Since the beginning of 2015, at least 77 companies in the oil and gas industry have sought bankruptcy relief in the United States.  The flow of oil and gas company bankruptcies shows no sign of slowing down and, based on the second quarter of 2016, actually appears to be increasing.  Since April 2016 alone, the following notable companies and their affiliates filed for bankruptcy:

• LINN Energy, LLC (over $7.6 billion in funded debt)
• SandRidge Energy, Inc. (approximately $4 billion in total debt)
• Pacific Exploration & Production Corp. (over $5.3 billion in unsecured debt)[1]
• Ultra Petroleum Corp. (over $3.7 billion in unsecured debt)
• Energy XXI Ltd. (approximately $2.9 billion in total liabilities)
• Midstates Petroleum Company, Inc. (over $2.0 billion in funded debt)
• Chaparral Energy, Inc. (approximately $1.2 billion in unsecured funded debt)

Analysts watching the oil and gas area expect oil and gas bankruptcies to continue for some time.

The recent and continuing influx of oil and gas companies into the bankruptcy courts provides an opportunity for third parties to purchase these debtors’ assets at significant discounts through court-supervised asset sales.  While these sales, which are referred to as “363 sales” because they are governed by Section 363 of the U.S. Bankruptcy Code, potentially provide significant protections to buyers as compared to out-of-court transactions, they are not without their pitfalls.

Overview of 363 Sales

Typically, the 363 sale process begins when the debtor in a Chapter 11 case files a motion to approve a sale to a “stalking horse” bidder.  Bankruptcy courts usually require the debtor to allow other potential purchasers to outbid the “stalking horse” at an auction following a marketing process.  Following selection of the winning bid at the auction, the bankruptcy court is then asked to approve the proposed sale transaction.  Depending on the circumstances of the case, including the extent to which the assets were marketed prior to the bankruptcy filing, the sale process typically lasts from a few weeks to a few months.

With some exceptions and upon fulfilling certain requirements, Section 363 of the Bankruptcy Code allows the debtor to sell its property “free and clear of any interest” in the property, with such interests attaching to the sale proceeds.[2]  The term “interest” generally has been interpreted broadly to include claims, liens and other types of encumbrances.[3]  Thus, purchasers in 363 sales typically enjoy a greater degree of comfort than buyers outside of the bankruptcy process.  Notwithstanding the protections offered by Section 363, buyers should be aware of and avoid certain pitfalls associated with purchasing assets that may be tainted with environmental liability. 

Section 363 Does Not Always Cleanse Environmental Liability But May Provide Some Protection

One of the primary benefits of buying assets in a bankruptcy case is the buyer’s ability to obtain an order declaring the assets free and clear of liens, claims and other encumbrances.  When dealing with environmental liabilities, however, there is some question as to whether a free and clear order under Section 363 will shield an asset purchaser from liability related to the assets or the debtor’s pre-sale actions. 

With respect to real property assets, the purchaser likely can be held liable under CERCLA and similar state statutes for any contamination based on its ownership of the property, notwithstanding the language of any sale order.  Even if the bankruptcy court has the power to absolve the buyer of the debtor’s environmental liabilities, that order would not affect any liability arising under CERCLA.  CERCLA liability would attach the moment the buyer purchases the land, but the buyer would not be precluded from asserting the bona fide prospective purchaser defense under CERCLA.  Therefore, a purchaser should not simply rely on a free and clear sale order. 

If contamination is known or suspected at the time of the sale, the buyer should assess the scope of liability and negotiate with the debtor (and perhaps the relevant government agencies) to address the liabilities in the transaction.  This approach was taken in the case of Dune Energy, Inc., et al., Case No. 15-10336 in the United States Bankruptcy Court for the Western District of Texas.  In that case, the buyer agreed to assume the debtor’s obligations, including certain environmental liabilities relating to the purchased assets.  The purchase agreement provided that the debtor would use its best efforts to clean up an oil spill and, to the extent not completed upon closing, the debtor would pay the deductible on its insurance policy and assign such policy to the purchaser.  Although the purchaser was ultimately liable for the cleanup costs associated with the real property it was purchasing, by using this approach, the purchaser was able to divert costs to the debtor and its insurer.

