Locke Lord QuickStudy: The Assumed Contract Chimera

Locke Lord LLP
February 26, 2016

We are often asked what to do if you have an operating agreement and your operator or one of the other working interest owners files for bankruptcy. The Bankruptcy Code allows the debtor to assume or reject the JOA (it is usually an executory contract).

If the debtor assumes the JOA, then it must cure defaults that arose before and after the petition date and must provide adequate assurance of future performance. In some cases the debtor assumes the JOA and then assigns it to a third party notwithstanding contractual provision that might seek to limit assumption or assignment to third parties (with or without consent).

The purpose of the JOA, in addition to providing for operations, is to allocate costs and benefits and provide remedies in the event of a default by one of the parties. Once a JOA is assumed, the non-debtors may rest easier – but be careful because some of the default provisions may not work.  Some courts have held that if a debtor defaults or makes a non-consent election, the accrual of amounts owed by the debtor for lease acquisition, capital spends, or operations are considered “borrowings” and must be separately approved even if the payment of such amounts must come from production and cannot be collected directly from the debtor. Thus, one of the primary functions of the JOA may be rendered illusory.

A non-operator under a JOA should take prompt action to protect its rights. As a general rule, once a debtor files bankruptcy no further action should be pursued without bankruptcy court approval; but a consultation with your counsel is advisable in the cases of setoff, recoupment, and M&M liens. The time period between a bankruptcy filing and the assumption or rejection of the JOA, is called, cleverly, “the Twilight Zone.” During the Twilight Zone, the JOA may be held to be enforceable by the debtor but not against the debtor. If the debtor is a non-operator and it chooses to enforce, or receive the benefits of a JOA, the debtor non-operator may become bound by the same terms of the agreement because “the debtor-in-possession is obligated to pay for the reasonable value of those services, which, depending on the circumstances of a particular contract, may be what is specified in the contract.” Under some circumstances the inadvertent assumption of an obligation can be a true trap for the unwary.

If a debtor rejects the JOA then the JOA is deemed breached. The time of breach is determined by the bankruptcy court which can be immediately prior to the petition date, the date of the filings of a motion to reject or at another time. The JOA then becomes ineffective as to the debtor but remains in effect as to the remaining parties to the JOA. The rejection is not a rejection of the underlying ownership interest and it is not clear in what capacity the debtor owns the interest (as a co-tenant, free of the JOA?).

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