A bankruptcy court’s characterization of a debtor’s pre-petition conveyance of an overriding royalty interest (“ORRI”) has an important effect on whether that ORRI is part of an oil and gas debtor’s bankruptcy estate and, in turn, what rights the ORRI holder has with respect to that interest. If an ORRI conveyance is characterized as the transfer of a real property interest, the conveyance is generally excluded from the debtor’s bankruptcy estate and the ORRI holder’s interest may not be affected by the bankruptcy. If, however, a bankruptcy court characterizes the ORRI conveyance as a disguised financing transaction, then the ORRI holder may find itself a creditor with a claim subject to bankruptcy discharge.

The characterization of an ORRI is generally determined by state law. However, two recent bankruptcy court opinions which took different approaches to analyzing ORRI conveyances highlight the need for ORRI holders to plan and think broadly when negotiating and documenting an ORRI conveyance.

In an April 2015 opinion in In re Delta Petroleum Corp., Adversary Proceeding No. 12-50898, the United States Bankruptcy Court for the District of Delaware primarily focused on language in the parties’ transaction documents in interpreting the parties’ intent to evaluate whether the ORRI conveyances at issue were real property transfers to the ORRI holder by the debtor, or merely contractual interests under applicable state law. With respect to one ORRI at issue, the Court concluded that the conveyance was a real property interest, basing its analysis primarily on the plain language and definitions contained in the transaction documents alone.

By contrast, in a January 2014 opinion in NGP Capital Resources Company v.ATP Oil & Gas Corporation, Adversary No. 12-03443 in the United States Bankruptcy Court for the Southern District of Texas, the Court analyzed whether various term ORRI conveyances were transfers of real property, or were disguised financing transactions. In its memorandum opinion, the Court’s reasoning focused on the true economic substance of the parties’ transaction, notwithstanding language contained in the transaction documents. The Court considered extrinsic evidence in evaluating the economic substance of the conveyance – including evidence of the parties’ internal accounting, tax treatment, and the respective operational risk burdens borne by both parties. Finding that this type of extrinsic evidence reflected the parties’ true intent, and not the transaction documents alone, the Court rejected the ORRI holders’ argument that the court must limit its analysis to the transaction documents in interpreting the true nature of the conveyance. As a result, the Court held that issues of fact existed as to whether the ORRI conveyances at issue were real property transfers or debt instruments under state law, denying the term ORRI holder summary judgment.

The lesson learned from the NGP Capital case is that the economic substance of the conveyance, and not just the parties’ transaction documents, may influence a bankruptcy court’s characterization of an ORRI conveyance. It is possible that the parties’ intent in documenting a real property transfer in connection with an ORRI conveyance may be interpreted differently in the bankruptcy context, thus risking the ORRI holder’s ability to retain its interest outside of the bankruptcy estate. Parties to ORRI conveyances should ensure that not only the language of the transaction documents, but the economic substance of the contemplated transaction, is consistent with their intent under applicable state law, in avoiding any surprises in an oil and gas bankruptcy.