Lessor's Remedies

A Delaware bankruptcy judge has ruled in the SemCrude bankruptcy that the claims of Texas producers for unpaid revenues from oil sales are subordinate to the claims of SemCrude’s bankers. As a result, the Texas producers (and perhaps their royalty owners) may lose up to $57 million.

SemCrude filed for protection under Chapter 11 of the Bankruptcy Code in July 2008. SemCrude was a large purchaser of crude oil in Texas and seven other states. At the time of the filing, the SemCrude entities owed their banks $2.55 billion. It also owed more than one thousand oil and gas producers millions of dollars for oil purchased but not paid for in June and July 2008, including $57 million owed to oil and gas producers in Texas.

The court in the SemCrude bankruptcy recently ruled that the claims of Texas Producers for the $57 million in unpaid proceeds of oil and gas sales are subordinate to the claims of SemCrude’s Banks, who hold liens on all os SemCrude’s assets, despite a Texas statute that grants the Texas Producers a lien on their production and all proceeds of sale to secure the purchaser’s obligation to pay.

The arguments made in the dispute between the Banks and the Texas Producers are complicated because they involve the interpretation of Article 9 of the Uniform Commercial Code, a code that has been the bane of many law students’ studies. The judge’s ruling will be appealed and so is not the final word on the matter, but if the ruling stands it will adversely affect the rights of royalty owners in bankruptcy proceedings of oil and gas purchasers and producers, and could greatly reduce their rights to recover payments for their royalties.

Here is a simplified summary of the judge’s ruling:

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Last week I discussed Wagner & Brown v. Sheppard, a recent Texas Supreme Court case that involved a lease termination clause. Sheppard’s lease in that case provided that, if royalties were not paid to her within 120 days after first production, the lease would automatically terminate. That is exactly what happened.

Landowners are usually surpriesed to learn that, under a “standard form” oil and gas lease, the lessee’s failure to pay royalties does not give the lessor the right to terminate the lease. The lease remains in effect, and the lessor’s only remedy is to sue for the unpaid royalties. Landowners often seek to negotiate a clause like Sheppard’s that gives the lessor the right to terminate the lease for failure to pay royalties. Exploration companies of course do not like such a provision. It puts them at risk that, if royalties are not timely paid for some inadvertent reason, they can lose the lease even though they are willing and able to pay the royalties.

First, I think it is not a good idea to include a provision that a lease terminates automatically if royalties are not paid within a specified time. Depending on the circumstances, it may not be in the lessor’s best interest to terminate the lease, even though royalties have been delayed. A better provision is that, if royalties are not paid by a specified date, the lessor has the option to terminate the lease.

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Articles Posted in Lessor’s Remedies

Delaware Bankruptcy Court Rules Against Texas Producers (and Royalty Owners)

Oil and Gas Lease Termination Clauses