A recent court decision has reinforced the need to adequately document transactions for the physical sale of crude oil. In Arrow Oil & Gas, Inc., et al. v. J. Aron & Company, et al. (In re Semcrude, L.P., et al.), Case Nos. 15-3094, 15-3095, 15-3096 and 15-3097 (3d Cir. July 19, 2017), the United States Court of Appeals for the Third Circuit held that producers that want to perfect a security interest in crude oil which they sell to an out of state buyer must file a financing statement in the state where the buyer is located. Producers that have not filed such a financing statement do not have a perfected security interest in such crude oil.

This case stems from the sale of crude oil by a collection of upstream producers1 that sold crude oil on credit to Semgroup L.P and its affiliates (Semgroup). The crude oil was sold to Semgroup with Semgroup responsible for paying for the crude oil on the 20th day of the month following the sale. Semgroup in turn sold the crude oil to J. Aron and BP. Semgroup represented in its sales to J. Aron and BP that the crude oil was “free from all royalties, liens and encumbrances.” J. Aron and BP were responsible for paying for the crude oil on the 20th day of the month following the sale.

Semgroup also entered into call options with J. Aron and BP, with Semgroup betting that the price of crude oil would drop. J. Aron and BP wanted to secure a floor price in the event that the price of crude oil increased. Crude oil prices continued to rise throughout 2007 and 2008, with Semgroup selling more options to cover its losses. It was exposed to a potential loss of $2.8 billion in 2008 on such options. Semgroup eventually ran out of funds to cover its margin obligations in connection with the options and declared bankruptcy.

As J. Aron and BP had entered into master agreements to cover their physical and financial trades with Semgroup, they were able to set off amounts owed for crude oil purchases against amounts due under the options. When Semgroup failed to respond to J. Aron’s request for adequate assurance of performance under the master agreement, J. Aron set off amounts it owed to Semgroup for crude oil purchases against amounts owed to it by Semgroup for options trades. BP did the same when Semgroup declared bankruptcy.

Among the claims brought by the upstream producers was the assertion that each producer held a security interest in the crude oil that they had sold to Semgroup, which Semgroup then in turn sold to J. Aron and BP. The producers based in Texas and Kansas argued that, under their states' nonuniform amendments to the Uniform Commercial Code (U.C.C.), they had perfected security interests in the crude oil and that J. Aron and BP purchased the crude oil from Semgroup subject to those security interests. The producers asserted that such amendments give crude oil producers an automatically perfected security interest in the crude oil that they produce.

However, the court concluded that it must apply the corresponding conflicts of laws rules found in the Texas and Kansas U.C.C., which indicate that “while a debtor is located in a jurisdiction, the local law of that jurisdiction governs perfection, the effect of perfection or nonperfection, and the priority of a security interest in collateral.” The court found that Semgroup and its affiliates are registered and therefore located in Delaware or Oklahoma per U.C.C. § 9-307(e). The court indicated that the “local law of [Delaware or Oklahoma] governs perfection,” not Texas or Kansas law, and that Oklahoma and Delaware require perfection by filing a financing statement. Okla. Stat. tit. 12A, § 1-9-310; Del. Code tit. 6, § 9-310. The court concluded that since the producers never made such filings, their interests were unperfected. The court further concluded that neither J. Aron nor BP had actual knowledge of the producers’ security interests in the crude oil sold to Semgroup or acquired the crude oil as a secured party. Accordingly, the court held that J. Aron and BP were “buyers for value” under U.C.C. § 9-317(b) and purchased the crude oil free from any liens.

This case demonstrates the importance of purchase and sale documentation when engaging in physical sales of crude oil. As noted by the court, the upstream producers did not have contractual protections in place to deal with the potential insolvency of Semgroup. In contrast, J. Aron and BP entered into master agreements that provided for the ability to request adequate assurances, and, in the event of Semgroup’s insolvency, the ability to set off amounts owed under the master agreements. Had the upstream producers entered into similar contracts requiring collateral, adequate assurances and containing sufficient termination provisions, they likely would have been in a better position in the bankruptcy proceeding. Sellers of crude oil should consult with counsel to help ensure that their trading documentation contains adequate protections going forward. In addition, for sales of crude oil on credit, sellers may want to consider the relevant perfection laws of the state where their buyer is located and whether they should file financing statements in such state in order to perfect their security interests in the crude oil.