With the recent uptick in energy-related bankruptcies expected to continue for the foreseeable future (in one prominent example, industry giant Weatherford has just filed for Chapter 11 protection), oil and gas royalty owners need to be on alert. Because companies in financial distress usually fall behind on royalty payments, royalty owners, usually one of the largest groups of creditors in oil and gas bankruptcies, tend to have a lot at stake. This blog goes over how oil and gas royalty owners can protect their interests in these tough economic times.

Secured Status under Texas Law

In Texas, royalty creditors are afforded statutory protections. Section 9.343 of the Texas Business & Commerce Code states that a royalty creditor has a security interest to secure the obligations of the first purchaser of production to pay the purchase price. The “first purchaser” includes an operator who, by agreement with a third-party purchaser, collects production proceeds from the purchaser and distributes those proceeds to royalty owners. Provided the royalty interest is evidenced by a deed, lease, or other instrument recorded in the real-property records, no financing statement is required, and the security interest is perfected automatically. A 9.343 security interest is given the prioritized status of a purchase-money security interest and extends not only to oil and gas production, but also to the identifiable proceeds of that production.

Factors To Be Wary Of And How To Increase Protection

Although Section 9.343 favors royalty creditors, because security interests continue in cash proceeds that have been transferred to bona-fide purchasers, said interests become less effective in situations when cash proceeds are commingled, a common occurrence in bankruptcy scenarios and one which places creditors in a compromised position. Vigilant and proactive creditors can request that a separate bank/escrow account be created to prevent, or, at the least, minimize, commingling, resulting in the protection and preservation of important collateral.

Moreover, 9.343 has been recently interpreted by a bankruptcy court in Texas to create a security interest that can arise only by contract, and that is within the scope of both Texas’ and Delaware’s version of Article 9 of the Uniform Commercial Code (UCC). In re First River Energy, LLC, 2019 WL 1103294 (United States Bankruptcy Court, W.D. Texas, March 7, 2019). To this end, Texas § 9.301 and Delaware § 9-301 both provide 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.” Delaware law imposes the additional requirement that royalty owners perfect their security interests through the filing of financing statements in all jurisdictions where oil & gas product and proceeds are produced and/or held. Del.Code Ann. tit. 6, § 9–310(a). Because many oil and gas debtors are able to claim some sort of Delaware presence for bankruptcy jurisdictional purposes, royalty owners must be wary that Delaware law could come into play.

In sum, royalty interests are not statutory liens by nature, rather, they are contractual and subject to choice-of-law principles, something that commonly dilutes protection because of Delaware legal principles. To combat this, royalty owners should proactively file financing statements in all jurisdictions where oil & gas product and proceeds are expected to be produced and/or held.