Of course, a debtor may have environmental liability unrelated to any real property it may own, e.g., arranger liability for disposing of contaminated material on another site or transporter liability for moving hazardous substances.  When purchasing the debtor’s assets, a buyer will want to take steps to reduce the likelihood that it will be subject to liability for the debtor’s pre-sale activities.  A free and clear order under Section 363 may provide some—but not complete—protection.  In these circumstances, liability is not asserted based on ownership of the contaminated land but, rather, the purchaser being the contaminating party’s alleged successor in interest.  The enforceability of Section 363 orders will depend on the facts and circumstances of the case, including whether the environmental claim was or could have been asserted in the underlying bankruptcy case.

The court in Ninth Ave. Remedial Group v. Allis-Chalmers Corp., 195 B.R. 716 (N.D. Ind. 1996) addressed this very issue.  A remedial waste cleanup association sued several defendants for contribution to cleanup costs of a waste disposal facility, arguing that they were liable as arrangers under CERCLA on a successor liability theory.  One of the defendants had purchased assets from the debtor pursuant to a sale order providing the transfer was free and clear of all claims, liens and encumbrances.  Further, the order confirming the debtor’s plan of reorganization discharged the debtor from any claims arising prior to the date of the confirmation order.  The asset purchaser denied it had liability for the debtor’s actions, pointing to the free and clear language of the sale order. 

The court agreed with the purchaser but only in part.  The court found that the sale order and the debtor’s discharge precluded liability for claims that could have been brought during the bankruptcy case, but they did not necessarily shield the purchaser from potential successor liability claims that could not have been asserted prior to confirmation of the debtor’s plan.

In order to reduce the risk that it will be considered the debtor’s successor in interest, the buyer should insist on the sale order including both language finding the buyer is not the debtor’s successor and detailed factual findings to support that conclusion.  For example, in the recent sale of certain assets in the case of Quicksilver Resources Inc., et al., Case No. 15-10585 in the United States Bankruptcy Court for the District of Delaware, the sale order contained findings that, among other things:  (1) there was no common identity of the directors or stockholders between the purchaser and seller; (2) the purchaser was not purchasing all assets of the debtor; (3) the purchaser was not holding itself out to the public as a continuation of the debtor; and (4) the transactions were not being undertaken for the purpose of escaping liability for the debtor’s debts.  While such findings do not guarantee the purchaser will be immune from successor liability, they do provide more protection than a mere statement that the buyer is not the debtor’s successor.  Similar findings of fact have been utilized in other recent cases, including the recent sale order entered June 21, 2016 in the case of AIX Energy, Inc., et al., in the United States Bankruptcy Court for the Northern District of Texas, Case No. 15-34245.

Conclusion: Environmental Liability Risk and Cost Allocation Still Need to Be Addressed

Section 363 of the Bankruptcy Code is an important tool that, among other things, can provide some protections to buyers of oil and gas assets with respect to environmental liability.  Despite the free and clear language of Section 363 sale orders, however, buyers should not assume that a bankruptcy court order will be a magic bullet absolving them of any risk.  Instead, buyers should endeavor to fully understand the types of assets they are purchasing and work with the debtor, relevant governmental agencies and other parties of interest to address any potential environmental liabilities in the sale process.  These liabilities can be addressed, at least in part, by gaining a clear understanding of any known or potential contamination issues and negotiating the allocation of costs and risks in the purchase agreement and sale order, including assigning to the purchaser any applicable insurance policies.  In order to reduce the risk of successor liability for the debtor’s past actions, purchasers are advised to insist on the inclusion of robust findings of fact.

ENDNOTES

[1] This case was filed under Chapter 15 of the Bankruptcy Code, which deals with ancillary and cross-border bankruptcy cases, to administer the assets located in the U.S. in connection with the main insolvency proceedings pending in Canada.  The other cases referenced were filed under Chapter 11 of the Bankruptcy Code.

[2] 11 U.S.C. § 363(f).

[3] Encumbrances that may not be extinguished in a Section 363 sale include recorded overriding royalty interests, net profit interests, after-payout interests and similar interests.  A buyer would also be subject to all applicable federal/state regulations regarding oil and gas operations.

Republished in Law360, "Section 363 Is No Magic Bullet For Environmental Liability," on 08.03.2016.

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