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Another Bankruptcy Court Examines Overriding Royalty Interests

9 September 2015
Mayer Brown Article

In In re: Delta Petroleum Corp. (Bankr. Del. Apr. 2, 2015), the bankruptcy court (the “Court”) considered competing motions for summary judgment as to whether certain overriding royalty interests (“ORRIs”) constituted (1) mere contractual rights to payment that were discharged by the confirmed chapter 11 reorganization plan or (2) real property interests that were not part of the estate in bankruptcy and, thus, survived the trustee’s challenge. The Court’s ruling emphasized the importance of state law characterization of ORRIs, the parties’ intent as expressed in the documents, and state law recording and notice rules.

Background

In 1994, an affiliate of defendant BWAB Limited Liability Company (“BWAB”) acquired from Union Pacific an option to purchase a large number of properties, including certain federal oil and gas leases at Point Arguello, offshore Santa Barbara County, California (the “Properties”). BWAB assigned its option to purchase to Whiting Petroleum Corporation (“Whiting”). Whiting exercised the option in December 1994, acquired the Properties and assigned to BWAB an “overriding royalty interest consisting of an undivided Three and One-Half Percent (3.5%) interest in Whiting’s Net Revenue Interest from the Subject Properties” (the “1994 ORRI”). This assignment was recorded in the Official Records of Santa Barbara County and filed with the Minerals Management Service, Pacific OCS Region (“MMS”).

In 1999, Delta sought to acquire Whiting’s interest in the Properties, but could not obtain the required consents from other working interest owners. In a transaction designed to circumvent the consent requirement, Whiting and Delta agreed that Whiting would convey to Delta “a derivative product which would provide the economic equivalent of conveying title to the Properties.” To implement this arrangement, Whiting executed an assignment of its “net operating interest” (the “1999 NOI”) to debtor Delta Petroleum Corporation (“Delta”). However, Delta did not record the assignment, “due to Whiting’s concern that the other working interest owners would consider such an action as a conveyance of legal title in violation of its agreements with them.” Later in 1999, Delta entered into ORRI assignments with BWAB, granting an ORRI of 3% (the “BWAB ORRI”), and with Aleron Larson, Jr. (“Larson”), granting an ORRI of 1% (“the Larson ORRI”; together with the BWAB ORRI, the “1999 ORRIs”), neither of which were recorded in the county real property records, nor filed with the MMS.

On December 16, 2011, Delta and some of its affiliates filed for chapter 11 bankruptcy relief. On August 16, 2012, the Court confirmed the debtors’ reorganization plan (the “Plan”). Neither BWAB nor Larson filed claims, and apparently both continued to receive payments under their respective ORRIs until September 2012. Following confirmation of the Plan, Delta Petroleum General Recovery Trust and one of the reorganized debtors (the “Plaintiffs”) sought to recover post-petition payments to BWAB and Larson.

The Court’s Analysis

The Court recognized that California law classifies ORRIs as interests in real property.[1] In its analysis of the 1994 ORRI, the Court reasoned that the assignment established the parties’ intent to grant BWAB a fractional interest in the revenue from sale of the hydrocarbons attributable to Whiting’s working interest. The Court also agreed with a previous California opinion, which did not recognize a distinction between an interest granted in net revenue interest and one granted in land or hydrocarbons. See Schiffman v. Richfield Oil Co., 64 P.2d 1081 (Cal. 1937). As such, the Court held that the 1994 ORRI should be characterized as an interest in real property. Consequently, the 1994 ORRI was not a part of the estate in bankruptcy and the holder of the ORRI was not obliged to file a proof of claim.

