Third Circuit Applies Delaware Choice of Law Rules Allowing Subsequent Purchasers of Oil and Gas and Lenders to Prevail against Upstream Producers
On July 19, 2017, the Third Circuit Court of Appeals issued an opinion in Arrow Oil & Gas, Inc., et al. v. J. Aron & Company, et al. (In re Semcrude, L.P., et al.), Case Nos. 15-3094, 15-3095, 15-3096 and 15-3097, affirming the Delaware bankruptcy court and district court, holding that upstream oil producers do not have an automatically perfected statutory security interest in oil sold even if Texas or Kansas law applied. In order to perfect a lien to secure purchase money, upstream oil producers would need to file UCC-1 financing statements and would remain subject to the priority scheme under Article 9 of the U.C.C.
The upstream oil producers sold oil to SemGroup L.P. and affiliates (“SemGroup”). SemGroup is a conglomeration of midstream oil and gas service providers and the Debtors in the underlying Chapter 11 Cases. In turn, SemGroup sold oil to and traded oil futures with certain downstream oil purchasers, including J. Aron & Company (“J. Aron”). J. Aron purchased over $435 million of crude oil from SemGroup prior to the bankruptcy filing. J. Aron thereafter terminated its derivatives contracts with SemGroup and per the standard language of the contracts sought to “net” the amount owed to SemGroup against the amounts SemGroup owed on the derivatives contracts. The upstream oil producers only relied on the local laws of their respective states that could potentially give them automatically perfected security interests or trust rights in the oil purchased by downstream purchasers. As a result of the standard netting provisions in the derivatives contracts, when SemGroup filed for bankruptcy, many of the downstream purchasers were paid in full or left with small unpaid claims, but the upstream producers were left unpaid.
The upstream oil producers argued that Article 9 of the U.C.C. (Tex. Bus. & Com. Code § 9.343 and Kan. Stat. § 84-9-339) granted them an automatically perfected purchase money security interest in the oil sold to SemGroup. As such, the upstream oil producers argued that the Third Circuit should apply Texas’s and Kansas’s version of the Uniform Commercial Code (“U.C.C.”).
The Third Circuit stated that “even if we were to apply Texas or Kansas law, we apply those states’ versions of Article 9, not just their non-uniform amendments in isolation.” The Third Circuit then went on to state the universally adopted choice-of-law provision of the U.C.C., stating that “while a debtor is located in a jurisdiction, the local law of that jurisdiction governs perfection, the effect of perfection or non-perfection, and the priority of a security interest in collateral.” See U.C.C. § 9-301(1); see Tex. Bus. & Com. Code § 9.301(1) (same); Kan. Stat. § 84-9-301(1) (same). As such, even if the Third Circuit applied Texas's or Kansas’s U.C.C., the choice-of-law provisions contained in the Texas or Kansas U.C.C. would still lead to the application of Delaware or Oklahoma law. The Third Circuit then addressed and summarily dismissed the potential exceptions to U.C.C. § 9-301(1). Because SemGroup and its affiliates were formed in Delaware or Oklahoma, the state law of Delaware or Oklahoma governed perfection. Oklahoma and Delaware require perfection by filing a financing statement, and because the upstream oil producers did not file a financing statement, their interests were unperfected.
The Third Circuit further held that the downstream purchasers qualify as buyers for value under U.C.C. § 9-317(b) which states that “[a] buyer, other than a secured party, of . . . goods . . . takes free of a security interest . . . if the buyer gives value and receives delivery of the collateral without knowledge of the security interest . . . and before it is perfected.” If a security interest is not perfected, a buyer takes the property free of that security interest unless the buyer actually knew of the security interest, and the downstream purchasers did not know which producers’ oil they received, let alone whether there was a specific security interest in that oil. As such, the downstream purchasers qualified as buyers for value under U.C.C. § 9-317(b).
The Third Circuit rejected a fraud claim by the upstream oil producers finding that there was no evidence that the downstream purchasers knew they were taking oil for which the upstream producers had not been paid.
Finally, the Third Circuit addressed a specific claim asserted by the Oklahoma upstream oil producers which provides that the Oklahoma Production Revenue Standards Act (the “PRSA”), Okla. Stat. tit. 52, §§ 570.1 et seq., creates an implied trust in their favor that, absent full payment, travels perpetually down the stream of commerce. In other words, so long as those Oklahoma upstream oil producers have not been paid, whoever possesses the oil does so for the benefit of the producers. The Third Circuit held that the PRSA regulates the relationships of the many parties at the wellhead, which include the various interest owners and the operators of those wells, and, moreover, the PRSA has no provisions relating to downstream purchasers.