Third Circuit Denies Automatic Perfection of Oil Producer Liens

In a recently decided, but long-running dispute, the U.S. Court of Appeals for the Third Circuit has found that oil producers do not hold automatically perfected security interests in product they sell to midstream intermediaries, nor are the proceeds generated through the subsequent sale of such product held in an implied trust for the benefit of the upstream producers, as held in Arrow Oil & Gas v. J. Aron (In re SemCrude), 2017 U.S. App. LEXIS 12975 (3d Cir. July 19). In its decision, the Third Circuit determined that an automatically perfected security interest or implied trust would result in “chaos” in an industry where oil is comingled and sold multiple times in the stream of commerce.

Background

SemGroup L.P. was a midstream oil service provider that, along with its subsidiaries, bought oil from thousands of producers, including those located in Kansas, Oklahoma and Texas (collectively, the appellants). SemGroup then resold the oil to downstream purchasers, including J. Aron & Co. and BP Oil Supply Co. (collectively, the appellees). Per industry custom, SemGroup expressly warranted oil sales as being “free from all royalties, liens, and encumbrances.”

SemGroup also engaged in trading oil futures with the appellees. It sold “call options,” whereby the purchaser of the option would pay SemGroup an upfront premium in exchange for the right to purchase an amount of oil at a set price on a certain date. If on the futures option date, the market price for oil was less than the option price, the option became worthless, leaving SemGroup with the profit from the upfront premium. If, however, on the option maturity date, the market price for oil exceeded the strike price, SemGroup would lose money as it could have sold the oil for more on the open market but was constrained by the options price.

Throughout 2007 and 2008, SemGroup bet on an oil price drop in what turned out to be a rising market. Each time SemGroup lost money on a futures trade, it “doubled down” by selling more options in order to collect enough upfront premiums to cover losses. However, SemGroup was required to post collateral to margin accounts equal to what it would owe if the options liquidated at oil's current market price. SemGroup's exposure increased to $2.8 billion by July 2008, resulting in a liquidity crisis.

When the appellees began purchasing oil and trading options with SemGroup, they entered into ­agreements that allowed them, in the event of a default, to set off all outstanding amounts owed for oil purchased against amounts due from SemGroup related to the options. J. Aron first exercised this setoff right on July 17, 2008, after SemGroup defaulted on the adequate assurance of performance provision of the parties' agreement. On July 22, 2008, SemGroup filed for Chapter 11, triggering a default under SemGroup's agreement with BP, which then exercised its setoff right. After both setoffs were taken, SemGroup was owed a net of $90 million from J. Aron and $10 million from BP.

The appellants, who were unpaid in SemGroup's bankruptcy, filed suits against the appellees, alleging the appellees purchased oil from SemGroup subject to the appellants' perfected security interests or held proceeds of the oil sale in an implied trust on the producers' behalf. While these suits were pending, SemGroup confirmed a reorganization plan whereby the appellees paid SemGroup the net amount owed to it after setoff of the options. On the appellees' motion, the Delaware Bankruptcy Court recommended summary judgment in the appellees' favor, finding the appellees were buyers for value or in the ordinary course and thus purchased oil from SemGroup free and clear of any alleged security interest. The district court adopted the bankruptcy court's recommendation on summary judgment.

On appeal, the appellants' first argument was that Texas and Kansas nonuniform amendments to Article 9 of the Uniform Commercial Code (the UCC) provided Texas and Kansas producers with automatically perfected security interests that remained attached to the oil the appellees purchased. The appellants next maintained the oil was collateral for the appellants' extension of credit to SemGroup, and therefore, the appellants could reclaim the oil (or the value thereof) from the appellees, because SemGroup never paid the appellants for the oil. The appellees asserted the “buyer for value” defense, which provides that when a security interest is not perfected, a buyer who did not actually know of the security interest takes the property free from that security interest.

The Ruling

The Third Circuit determined that the appellees satisfied all three elements of the buyer-for-value defense, and thus purchased the oil free and clear of any appellant lien. First, the court determined that the appellants did not have perfected security interests in the oil. The appellants' claim of automatically perfected security interests was based on Texas and Kansas UCC amendments, but the court determined that Article 9's choice-of-law provision required courts to apply the state law of the jurisdiction where the debtor is located, not the production location's state law.

SemGroup and its affiliates, as Delaware and Oklahoma corporations, were subject to Delaware and Oklahoma perfection laws, which both require perfection by filing a financing statement. Thus, the court determined that the appellants' interests were unperfected because they did not file financing statements. Second, the court concluded that the appellees' purchases were for “value,” not as collateral for the options.

The court found the appellants mischaracterized the appellees' and SemGroup's transactions in arguing that oil was collateral securing the options. Thus, the court held the appellees' oil purchases on industry-standard credit satisfied the value requirement. Last, the Third Circuit found the appellees had no actual knowledge of the appellants' purported security interests.

The court noted that SemGroup's sales to the appellees were on industry-standard terms, expressly disclaiming any continuing security interest. Furthermore, no evidence was presented supporting the appellees' actual knowledge of alleged security interests, and any potential constructive knowledge of the appellees was irrelevant under the buyer for value defense. Thus, the Third Circuit held that the appellees were buyers for value and took the oil free of any liens.

The appellants' second argument on appeal was that an Oklahoma statute imposed an implied trust on the oil proceeds for their benefit. The Third Circuit held that the appellants' argument failed under a plain reading of the statute. First, the court determined that the statute was meant to govern the relationship between producers and parties closely related to wellheads, not the appellees as downstream purchasers not knowing who produced the oil they ultimately purchased. Second, the court determined that a plain reading of the Oklahoma statute did not logically establish an implied trust running to each downstream purchaser, further evidenced by the statute's lack of any imposed trust duties.

Conclusion

The SemCrude decision, from an energy industry perspective, helps eliminate some of the potential chaos that might ensue if a downstream purchaser is faced with the risk that a producer lien might follow the product or proceeds thereof. It also reduces the concern a lender to such downstream purchaser might have as to whether its collateral is subject to a prior producer lien, which might otherwise impair the ability of the downstream purchaser to obtain credit.

However, the decision does reduce to some extent protections afforded to producers that are otherwise not paid in the ordinary course for the product sold. Also, it should be noted that the SemCrude decision was based upon an application of Delaware and Oklahoma law, which means its application with respect to the law of other states remains an open question.

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Francis J. Lawall is a partner in the Philadelphia office of Pepper Hamilton. Marcy McLaughlin is an associate in the firm's Wilmington, DE, office. This article also appeared in The Legal Intelligencer, an ALM sibling publication of this newsletter.