For comparison purposes, the bankruptcy court in the ATP Oil & Gas Corp. bankruptcy,[2] also involving offshore federal leases, but applying Louisiana law, found that the analysis of intent of the parties necessarily went beyond the four corners of the document. That court held that under the Louisiana Supreme Court’s decision in Howard Trucking Co. v. Stassi, 474 So.2d 915 (La. 1986), the proper characterization of the transactions depended on the true commercial nature of the transaction, notwithstanding the explicit language of the transaction documents. The court concluded that the best evidence of the parties’ intent as to characterization is “what the parties agreed to do,” i.e., the “economic substance of the transactions,” not the description of the transaction set out in the transaction documents.[3] It is not clear from the opinion in the Delta case whether these sorts of arguments were raised and argued.

Regarding the 1999 ORRIs, the Plaintiffs argued that the 1999 NOI was not a real property interest and, consequently, the 1999 ORRIs could not be real property interests either. The Court found that there was an issue of fact as to whether the parties intended the 1999 “net operating interest” to be a real property interest or a contractual right to payment. Because an assignee’s rights are derivative of the assignor’s rights, the Court engaged in a two-part analysis of the ORRI grant. First, the Court examined the situation assuming that the 1999 ORRIs were real property interests. If the 1999 ORRIs were real property interests under California law, then under California’s recording statute, holders must record the conveyances of their interests in the county real property records to provide constructive notice to subsequent purchasers or mortgagees. As the assignments of the 1999 ORRIs were not recorded, and there were no other facts constituting inquiry notice, the trustee in bankruptcy, who stands in the position of a bona fide purchaser for value and without notice, would be able to avoid the priority status of the unrecorded 1999 ORRIs pursuant to Bankruptcy Code § 544(a)(3).

In the alternative, the Court assumed that the 1999 ORRIs were pre-petition contracts providing for payments to BWAB and Larson. The Court reasoned that, although there were no breaches prior to the effective date of the Plan, the contractual rights to payment were claims within the definition of Bankruptcy Code § 101(5). As such, to the extent that the 1999 ORRIs were contractual rights to payment, they were “claims” subject to the discharge provisions of the Plan. Because BWAB and Larson did not file claims in the bankruptcy proceeding, they lost their rights.

Although holders of the 1999 ORRI lost on summary judgment, on a related question about whether they were entitled certain post-petition payments, the Court noted that the parties would be given an opportunity to brief the question of whether the 1999 ORRIs were “production payments” or “term overriding royalty interests” pursuant to § 541 of the Bankruptcy Code.

Conclusion

The Court’s ruling has several important reminders for holders of ORRIs. Most importantly, the conveyance or reservation of an ORRI must comply with applicable state law concerning the nature of the interest conveyed. This analysis should examine (1) how ORRIs are typically characterized (real property interests or contractual rights to payment), (2) whether the express language of the conveyance and the underlying agreements clearly expresses the intent of the parties regarding the interest conveyed, and (3) if the ORRI is an interest in real property, does the state’s recording statute require recording of the instrument in order to create constructive notice that would prevent the trustee in bankruptcy from asserting its status as a BFP without notice, thereby avoiding the ORRI.



[1] The 1994 ORRI conveyance provided that it was to be governed by Colorado law. The Court cites both Colorado and California law with respect to the classification of the ORRI as an interest in real property. The Court also notes that under applicable federal law, the law of the adjacent state – California in this case – controls as to various issues involving the classification of these federal lease interests.

[2] See In re: ATP Oil & Gas Corp., 2014 Bankr. LEXIS 33 (S.D. Tex. Bankr., Jan. 6, 2014) (Case No. 12-36187, Adversary No. 12-03443); In re: ATP Oil & Gas Corp., 497 B.R. 238 (S.D. Tex. Bankr. 2013) (Case No. 12-36187, Adversary Nos. 12-03425, 12-03429).

[3] See In re: ATP Oil & Gas Corp., 497 B.R. at 244-45, 248-55; In re ATP Oil & Gas Corp., 2014 Banrk. LEXIS 33, * 10-58.

Authors

  • Kevin L. Shaw
    Senior Counsel
    T +1 713 238 2665
  • Karl “Lander” Brandt
    T +1 713 238 2735

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