Close to 10 years have passed since the filing of the Chapter 11 cases of Tulsa, Oklahoma-based SemCrude L.P. However, the Third Circuit Court of Appeals recently affirmed a 2015 district court ruling that resolved a dispute between oil producers and downstream purchasers over the perfection and priority of interests in oil sold by SemCrude L.P. and its affiliates. The Third Circuit’s holding in In re SemCrude L.P., 864 F.3d 380 (3d Cir. 2017), affirmed the earlier bankruptcy and district court rulings that the downstream purchasers were “buyers for value” and took oil purchased from SemGroup free and clear of the oil producers’ liens. The decision serves as a stark warning for oil producers not to rely on automatic perfection provisions of state law, and take efforts to put subsequent purchasers on actual notice.
SemGroup filed for Chapter 11 in 2008. SemGroup and its subsidiaries provided midstream oil services, whereby SemGroup purchased oil from oil producers and resold that oil to downstream purchasers. SemGroup also traded oil futures with two of its downstream purchasers in a trading strategy that ultimately led to SemGroup’s insolvency. The downstream purchase agreements provided that in the case of default, the downstream purchasers could offset the amounts owed to SemGroup by the amount that the SemGroup owed the purchasers for the value of outstanding futures trades. At the time of SemGroup’s filing, more than one thousand oil producers were unpaid.
The offset feature of the purchase agreements resulted in full recovery to the downstream purchasers; however, the oil producers received only partial payment in the plan of reorganization. Unhappy with only a partial recovery under the plan, the oil producers brought claims against the downstream purchasers under theories of fraud, priority security interests under Texas and Kansas laws, and implied trust under the Oklahoma Production Revenue Standards Act (PRSA).
The court entirely rejected the claims of security interests. Texas and Kansas have enacted nonuniform Uniform Commercial Codes with special provisions for owners such as oil producers. In Texas, interest owners have an automatically perfected security interest in oil produced and the identifiable proceeds related thereto. In Kansas, oil producers are required to file an “affidavit of production” in order to perfect their security interests in the oil. In both jurisdictions, the oil producers’ lien is extinguished after the first purchaser sells to a buyer in the ordinary course.
The oil producers argued that, under applicable state law, they held automatically perfected security interests in all oil sold to SemCrude, and that the downstream purchasers took subject to those security interests. First, the court held that the oil producers had not perfected the security interests in accordance with the local laws of Delaware and Oklahoma (where the debtors, the first purchaser of the oil, reside). Given that Texas and Kansas had adopted Article 9 of the Uniform Commercial Code, it is the laws of the jurisdiction of the debtor’s location that “governs perfection, the effect of perfection or nonperfection, and the priority of a security interest in collateral” under U.C.C. § 9-301(1).
Second, the Third Circuit held that the downstream purchasers were “buyers for value” who acquired the oil without any actual knowledge of the oil producers’ interests, and therefore the downstream purchasers acquired the oil free and clear of any asserted security interest. In short, although Texas and Kansas state law appeared to afford oil producers automatic protection of their security interests, the validity of those security interests turned on perfection in the debtor’s locale and the actual knowledge of the purchaser.
With respect to the oil producers’ PRSA claim, the oil producers asserted that they held an implied trust that traveled “perpetually down the stream of commerce . . . [and] whoever possess the oil does so for [the oil producers’] benefit.” The Third Circuit rebuffed the oil producers, holding that “this interpretation simply fails the text of the statute” and that “whatever duties PRSA creates, they do not apply to downstream purchasers.” Similarly, the court found no hallmarks of fraud and observed that there existed no evidence that SemGroup “ever intended to avoid paying for oil” or that the downstream purchasers conspired with SemGroup.
In closing, the court observed that the oil producers “theoretically could have perfected their security interests, traced those interests in the oil that extended to their accounts receivable, and forbade SemGroup from using those accounts as margin collateral for their options trades.” Having failed to take those steps, the oil producers could not look to parties like the downstream purchasers “who took precautions against insolvency . . . [to] act as insurers to those who took none.” The effect of any other finding “would be chaos.”