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Pump jack

By Megan R. Knell and William G. Bredthauer

In March of 2020, demand for oil began to steadily decline due to stay-at-home orders and self-quarantine measures that were implemented in response to the COVID-19 pandemic.  The significant decrease in demand led to an excessive supply of oil that caused oil prices to plummet to lows not seen in nearly twenty years. Now, in the wake of the pandemic, exploration and production companies are left to navigate the depressed price environment with limited capital.  Ultimately, a number of companies may be forced to file for bankruptcy protection.  Because an operator or purchaser’s bankruptcy could affect royalty payments, royalty owners should begin taking steps now to protect themselves.

Article 9 of the Uniform Commercial Code (the “UCC”) governs the granting of security interests in “goods” and proceeds from the sale of such goods. Once produced, oil and gas are considered “goods” under the UCC. Each state has passed its own version of the UCC. Article 9 provides that a security interest must be “perfected” by filing a financing statement. Once a security interest is perfected, the holder of the perfected security interest will have priority over unperfected security interests of others in the same produced oil and gas.  

Section 9 of the Texas Business and Commerce Code is Texas’ version of Article 9 of the UCC. Section 9.343 of the Texas Business and Commerce Code, referred to as the First Purchaser Statute, governs (i) the creation of security interests in produced oil and gas and in proceeds therefrom, and (ii) the priority of creditors who claim security interests in oil and gas proceeds. Unlike the general rule under Article 9 of the UCC, Section 9.343 provides that royalty owners do not have to file financing statements in order to perfect their security interests. Instead, their interests are automatically perfected upon the recording of their lease (or a memorandum of lease) in the applicable county records. As a result, the royalty owner holds a perfected security interest whose priority in relation to other secured interests is determined based on the date the lease is recorded. However, as illustrated in two bankruptcy cases, the First Purchaser Statute may not adequately protect a royalty interest owner if the operator or purchaser by whom they are paid is organized in a state other than Texas.

In Samson Res. Co. v. SemCrude, L.P. (In re SemCrude, L.P.), 407 B.R. 140 (Bankr. D. Del. 2009), Texas producers sold oil and gas produced in Texas to SemCrude, who subsequently sold such production to a third party. In the SemCrude bankruptcy, the Texas producers claimed that their security interests in the produced oil and gas, and the proceeds from the sale of such oil and gas, were automatically perfected under Section 9.343. Further, the Texas producers claimed that their security interests under Section 9.343 were superior to those of SemCrude’s banks. The commercial codes in Delaware, Texas, and Oklahoma all contained an identical provision, Section 9.301, which states that the court must apply the laws of the state in which the debtor is organized when determining whether a security interest in collateral was properly perfected. For “cash proceeds,” Section 9.301 provided that the laws of the bank’s jurisdiction would govern.  SemCrude was a Delaware corporation. The bank in which the cash proceeds from SemCrude’s sale of oil and gas were held was located in Oklahoma. Thus, the court determined that Oklahoma law governed perfection of security interests in proceeds from the sale of oil and gas. Although Oklahoma law contained a First Purchaser Statute similar to Texas, Oklahoma’s first purchaser statute expressly provided that it would not “impair or affect the rights, priorities, or remedies of any person” under the UCC. Because the Texas producers did not file financing statements in either Oklahoma or Delaware, their security interests were subordinate to the perfected Article 9 security interests of SemCrude’s banks.  

In the more recent case of In re First River Energy, LLC, 2019 WL 1103294 (Bankr. W.D. Tex. March 7, 2019), First River purchased oil from producers in Texas and Oklahoma. First River subsequently filed for bankruptcy protection.  First River was organized in Delaware as a corporation. The court in First River’s bankruptcy applied the same analysis as the court in Samson Res. Co. v. SemCrude, L.P. (In re SemCrude, L.P.). However, prior to the First River bankruptcy and in response to the outcome in the SemCrude bankruptcy case, Oklahoma amended its version of the First Purchaser Statute to provide that Oklahoma law applies to the perfection of security interests in oil and gas produced from Oklahoma wells and proceeds therefrom, regardless of where the purchaser or operator is incorporated or where their bank is located. It additionally provides that such security interest takes priority over any other security interest, giving the lien a super-priority without filing a financing statement or taking other action. As a result, the Oklahoma producers were able to claim a first-priority security interest in the proceeds from the sales of their production in the First River bankruptcy. However, the Texas producers, without filing financing statements, were again left with liens subordinate to perfected UCC security interests.

Given the outcomes in SemCrude and First River, and the fact that Texas has not yet amended its First Purchaser Statute similar to the Oklahoma first purchaser statute, royalty owners should take inventory of the operators and/or purchasers by whom they are currently being paid. To the extent that their operators and/or purchasers are organized in states other than Texas, and such states do not have a statute similar to Texas’ First Purchaser Statute, royalty owners should file a financing statement in such states in order to perfect their security interests in produced oil and gas and the proceeds therefrom. Due to the rising possibility for bankruptcies in the coming months, royalty owners should begin exploring their rights now to secure their interests in the future.