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April 26, 2021

Governing Law Provisions of Texas Article 9 Result in Unintended Effect for Oil & Gas Producers

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GOVERNING LAW PROVISIONS OF TEXAS ARTICLE 9 RESULT IN UNINTENDED EFFECT FOR OIL & GAS PRODUCERS

In a recent case (“First River”) involving the priority of a security interest in hydrocarbons produced from a well in Texas, the Fifth Circuit affirmed the holding of the Bankruptcy Court that the security interest of a lender to a third-party purchaser had priority over the security interest of the producer that sold the hydrocarbons to such third-party purchaser[1]. The producer (“Producer”) had extracted the hydrocarbons from a well in Texas and sold them to a company formed in Delaware (“Purchaser”). The sale of the hydrocarbons was secured by a security interest in favor of the Producer pursuant to Section 9.343 of the Texas Uniform Commercial Code (the “Texas UCC”). The Purchaser had a loan from a bank (“Bank”) which was also secured by the hydrocarbons. Subsequent to the loan from the Bank and the sale of the hydrocarbons from the Producer, the Purchaser filed in Bankruptcy Court. With regard to the hydrocarbon collateral, the issue was whether the Producer or the Bank had priority in the hydrocarbons.

History of Section 9.343

After the decline of oil prices in the 1980s, Section 9.343 of the Texas UCC was enacted in 1983 as a non-standard provision of the Texas UCC to provide interest owners (such as royalty owners and producers) a security interest to secure the payment obligation of a first purchaser who has purchased oil and gas from such interest owner. The security interest covers oil and gas production in the first purchaser’s possession and the identifiable sales proceeds owned, received or due to the first purchaser[2]. This security interest is perfected automatically without the filing of a financing statement and generally has priority over all other security interests in the production whether such security interests were filed earlier.

Perfection and Priority

In First River, the Producer argued that Section 9.343 of the Texas UCC gave it priority and the Bank argued it was the first to file a financing statement (in Delaware) and therefore had priority under the priority rules of Section 9.322(a) of the Texas UCC. At issue was whether Texas or Delaware law applied. Both states had adopted the uniform version of Section 9.301 of the Uniform Commercial Code which provides that the law of the jurisdiction of the debtor’s location[3] governs the perfection and priority of a security interest in collateral. Because the Purchaser was a Delaware entity, the Bankruptcy Court held that the special perfection and priority rules of Section 9.343 of the Texas UCC did not apply. Under Delaware law, since the Producer did not file a financing statement with the Delaware Secretary of State, it failed to perfect its security interest and further, if the Producer had filed such a financing statement, its security interests would be subordinate to the Bank’s because the Bank’s filing was prior to the sale of the hydrocarbons.

Conclusion

The Texas legislature enacted Section 9.343 of the Texas UCC to protect producers in the sale of their production. When Article 9 of the Texas UCC was revised and updated, the Texas legislature failed to consider the effect of new governing law provisions which streamlined earlier provisions and placed nearly sole importance on the location of the debtor. The Oklahoma Legislature addressed a similar statute by classifying produced oil and gas as a real property interest outside of Article 9 rather than personal property[4]. This was intended to move the governing law matter from the location of the debtor to the location of the production. However, it is not clear whether other jurisdictions will recognize produced oil and gas as real property. The UCC has traditionally classified produced oil and gas (i.e. “as-extracted collateral”) as personal property subject to the provisions of the UCC[5]. As a result, a Delaware court may hold that the oil and gas of a Delaware purchaser is personal rather than real property based upon the Delaware UCC despite the Oklahoma statute.

Consequently, a current state of uncertainty exists for producers and lenders. There are very few cases addressing this matter leaving producers and their lenders as well as lenders to purchasers less than certain about the priority of the interest in the oil and gas prior to payment for such oil and gas once it is in the hands of the purchaser. Accordingly, Producers and lenders need to be aware of this risk and address it appropriately. Various options exist to provide greater certainty, including (1) requiring full payment up front, (2) assessing more carefully counterparty credit risk and obtaining adequate credit support if appropriate, (3) obtaining a subordination agreement from lenders to purchasers until the producer is paid in full, (4) revising the UCC in the relevant jurisdictions to recognize a purchase money security interest of producers in the oil and gas they sell[6] or (5) other legislative, contractual or commercial approaches to insure payment for the production is not at risk if the purchaser defaults under its credit facility or goes bankrupt prior to paying for the production. None of these fixes will be easy and will require careful consideration by all parties in interest of all the potential issues.

Footnotes

[1] In re First River Energy, LLC, 98 U.C.C. Rep. Serv. 2d 179 (Bankr. W.D. Tex. 2019), motion to certify appeal granted, 2019 WL 1782628 (Bankr. W.D. Tex. 2019), aff’d, 986 F.3d 914 (5th Cir. 2021).
[2] Bernard F. Clark Jr. and Ellen Conley, Oil and Gas Matters, In the First Purchaser Protection Matchup, Oklahoma Leads Texas 1-0, State Bar Of Texas
[3] As a general rule under the Uniform Commercial Code, a debtor is located in the jurisdiction in which it is formed; in this instance, the Purchaser was formed in Delaware.
[4] Bernard F. Clark Jr. and Ellen Conley, Oil and Gas Matters, In the First Purchaser Protection Matchup, Oklahoma Leads Texas 1-0, State Bar Of Texas
[5] Section 9-102(a)(6).
[6] Section 9-324 of the UCC gives a holder of a purchase money security interest in goods priority over conflicting security interests.

Authors and Contributors

Hugh Tucker

Partner

Mergers & Acquisitions

+1 713 354 4899

+1 713 354 4899

Houston