Buyer (And Its Creditors) Beware: Semcrude District Court Finds That Purchasers Took Oil And Gas Free And Clear Of Producers' Liens

Although almost eight years have lapsed since the chapter 11 cases of Tulsa, Oklahoma-based SemCrude L.P. were confirmed, many of the issues at the forefront of those cases are re-emerging in light of the recent uptick in oil and gas-related restructurings. The SemCrude cases provided useful guidance for oil and gas producers and purchasers to best address the perfection and management of security interests in oil and gas-related collateral. Perhaps of most significance are the lessons SemCrude taught regarding the repercussions of a secured lender's failure to timely perfect oil and gas security interests, especially if producers have a basis for asserting a security interest under state law. The lessons have not stopped: on July 30, 2015, the Delaware district court resolved a dispute between producers and purchasers, and affirmed the bankruptcy court's holding that the purchasers took oil purchased from SemGroup free and clear of the producers' lien, because the purchasers were "buyers for value" or in the alternative, "buyers in the ordinary course."

The recent decline in oil prices and the concurrent instability and volatility in the oil and gas industry, bring these lessons back into the limelight, making it essential for producers and secured lenders to not only evaluate the status of their security interests, but also manage their relationships with first purchasers.

Background: Typical Energy Transaction

Refining oil and gas for sale typically begins with producers leasing mineral rights from mineral interest owners (who may not be the same parties that own the surface rights for a given parcel of land). After producers extract the oil or gas, first purchasers typically buy the oil or gas at the wellhead, from local tanks located on the leased premises, or at nearby market centers or hubs. Although first purchasers could use the oil or gas for their own commercial purposes, they often (particularly in the case of oil) transport the products for temporary storage before reselling to downstream purchasers like refiners or commodities traders.

Each party involved in the transaction is paid on a different timeline, resulting in open balances between one party and another at various points during the process. Mineral interest owners are usually paid royalties by producers in accordance with their oil and gas leases. Producers are customarily paid by first purchasers on either the 20th day or 25th day of each month for oil or gas produced in the previous calendar month. First purchasers are then paid by downstream purchasers pursuant to the terms of their respective agreements.

The multiple parties involved with the production and shipment of oil or gas results in competing interests. Accordingly, it is of utmost importance for producers and secured lenders to protect their interests by actively monitoring their collateral and debtor counterparties. As explained further below, this precise issue came to a head in the SemCrude bankruptcy cases, where producers and downstream secured lenders both asserted perfected security interests over a first purchaser's assets,1 resulting in a judicial battle over perfection and priority. In SemCrude, J. Aron & Company ("J. Aron") was a downstream commodities dealer that purchased oil from SemGroup, a first purchaser that purchased oil from a variety of sources and places.2 J. Aron purchased over $435 million of crude oil from SemGroup prior to its bankruptcy petition.3 J. Aron thereafter terminated its derivatives contracts with SemGroup and sought to "net" against $345 million owed to SemGroup and tender the remaining $90 million owed to SemGroup's bankruptcy estate for a release of all claims by third parties.4

The producers argued that J. Aron could not setoff over the producers' security interests.5 J. Aron alleged that the producers did not have a security interest, and if they did, it was a subordinate security interest because Oklahoma or Delaware law applied to perfection of the security interest and required the filing of a financing statement.6 Furthermore, J. Aron alleged that it was a "buyer for value" that gave value and received collateral without actual knowledge of any security interest, or in the alternative, a "buyer in the ordinary course" that purchased collateral in good faith and in the ordinary course of business without knowledge of the producers' security interests.7 In multiple decisions, the bankruptcy court ultimately sided with J. Aron and (a) held that the producers had a subordinate security interest relative to a downstream purchaser who validly perfected its security interest in the debtor's state,8 and (b) recommendedsup>9 that the district court find J. Aron to be a "buyer for value" or "buyer in the ordinary course" that took the oil and gas free of the producers' liens.10

On July 30, 2015, the Delaware district court adopted the bankruptcy court's findings and holdings.11 First, the court affirmed the bankruptcy court's holdings with respect to perfection of security interests - because the debtors were located in Delaware or Oklahoma, the laws of those states governed perfection (and not the laws where the oil and gas were produced), which laws required filing a financing statement in that state to perfect security interests.12 Next, the court found that J. Aron was a "buyer for value" because it purchased oil and gas in from SemGroup using unsecured credit without actual knowledge of the producers' purported lien - in fact, even if J. Aron knew where the oil and gas was located and the identity and location of the producers, J. Aron purchased the disputed oil and gas "subject to an express warranty that it was unencumbered."13 Furthermore...