandonment can occur. The majority of jurisdictions, however, have found that Midlantic only requires a debtor to ameliorateany identified and imminent harm to public health and safety. Id. at 545. Under this view, a party opposing abandonment must prove that there is an imminent harm to public health and safety before the court can require the debtor to address the issue.
Regardless of which interpretation of Midlantic is correct, a bankruptcy court must attempt to ensure that assets are brought into compliance with applicable statutes and regulations, or at least attempt to ensure that there is no imminent threat to public safety, before allowing the assets to be abandoned. Accordingly, courts applying Midlantic have held that decommissioning costs incurred by a third party are entitled to treatment as administrative expenses to the extent necessary to get the property into the condition required for abandonment. Because administrative expenses enjoy a higher priority than unsecured claims—which is how claims for abandonment costs would otherwise be prioritized—such claims are more likely to be paid.
When practicable, a debtor's lessors, joint-interest holders, and predecessors may want to take steps to maximize the amount of decommissioning costs that are paid by the estate. Such steps could include (1) filing a motion with the court requesting that it set aside additional funds for decommissioning costs or (2) paying the costs and then seeking reimbursement as an administrative expense. The preferred course of action will depend on the facts of the particular case.
Are the Debtor's Predecessors in Interest Responsible for Unfunded Decommissioning Obligations?
When funds from the estate and other sources like bonds and trust funds are insufficient to cover the costs of a debtor's decommissioning obligations, co-owners and lessors will want to consider whether the debtor's predecessors in interest are liable for the debtor's share of decommissioning costs. The party that assigned the abandoned interest to the debtor could be liable for unfunded decommissioning costs, as could any other prior owner of those interests, going back to the original contracting or purchasing party. Frequently, interests sought to be abandoned will have been assigned numerous times, and the chain of title for the interests may be complex.
If the operating agreements, leases, or other governing documents specifically address assignor liability, courts will generally enforce the language in the agreements. Where decommissioning obligations are owed to a governmental entity, there may be applicable statutes and regulations that address the issue. See, e.g., 30 C.F.R. § 256.1702. If the relevant agreements and laws do not address assignor liability, different common-law rules may apply. Courts will not ignore clear evidence of the parties' intent, but they will look to common-law rules regarding assignor liability as gap-fillers and in construing agreements without clear assignor liability provisions.
The courts that have considered the issue of assignor liability to date have found that at least some of a debtor's predecessors in interest remain liable for decommissioning or operating costs that an assignee does not pay. These courts have looked to the common-law assignor liability rules applicable to contracts and leases to hold that an assignor of interests in oil and gas assets is liable for costs that accrue while it is in either privity of contract or privity of estate with the obligee.
Seagull Energy E & P, Inc. v. Eland Energy, Inc., 207 S.W.3d 342, 347 (Tex. 2006), is the seminal case holding assignors liable for abandonment costs. In that case, the Texas Supreme Court ruled that an assignor remained liable for abandonment costs "because the operating agreement did not expressly provide that . . . the operating agreement should terminate upon assignment" and there was no express release of the assignor. Id. at 347. Wyoming has recently followed Seagull, and other courts that have considered the issue have reached the same conclusion. See Pennaco Energy, Inc. v. KD Co. LLC, 363 P.3d 18 (Wyo. 2015); Wold v. Diamond Res., Inc., 2011 U.S. Dist. LEXIS 115118 (D.N.D. 2011); Chieftain Int'l v. Southeast Offshore, Inc., 553 F.3d 817 (5th Cir. 2008).
There is some disagreement, however, as to whether the obligee may look to intermediate assignees—those who were assigned interests and then in turn assigned those interests to another party—to cover any unfunded decommissioning costs. Where interests have been assigned multiple times, intermediate assignees generally are liable only for obligations that accrued while they held an interest in the property, absent an express assumption of the obligation (at what point decommissioning costs accrue is a separate issue that is beyond the scope of this article). In other words, if the intermediate assignee is not in privity of contract with the obligee, it must be in privity of estate with the assignee to owe decommissioning obligations under the common law. In Texas, the Seagull court assumed that each assignee was in privity of contract with the obligee as a matter of law, regardless of whether each one signed a contract with the obligee. Texas appears to be in the minority on this issue, though. In other states, an intermediate assignee may not be liable for obligations that arose before the assignment or for obligations that arose after the intermediate assignee further assigned those interests to another party, unless it signed an agreement with the obligee or the obligee can enforce the assignment agreement as a third-party beneficiary. 4 Williams & Meyers, Oil and Gas Law § 403.
Although the courts that have decided issues of assignor liability for operating or abandonment costs to date have found that assignors are liable, there is an alternative common-law rule that some in the oil and gas industry have argued should apply instead. Under the assignor liability rule that applies to conveyances of real property, an assignor or conveyor is liable only for costs that accrue while it owns an interest in the real property.
The American Association of Professional Landmen (AAPL) and the Independent Petroleum Association of America (IPAA) filed an amicus brief with the Seagull court asserting that operating agreements in the oil and gas industry are based on a long-held assumption that assignors will not remain liable after assignment. In other words, they asserted that, prior to Seagull, the oil and gas industry had assumed that decommissioning costs were covenants that would run with the land. The AAPL claimed that each of the early form operating agreements it published was based on this assumption. The AAPL and IPAA also argued that applying the common-law contract or lease rule would
- chill exploration and production activity;
- result in an explosion of litigation;
- result in limitless liability for far removed parties;
- require expansion of the rights of prior owners to object to costs; and
- create uncertainty as to financial and risk analyses.
We are not aware of any court to date that has adopted the AAPL/IPAA position, but parties should keep these arguments in mind if they are in one of the many jurisdictions that have not yet decided the issue of assignor liability for decommissioning costs.
Barring a court's adoption of the AAPL/IPAA position and the conveyance rule of assignor liability, at least some of a debtor's predecessors in interest will be on the hook for any unfunded decommissioning costs the estate does not pay. Co-owners and lessors responsible for decommissioning can seek contribution from predecessors in interest after costs are incurred or they can seek a declaratory judgment regarding liability beforehand so anyone ultimately liable can be involved in planning the decommissioning and cannot later claim the costs incurred were unnecessary or otherwise objectionable.
If a debtor seeks to sell assets rather than abandon them, lessors, co-owners, and predecessors in interest should carefully review any related pleadings and sale documents. In a bankruptcy scenario, a debtor or trustee may attempt to sell oil and gas interests to a third party free and clear of all liens, claims, and encumbrances pursuant to section 363 of the Bankruptcy Code. Plugging and abandonment obligations will not be extinguished under applicable law by such a sale. In re Rosbottom, 2010 Bankr. LEXIS 4305 (Bankr. W.D. La. 2010).
Oftentimes a debtor will provide for the treatment of such obligations in its plan of reorganization in a Chapter 11 case. Predecessors in interest should carefully scrutinize these provisions in the plan, however, as they often attempt to limit or discharge such liability. In addition to opposing the limiting or discharging of liability, predecessors should consider requesting that the debtor set aside funds, a letter of credit, or bonds to address current and future liabilities in connection with the implementation of the plan.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.