The United States Circuit Court of Appeals for the Third Circuit issued a decision that significantly affects the rights of upstream producers. Applying Delaware law, the Third Circuit explained that the upstream producers needed to file a financing statement in the state where the first purchaser was located in order to perfect their security interest in the oil that they sold. Where the upstream producers did not file financing statements, the Third Circuit held that they did not possess a perfected security interest in the collateral. In light of existing commercial practices in the oil and gas industry, firms may wish to review their credit policies and procedures to ensure that their interests are fully protected once they relinquish possession of their oil.1

SemGroup L.P. and its subsidiaries purchased oil on credit from thousands of upstream producers across a number of states. SemGroup transported the oil via truck and pipeline, and the oil was stored in “major aggregation centers in Oklahoma, Kansas, and elsewhere.” SemGroup would then sell the oil to downstream purchasers on credit, and it expressly warranted that the oil was sold “free from all royalties, liens, and encumbrances.”

SemGroup was also involved in the trading of options contracts, which provided the right to buy or sell oil at a fixed price on a specified date. SemGroup experienced significant losses in 2007 and 2008 based on the position it took on oil prices, and as a result, it sold additional options to cover its losses. SemGroup also pledged cash collateral to margin accounts to cover its exposure. SemGroup was ultimately unable to honor its obligations and filed for protection under Chapter 11 of the Bankruptcy Code.

Lenders, producers, and purchasers were actively involved in the bankruptcy case, in which the parties filed numerous suits to determine their rights and priority position in the assets of the bankruptcy estate. Numerous upstream producers, including J. Aron & Co. and BP Oil Supply Co., commenced adversary actions against the downstream purchasers. The litigants filed cross motions for summary judgment, and the bankruptcy court concluded that the downstream purchasers, as buyers for value, bought the oil from SemGroup free and clear of all liens. The district court adopted the bankruptcy court’s recommendation, and the upstream producers appealed the decision.

The Third Circuit held that the upstream producers did not possess perfected security interests in the oil. Applying Delaware law because the choice-of-law provision in the Texas and Kansas versions of the Uniform Commercial Code (UCC) required application of the law of the jurisdiction in which the debtor was located, the court explained that the upstream producers needed to file financing statements in order to perfect their security interest. Where the upstream producers failed to make the requisite filings, their security interests were not perfected.

The upstream producers argued that they were not required to file financing statements under the as-extracted collateral exception to Section 9-301 of the UCC. “[A] debtor must have a preexisting interest in the oil before it is extracted at the wellhead” in order to qualify under the as-extracted collateral exception. As SemGroup did not possess any rights to the oil while it was in the ground, the exception failed. The Third Court explained that “[i]f the oil producers want to encumber the oil they sell to an out-of-state first purchaser, all they need to do is comply with the rules uniformly applicable throughout the country to all sellers of goods—file a financing statement in the state where that first purchaser is located.”

The Third Circuit also held that the downstream purchasers qualified as buyers for value. J. Aron and BP acquired the oil on credit, and “purchases on credit—promises to pay—are more than sufficient to satisfy the ‘value’ requirement.” Further, they purchased the oil without knowledge of the security interest of the upstream producers. Despite extensive discovery, the upstream producers were not able to show that J. Aron and BP possessed anything more than constructive knowledge of their security interest in the oil. SemGroup sold the oil free and clear of all liens. The upstream producers did not take any action to notify the relevant parties of their security interest, nor did they communicate directly with J. Aron or BP on any subject. While the downstream purchasers were aware of state lien laws, the existence of the upstream producers, and SemGroup’s purchase terms, the evidence demonstrates that J. Aron and BP might have known of the upstream producers’ security interests. Constructive knowledge, however, “does not defeat the buyer-for-value defense ...” The downstream purchasers thus acquired the oil free and clear of any liens.

The Semcrude decision is significant in light of existing commercial practices in the oil and gas industry. Where parties make purchases on credit and such transactions involve multiple parties, oil producers should revise their policies and procedures to ensure that their security interests are properly created and perfected. Firms should also pay increased attention to whether their purchasers intend to resell the oil to third parties and, if so, review the terms of these third-party sales to ensure that their purchasers do not make representations or warranties that adversely affect their security interest in the oil.

The above-referenced case is Arrow Oil & Gas, Inc., et al. v. J. Aron & Co., et al. (In re Semcrude, L.P., et al.), Nos. 15-3094, 15-3095, 15-3096 and 15-3097 (3d Cir. July 19, 2017).