Capital Infusion: Case Spotlight: In re SemCrude, L.P.

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Sudden interruptions in oil supplies caused by the 1973 Arab oil embargo, the Iranian revolution of 1979 and the outbreak of the war between Iran and Iraq in 1980 led to the energy crises of the 1970’s and 1980’s, forcing several of the world’s largest crude oil producers to file for bankruptcy. In response, certain “oil and gas states” such as Texas, Oklahoma and Kansas enacted Oil & Gas Product Lien Statutes to protect those operators producing oil and gas. Under Texas law, for example, an oil and gas producer has an automatically perfected purchase money security interest in the oil and gas it sells at the wellhead without the filing of an actual financing statement. If the interest of the secured party i.e. the operator is evidenced by a recorded deed, mineral deed, mineral reservation, oil or gas lease, mineral assignment, or any other such filing in the real property records of a county clerk in the county in which the minerals are located, that record is effective as a filed financing statement for purposes of UCC Article 9. There is no requirement of re-filing every five years to maintain effectiveness of the filing.

To better understand the potential effect of these non-uniform amendments, industry context is important. Generally, when oil is produced from a well it is either temporarily placed in storage tanks and later transported by truck, or placed into a gathering line with other products (like natural gas) to be delivered to a pipeline and sold. The producer may then market the production and sell to a third party (the “first purchaser”) who may in turn sell it to another subsequent party (a “second purchaser” or “downstream purchaser”).

SemGroup, L.P., a highly-leveraged oil and gas conglomerate of Delaware and Oklahoma companies, was the 18th largest private company in the United States when it filed for Chapter 11 bankruptcy in 2008. Part of SemGroup’s business practices entailed establishing margins on its anticipated purchases of energy products from a producer (therefore becoming the first purchaser) by selling energy products for physical delivery to the customer or entering into futures contracts on the New York Mercantile Exchange or the over-the-counter market (or to the second or downstream purchaser).

SemCrude and certain other affiliates of SemGroup entered into purchase contracts with a variety of oil and gas producers which obligated SemCrude to purchase the producer’s oil and gas production between June 1 and July 21, 2008. However, the economic crisis of 2007–2008 caused volatile energy prices, leading to increased margin requirements on energy hedges. Energy market volatility left SemGroup with over $2.4 billion in recognized trading losses, rendering the massive energy conglomerate incapable of meeting its margin calls. Consequently, SemCrude was unable to pay thousands of oil and gas producers for oil and gas valued to be in excess of $400 million.

When SemGroup filed for Chapter 11 relief, the creditors were comprised of two groups:  the unpaid oil and gas producers and the lenders. Its lenders asserted claims in the aggregate of $2.55 billion, with duly perfected security interests in substantially all of SemGroup’s assets under an existing security agreement. Relying on the Texas product lien statute, the producers argued that their interests were automatically perfected at the wellhead. In a declaratory judgment action on priority, the key question before the bankruptcy court was whether a security interest perfected only in Texas by virtue of automatic perfection was subordinate to a security interest that was duly perfected in accordance with UCC Article 9 rules regarding perfection.

Applying the UCC conflicts of law rules, the court held that a security interest perfected only in Texas by virtue of the automatic perfection under the Texas product lien statute was subordinate to a security interest that was duly perfected against the debtors in the appropriate state. The court reached this conclusion because SemCrude and its subsidiaries were incorporated in Delaware, located in Oklahoma and none of the entities were located in Texas. Under either Delaware or Oklahoma law, the Texas producers would have had to file financing statements in those states to perfect their security interests in the Texas oil and gas and the proceeds thereof. Even if the Texas producers had perfected security interests in the Texas oil and gas and the proceeds thereof, Texas law would govern only the priority of the Texas producers’ security interests in Texas oil and gas or proceeds thereof in the form of exchanged oil or gas held by SemCrude in Texas as of the petition date.

Recognizing that the decision was one of first impression, the court certified its rulings for direct appeal to the United States Court of Appeals for the Third Circuit. Prior to oral arguments however, SemCrude, its lenders and certain producers reached a settlement. The subsequent purchasers (the second and downstream purchasers) were not a part of that settlement and the producers preserved their right to continue to pursue to recover against them. So, in what the Delaware Bankruptcy court has deemed “a tidal wave of disparate adversary proceedings,” the In re SemCrude litigation continues.

Producers filed suit against the subsequent purchasers in an effort to obtain full payment of the purchase contracts. The producers argued that the security interest created by the Texas law still attached to the production sold by SemCrude to the downstream purchasers. The practical result of successfully arguing these claims would leave the downstream purchasers, who have already paid for oil and gas received from a first purchaser, at risk of becoming the involuntary guarantor or insurer of obligations of the first purchaser and being required to pay for the same oil twice. In defense of this argument, the downstream purchasers asserted that they were i.) buyers for value under UCC §9-317 and ii.) buyers in the ordinary course of business under UCC §9-320.

