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Royalty Owners’ Rights in Bankruptcy

Another recent bankruptcy court ruling may bode ill for producers and royalty owners in Texas in light of the collapse of oil prices and increased risks of bankruptcy of producers and oil purchasers. In Re: First River Energy, LLC, 2019 WL 1103294(US Bankr. W.D. Tex., March 7, 2019), also highlights a fix to the First Purchaser Statute the Texas legislature needs to address.

The oil industry in Texas fell on hard times in the early 1980’s. Several large oil purchasers filed for bankruptcy, leaving many royalty owners and producers unpaid. In response the Texas Top-TenLegislature passed a law intended to give producers and royalty owners a better chance to recover their monies in bankruptcy court. The statute is now Section 9.343 of the Texas Business and Commerce Code, which is Texas’ version of the Uniform Commercial Code (UCC). All states have passed their version of the UCC. The UCC is intended to govern rights of parties in commercial transactions; the intent of having a “uniform” code in all states is to ensure that such transactions will not be hindered by differing laws from state to state. Article 9 of the UCC governs security interests granted in “goods” and proceeds from the sale of goods. “Goods” includes oil and gas, once they have been produced. So, the UCC, and particularly Article 9, govern how security interests are granted in produced oil and gas and in proceeds from the sale of oil and gas and the priority among creditors claiming security interests in oil and gas and proceeds.

Section 9.343 of the Texas Business and Commerce Code, passed by the Texas Legislature in 1983, is a “non-uniform” provision of the Code – that is, it is unique to Texas. Commonly referred to as the First Purchaser Statute, it provides that producers and royalty owners have a security interest in oil and gas produced from their properties to secure the purchaser’s obligation to pay for that oil and gas. Under other provisions of Article 9, the holder of a security interest must “perfect” its security interest by filing a “financing statement” in order to have priority over others who claim security interests in the same oil and gas. Whoever files a financing statement first and thus perfects its security interest has priority over other creditors who claim security interests in the same oil and gas. But Section 9.343 provides that producers and royalty owners do not need to file financing statements in order to perfect their security interest. Furthermore, the Legislature provided that the security interest granted to producers and royalty owners is a “purchase-money security interest,” which entitles it to a kind of super-priority over other claimants. In the bankruptcy context, that means the producers and royalty owners are first in line for getting paid their claims if their purchaser goes bankrupt.

The applicability of the First Purchaser Statute was first addressed in the SemCrude bankruptcy, Samson Res. Co. v. SemCrude, L.P. (In re SemCrude, L.P.), 407 B.R. 140 (Bankr.D.Del. 2009). In the SemCrude bankruptcy, Texas producers who sold to SemCrude claimed that they had security interests in the oil and gas they sold to SemCrude in June and July 2008, and in the proceeds from SemCrude’s sale of that oil and gas, under Section 9.343. They also claimed that their security interest was superior to the security interests SemCrude had granted to its banks in the same collateral. In other words, the Texas producers argued that they should be paid $57 million before SemCrude’s banks received any money from the bankruptcy.

SemCrude was organized as a corporation in Delaware. Its principal bank accounts, from which it paid all producers and royalty owners, were located in Oklahoma. So the first issue the bankruptcy court had to decide was which state’s laws applied to the claims of the banks and the Texas producers. The commercial codes of Delaware, Texas and Oklahoma all had an identical provision that deals with this issue. That provision, Section 9.301, says that, to determine whether a security interest in collateral is properly perfected, the court must apply the law of the state where the debtor was organized – in this case Delaware. Section 9.301 contains an exception to that rule for “cash proceeds” from the sale of goods. For such cash proceeds, the bank’s jurisdiction’s law governs. Since SemCrude’s bank where the cash proceeds from its sale of oil and gas were held was located in Oklahoma, the court concluded that the law of Oklahoma governed perfection of security interests in that collateral. Under either Delaware or Oklahoma law, the Texas Producers would have had to file financing statements in Delaware or Oklahoma to perfect their security interests in the oil and gas and cash proceeds. Because they did not do so, the security interests granted to the Texas Producers by Section 9.343 were held to be subordinate to the banks’ security interests. In other words, the banks win.

There is another exception in the Delaware statute to the general rule that Delaware’s law governs perfection. It says that, while goods are located in a jurisdiction, the local law of the jurisdiction governs the perfection of a security interest in the collateral. So, as to oil and gas purchased by SemCrude that was still located in Texas when SemCrude filed bankruptcy, Texas law would govern priority of the Texas producers’ security interests. To that limited extent, the court ruled that the Texas Producers’ claims would have priority.

The bankruptcy court also addressed how the dispute between the Texas producers and the banks would play out if Texas law applied to their dispute. The court held that, if Texas law applied, the Texas producers would have priority as long as the deed, lease or other instrument that gave them an interest in the land from which the oil and gas was produced was filed before the banks’ financing statements covering the same collateral.

Oklahoma also has a First Purchaser Statute protecting its producers and royalty owners, who also lost out in SemCrude. So the Oklahoma legislature fixed the statute by an amendment in 2010. As amended, the law provides that Oklahoma law applies to the perfection of liens and security interests in production and proceeds on Oklahoma wells, regardless of the state of incorporation of the purchaser or the location of the purchaser’s bank.

That brings us to the more recent case, In re First River. First River, an oil purchaser, filed for bankruptcy protection in January 2018. At the time, it had not paid for oil it purchased in December 2017 from producers in Texas and Oklahoma. It ceased buying oil, and as of January 2018 it had about $30 million to pay its creditors, including its bank lenders and its producers. First River was organized as a Delaware corporation. So the court faced essentially the same legal questions as to lien priority as had the court in SemCrude, and it followed the SemCrude court’s analysis in applying Texas, Oklahoma and Delaware law to determine claimants’ priority to assets of First River’s estate. But this time the outcome was different. Because Oklahoma had revised its First Purchaser statute to make clear that Oklahoma law applied to sales of oil from Oklahoma wells, producers in Oklahoma were able to claim a first-priority security interest in proceeds of sale of their production, but Texas producers were not. Undoubtedly Texas producers will seek legislation in the next legislative session to fix Texas’ First Purchaser statute, as Oklahoma has done. Unfortunately, it may be too late for the next round of bankruptcies.

What, then, does this all mean for Texas royalty owners? Royalties may be paid either by the operator of the well or by the purchaser of production from the well. Most gas royalties are paid by the operator, but oil royalties are sometimes paid by the oil purchaser.

If the purchaser pays the royalty pursuant to a division order signed by the royalty owner, and if the purchaser goes into bankruptcy, the royalty owner may have no recourse against the operator for the unpaid royalty.

If the operator pays the royalty and goes into bankruptcy, Section 9.343 may not protect the royalty owner if the operator is organized in another state or pays royalties from a bank account located in another state.

If the operator pays the royalty and the operator’s purchaser goes into bankruptcy, the royalty owner should insist that the operator is nevertheless liable to pay the royalty and should bear any loss resulting from the bankruptcy.

Finally, the above results may be different depending on the language in the royalty owner’s oil and gas lease. Royalty owners may be able to argue that their royalty share of proceeds from sale of oil are not part of the bankrupt producer’s bankruptcy estate, but monies held in trust by the producer for the benefit of the royalty owner.

Royalty owners can protect themselves by reserving a lien and security interest in production and proceeds in their oil and gas lease. Under Texas law the lien is perfected by filing the lease, or a memorandum of the lease referring to the reserved lien, in the deed records of the county. But if the lessee-producer is incorporated in another state, the lessor should also file a financing statement in that state to perfect its security interest in proceeds and accounts under the laws of that state.

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