United States: District Court Confirms Netting/Setoff Practices

In a recent decision related to the SemCrude bankruptcy, the federal district court upheld the Bankruptcy Court's rulings on the efficacy of certain common risk-mitigation tools used in the energy trading and marketing business – namely product payment netting and cross-product setup upon liquidation and closeout. The decision comes amid long-running challenges from producers who had sold product to the SemGroup entities on credit. Failure to uphold these netting practices in favor of the producers' assertions of the priority of their unrecorded liens would have caused a significant disruption to the energy supply chain. Even so, practical lessons may be taken from the decision: (i) it is important for purchasers of product from a counterparty of questionable credit to check for recorded producer liens before doing business with such counterparties, and (ii) in a bankruptcy involving companies like SemGroup, downstream purchasers may want to consider filing protective claims for potential breaches by the debtor of representations related to title to the product being sold.

The decision was issued seven years following the commencement of the SemCrude chapter 11 bankruptcy. In the underlying lawsuits, SemCrude's downstream purchasers (Purchasers) included J. Aron & Company and BP Oil Supply Company. Multiple suppliers upstream of the debtor were adverse to these Purchasers. Prior to the bankruptcy filing, SemCrude and the Purchasers engaged in various types of oil transactions – physical purchases and sales, options, and financial derivatives. As a result of significant price volatility in the market leading to increased forward exposure to SemCrude by the Purchasers, the Purchasers sought from SemCrude adequate assurances of performance. On July 22, 2008, the SemGroup filed for bankruptcy protection, which was a default under the Purchasers' contracts and triggered contractual termination and close-out netting rights that were protected by the Bankruptcy Code safe harbor provisions.

The Purchasers each terminated and liquidated their respective positions with SemCrude and calculated the respective early termination amounts. Notably, the Purchasers collectively owed approximately $122 million on a net basis, which they paid into an escrow pending resolution of the relevant lawsuits.

At the time that SemCrude commenced its chapter 11 case, it was indebted to scores of producers, including those who ostensibly produced the oil and gas purchased by J. Aron and BP. To ease the process of resolving the respective claims between the parties, separate lawsuits were commenced with regard to the legal issues arising out of the laws of the eight different states in which the several producers operated their extraction and production facilities.

The Bankruptcy Court decision under de novo review by the District Court involved four issues:

  • Whether the Purchasers took oil from SemCrude free and clear as buyers "for value" pursuant to Uniform Commercial Code section 9-317
  • Whether those Purchasers, in the alternative, took that oil free and clear as buyers "in the ordinary course of business" pursuant to Uniform Commercial Code section 9-320
  • Whether the producers had viable and preemptive claims under principles of common law tort and in equity (under various theories, including unjust enrichment and fraud) which superseded Purchasers' UCC-based rights
  • Whether Oklahoma-based producers had unique and viable rights under the Oklahoma Production Revenue Standards Act

The District Court found for the Purchasers on all points.

On the "buyer for value" theory, the District Court agreed with the Bankruptcy Court that the Purchasers took the disputed oil free and clear of all liens as buyers for value under section 9-317 of the UCC as that provision was adopted by each of the relevant eight states. Importantly, the producers' assertions that "automatic" lien perfection statutes under Kansas and Texas law gave them priority were discounted because the producers had failed to file UCC-1 "financing statements" in either Delaware or Oklahoma (where the debtors' operations were located). The District Court also rejected the producers' assertion that the Purchasers had "actual knowledge" of the producers' specific statutory liens based on their general knowledge of the business, and further declined to impute actual knowledge that producers' sales to the debtor remained unpaid, even though the producers argued such sales often are made on credit to the buyer.

The District Court further held that the Purchasers were "buyers in the ordinary course of business." The Purchasers had to demonstrate four distinct elements to prevail on this defense: (i) that they made the purchase in "good faith"; (ii) that they lacked knowledge that the sale violated rights of the producers; (iii) the purchase was made in the "ordinary course of business," and; (iv) the transfer was not in satisfaction of a debt, per UCC section 1-201(b)(9). The District Court determined that the Purchasers met all four elements.

In addition, producers argued that the offsetting (netting) of obligations between Purchasers and debtors with regard to product purchases and derivatives obligations deprived the transactions of the "ordinariness" requirement. However, the District Court rejected the argument that closeout netting and setoff retroactively deprived a transaction of having been entered into in the ordinary course. Notably, the parties engaged in two distinct netting operations: monthly oil-for-oil netting and "cross-product" netting, the latter of which occurred only upon a default under the Master Agreement for the parties' swaps (an "ISDA Master Agreement"). Because the cross-product netting only occurred after default, and after all "physical" oil transactions were complete, the relevant time for a determination of "ordinary course" status had passed, thus preserving the defense.

Finally, with regard to whether the acquisition of oil products possibly subject to the producers' liens was "in total or partial satisfaction of a money debt," the Bankruptcy Court had held – and the District Court agreed – that "money debt" meant one that was preexisting at the time of the transaction. Applying relevant precedent, the District Court affirmed the Bankruptcy Court's determination that the substantially contemporaneous netting by the parties of their mutual obligations did not rise to the level of satisfaction of an antecedent money debt.

This case involving numerous theories by producers to hold downstream purchasers of a debtor responsible for their own credit decisions and practices had caused some concern in the industry. These concerns have been largely put to rest. Because the District Court's decision turns significantly on the failure of the producers to record their liens, it is prudent as part of the due diligence on the creditworthiness of a counterparty to check for recorded liens. For their part, producers can take away a couple of lessons as well: (i) to the extent they want the priority of their liens to be recognized, they may consider recording them, and (ii) the automatic liens may not be sufficient to protect their interests, so they may want to evaluate a buyer's credit and put in place additional risk-mitigation measures.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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