A buyer for value takes free of all security interests if the buyer gives value and receives delivery of the collateral without actual knowledge of the security interest and before perfection. “Value” is any consideration sufficient to support a simple contract. Courts do not inquire into the adequacy of consideration. The In re Semcrude, L.P. court noted that the producers conceded that extension of credit is considered “value given.” Therefore, by paying cash, buying and selling oil, netting payments, and buying on credit, the court found that the downstream purchasers satisfied the § 9-317 value requirement. As to perfection, the court simply noted that it already ruled that the producers’ security interest, if any, was unperfected.

The court went through an extensive analysis of the buyer for value’s knowledge requirement but ultimately based its decision on the express warranty language in the purchase contracts. SemCrude expressly warranted to the downstream purchasers that the oil was not subject to any liens making the existence of the lien statute immaterial as to the purchasers’ actual knowledge of a security interest. When a seller provides a buyer with an express warranty that goods purchased are sold free and clear of all liens in the absence of a record filing, there can be no actual knowledge of the alleged security interest according to the court.

The court granted summary judgment in favor of the downstream purchasers concluding that because the downstream purchasers had no actual knowledge of the producer’s security interest and a security interest in the oil and gas had not been perfected prior to its delivery, the downstream purchasers took the oil and gas free and clear of prior liens and were buyers for value. Having reached this conclusion, it was not necessary for the court to consider the ‘buyers in the ordinary course of business’ defense. However, one might suspect that in light of the ‘tidal wave,’ the court opined on its ‘buyers in the ordinary course of business’ position, likely for the benefit of future litigants.

A buyer of goods in ordinary course takes free of a security interest created by the seller, even if the security interest is perfected and the buyer knows of its existence, if they can show they bought the goods in good faith, without knowledge that the sale violated the producers’ rights, and in the ordinary course of business. The producers did not point to any evidence that illustrated the downstream purchasers lacked good faith. Relying on precedent, the court stated that “[k]nowledge” in this context means ‘actual knowledge,’ and is measured at the time of the sale and that the uncontroverted record indicated that the downstream purchasers could not have known of a violation of the producer’s alleged security interest at the time of sale. Finally, the SemCrude producers argued that the practice of “netting,” whereby the transactions between the first purchaser and the downstream purchasers are settled by netting physical purchases against derivatives trading liability, was not “ordinary course of business.” The court disagreed because SemCrude was in the business of buying oil and gas from producers and then promptly sold it to the downstream purchasers who in turn were also in the business of buying and selling oil and trading oil derivatives.

Texas has historically paved the way for evolving oil and gas issues, but In re SemCrude, L.P. illustrates the importance of fully appreciating the rules of perfection, priority and conflict of laws rules within a particular industry. While the Texas product lien laws were meant to protect producers, In re SemCrude, L.P. exposes the law’s weakness. While it may be that the SemCrude producers are never made completely whole, a Texas senator recently introduced legislation (SB 1094/HB 1859) which purports to protect Texas producers and eliminate potential double liability for downstream purchasers by clarifying certain industry definitions and practices in the current statute. In light of the bankruptcy court’s recent opinion, the Texas legislation is poised to pass in the 2015 session; but as In re SemCrude, L.P. demonstrates, there may still be no guarantees.

The Texas product lien laws have also been said to cause the unintentional effect of diminishing a first purchaser’s ability to obtain financing. The potential that a first purchaser’s inventory, accounts receivable and bank deposits would be subordinate to a producer’s purchase money security interest in those same assets often makes it challenging to structure financing in such a way that lenders can get comfortable. For example, a borrower’s overall borrowing costs may be increased as lenders may require increased reserves against the borrowing base, additional collateral, higher interest rates and certain specialized high risk insurance policies that include protection against the insolvency of a first purchaser.

If you are a bank potentially lending to a producer, part of your due diligence should include not only an analysis of the purchase contracts and any express warranty language they may contain, but also whether or not financing statements have been filed in the appropriate states since, in light of In re SemCrude, L.P., reliance on a state’s product lien law may not be sufficient. In other words, has your borrower taken the necessary steps to perfect its own security interest or will your borrower have to get in line behind the bank financing the purchaser?  On the flip side, if your borrower is a purchaser, have you assessed whether the producer has perfected its purchase money security interest or is there express language in the purchase contract that satisfies the actual knowledge requirement? Do all of the parties who have access to high-risk industry specific insurance have the appropriate policies and endorsements in place? Whether you are targeting a producer, first purchaser or downstream purchaser, or you are advising the same, understanding your position and priority in the energy stream as well as what insurances are available to offset this type of specialized risk could mean the difference of being a $400 million unsecured creditor or a $2.55 billion dollar secured creditor.