Sometimes a buyer is upset because he received less than he paid for.  On the other hand, sometimes the buyer is upset because he received way more than he paid for.  In a recent Texas Supreme Court decision, the buyer of contracts out of bankruptcy realized too late that it had purchased tens of millions in liability under an undisclosed indemnity agreement which had been dormant for years.

Indemnity Cat

To understand what happened, it’s helpful to have a general understanding of two things.  First, what is an executory contract.  Second, how does a sale process work in bankruptcy.

An executory contract is any contract under which both sides still owe an obligation under the contract at the time of the bankruptcy filing of one of the parties.

In defining an executory contract, the US Supreme Court has stated:

“Congress intended the term to mean a contract on which performance is due to some extent on both sides.

The Fifth Circuit has said:

“an agreement is executory if at the time of the bankruptcy filing, the failure of either party to complete performance would constitute a material breach of the contract, thereby excusing the performance of the other party.”

The characterization of an executory contract is important because the bankruptcy code has special provisions on how they must be treated.  One of the features of an executory contract is that it can be treated as an asset which can be “sold” to a third party; even over the objection of the contract counter-party.

Importantly, to sell an executory contract, the purchaser must take the contract subject to all of its terms.  The process is referred to as the assumption/rejection process.  (because the executory contract can also be rejected, which is a way to jettison liability on a bad contract).

As an asset of the bankruptcy case, an executory contract can be sold (technically assigned) either on its own or as part of a larger purchase.   This can done in a couple of ways, but one of the safer ways to do it is in a chapter 11 plan.  That was the case in Noble Energy v. ConocoPhillips in the Texas Supreme Court.

Noble purchased a slew of oil and gas properties and rights from a bankrupt debtor.  Prior to bankruptcy, the Debtor had entered into a number of transactions with ConocoPhillips.  One of the transactions included an environmental indemnity agreement which broadly and forever required ConocoPhillips and the Debtor to indemnify each other for environmental claims made against oil and gas properties they traded.

Unfortunately for Noble, those indemnity agreements were never disclosed in any way in the bankruptcy case – not even in the applicable purchase agreement.  Fortunately for ConocoPhillips, when Noble purchased the assets from the Debtor:

The Plan provides that any executory contracts not specifically referenced were to be assumed and assigned to Noble unless rejected at closing.  Noble agreed to the Plan and the APA has language that basically said “the assets and contracts we are purchasing includes, but is not limited to x y & z.”

Here was the error for Noble (in my humble opinion).  Noble had no actual knowledge of the existing indemnity agreement.  However, it agreed to assume – with all the burdens – ALL executory contracts unless specifically rejected.  Noble did not know about the indemnity agreements, so it did not “specifically reject” the unknown contracts.

Now, fast forward 10 years and ConocoPhillips sues Noble for $63 million based on the dormant environmental indemnity provision.

In the case, the Texas Supreme Court holds (importantly for the bankruptcy folks), that the cross indemnity provision was legally an executory contract which could be “sold” in bankruptcy.  The Texas Supreme Court holds (importantly for the transactional folks) that the unlimited scope of the purchase caused the unknown and undisclosed indemnity agreement to be part of the asset purchase agreement and bankruptcy plan thereby binding Noble to the terms.  Interestingly the environmental claim arose prior to the bankruptcy case, but the claim for indemnity was not made until after the purchase by Noble was completed.

While there is some interesting points on bankruptcy law in the opinion, the larger lesson from this case is that the common desire in drafting APAs to capture as much as possible may backfire if the purchaser unknowingly captures an indemnity that is sleeping.

Noble Energy, Inc. v. ConocoPhillips Company, cause no. 15-0502, Supreme Court of Texas.  June 23, 2017.

Last week Regions Bank sued Comerica Bank seeking a declaration that Regions is not liable to Comerica in connection with their $53MM syndicate loan to a plant nursery that went very wrong.  Regions Bank v. Comerica Bank, civil action 3:14-cv-3607, pending in the United States District Court for the Northern District of Texas.

In short:

  • The two banks loaned $53MM (total) to the plant nursery based on allegedly massively fraudulent inventory numbers.
  • The nursery filed bankruptcy and basically everyone apparently got sued for the alleged fraud.
  • Comerica allegedly has been threatening Regions with a lawsuit for misrepresentation or fraud for talking them into the syndicate.
  • Rather than wait for the lawsuit, Regions filed its declaratory judgment action.
  • In the lawsuit, Regions asserts that Comerica contractually waived any reliance on facts or representations that Regions provided to Comerica.  Thus, argues Regions, Regions cannot be liable to Comerica on account of Comerica relying on any information Regions forwarded to Comerica about the borrower.

There are a number of issues related to the lawsuit that are worthy of analysis.  (There are also a number of one-liners about money not growing on trees).  However, as the case is only a week old it provides a good avenue to illustrate the two levels of reliance waivers in Texas.

Money Dino

What kind of waiver am I talking about?  Contracting parties can waive reliance on representations of the other which are not contained in the contract.  It seems straightforward – if the representation is not in the contract, then forget I said (or failed to say) anything prior to signing.  Why the two levels then?

  •  The Basic Waiver: The typical waiver of reliance in a contract will essentially say that the parties waive any reliance on non-contractual representations.  However, the SCOTX has pointed out that such a contractual provision, like any contractual provision, is subject to avoidance for fraud.  Essentially, even if you waive reliance on prior non-contract statements, if someone made a fraudulent misrepresentation that lead to the execution of the contract (without the representation), the contract risks being avoided for fraud.
  • The Super Wavier: On the other hand, the SCOTX recognizes that some parties may contractually agree to waive any reliance non-contractual representations, regardless of how fraudulent they might be, if the parties so intended. Thus, the super waiver.

So, which waiver is in your contract?  It depends on what the Court thinks you meant when you signed the contract (containing the waiver).  Any answer that begins with “it depends” is not a lot of comfort for lender clients and the SCOTX has been somewhat unclear about which is which.

The SCOTX has said that “The contract and circumstances surrounding [the contract’s] formation determine…[how expansive the waiver is]”.  Schlumberger v. Swanson, 959 S.W.2d 171.  The Court goes on to instruct that lower courts should consider the sophistication of the parties, course of dealings and representation by counsel and, importantly, did the parties intend to put a final end to a long running dispute to determine whether the waiver is basic or super.  (Both terms I made up for ease of reading this post so don’t Google them).

I have not parsed through the complaint in the Regions case and Comerica has not yet answered.  Also, I am not opining on the merits of either parties’ positions.  However, the case provides a good excuse to point out that even if two parties waive any reliance on prior representations, in Texas, that waiver may not be enough to waive claims of fraud.  Meaning, the Court may let the case proceed even if a waiver of reliance is contained in the contract regardless of whether the fraud claim is ultimately determined to be without merit.

Lenders should be cautious and deliberate when drafting these waivers of reliance to attempt to remove as much risk as possible that a court will later find that the borrower may sue the lender for fraud.