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Farmout agreements in bankruptcy
LESSONS LEARNED FROM THE VNR BANKRUPTCY
JASON S. BROOKNER, PHILIP B. JORDAN, LYDIA R. WEBB AND ETHAN M. WOOD, GRAY REED & MCGRAW LLP, DALLAS, TEXAS
FARMOUT AGREEMENTS are a common form of agreement
in the oil patch whereby the owner of an oil and gas lease agrees
to assign that lease to an operator who undertakes the obligation
to drill one or more wells on the assigned acreage in exchange
for an interest in the completed wells. Famouts are used to
transfer interests in oil and gas leases literally every day and
have been in use for decades. Farmees often invest millions of
dollars to develop farmout acreage and can assign great value
to undeveloped land that they intend to drill over the term of
the agreement. However, when a farmor files for bankruptcy,
the farmee can suddenly find itself in an unforgiving landscape
where the treatment of its farmout agreement is far from certain.
Land that the farmee rightfully believed it had the right to drill
and develop can potentially be drawn into the farmor’s bankruptcy estate and sold for the benefit of the farmor’s
creditors.
This fight most recently played out in the Vanguard Natural
Resources LLC bankruptcy located in the Southern District of
Texas, Houston Division (the VNR Bankruptcy), where debtor/
farmor Vanguard Operating LLC won the right to reject its
farmout agreement with Encana Oil & Gas (USA) Inc. and sold
unearned acreage in the Permian Basin free and clear of Encana’s
rights under the farmout agreement.
OIL & GAS BANKRUPTCY 101
Since 2015, more than 120 US oil and gas companies have filed
for bankruptcy. Determining what is or is not in a debtor’s
bankruptcy estate is often a key part of an oil and gas bankruptcy
and can be the subject of intense litigation.
The Bankruptcy Code provides that, subject to court approval,
a debtor may assume or reject any executory contract or unexpired lease. Rejection allows a debtor to forgo future performance under the contract or lease upon a showing of reasonable
business judgment (a very low threshold), leaving the counter-
