United States: Houston Bankruptcy Judge Takes Step Toward Recharacterizing Term Overriding Royalty Interest As Loan

Last week, Houston bankruptcy Judge Marvin Isgur found that a term overriding royalty interest (ORRI) can be recharacterized as a loan in some circumstances where the interest terminates upon the repayment of the purchase price and an imputed rate of interest, regardless of how the transaction is documented. Judge Isgur considered the substance of the transaction over the form. This transaction structure, frequently used to raise capital in the energy industry, is commonly assumed to protect the overriding royalty owner from any interruption in payment out of its share of production, even if the seller files bankruptcy. Judge Isgur's opinion challenges this assumption.

The characterization of this transaction is critically important to the parties where the seller files bankruptcy because loans do not enjoy the same protection as an ORRI, which remains the property of the buyer and does not become property of the seller's bankruptcy estate. As a result, the bankruptcy does not affect the buyer's right to the proceeds from its share of production because the seller cannot use the proceeds or alter the rights of the buyer. On the other hand, if the transaction is characterized as a loan, the royalty owner is treated as a lender and its rights in production are treated as collateral owned by the seller.

When the seller files bankruptcy, the share of production attributable to the override becomes property of the seller's bankruptcy estate with the royalty owner's interest treated as a lien. Under bankruptcy law, a debtor, after proving to the courts that it is adequately protecting the creditor's interest through collateral, can use the proceeds payable to a lender for other purposes. Adequate protection can be provided by showing that there is an equity cushion in the collateral, or, if there is no equity, providing substitute collateral so that the value of the lender's collateral does not decline. Moreover, under a Chapter 11 Plan, the debtor is given wide leeway to extend and modify the terms of the "loan."

In In re ATP Oil & Gas Corp., 2014 Bankr. LEXIS 33, (Bkrtcy S.D.T.X. 2014), the royalty owners filed a motion for summary judgment asking the court to determine that it owned an ORRI as a matter of law. Judge Isgur denied it.The court found fact issues existed as to whether the transaction should be recharacterized as a loan despite being documented as an ORRI. The court applied Louisiana law, but the principles and reasoning of the court could be generally applicable in other states.

The facts presented were that NGP Capital Resources Co. (NGP) bought term ORRIs from ATP for $65 million. The agreements essentially provided that the ORRI remained in effect until the purchase price and an amount equal to interest were paid. The payments were subordinated to payments due to Diamond Offshore out of production from the same wells.

In examining whether the terms were inconsistent with a term ORRI under Louisiana law, the court found that the calculation of an ORRI using a formula that provides for a specified return on investment and the subordination provision may be inconsistent with a term ORRI.

The court then examined whether the transaction was consistent with a mortgage under Louisiana law. The transaction did not meet the threshold requirements for a mortgage under Louisiana law because NGP did not have any right to foreclose on the properties. Judge Isgur noted that the 5th Circuit Court of Appeals, in In re Senior-G & A Operating Co. 957 F.2d 1290, 1296 (5th Cir. 1992), had recharacterized an ORRI as a loan where the agreement allowed the royalty owner to foreclose upon and operate the well if the well did not produce. In ATP Oil, the court distinguished In re Senior-G & A Operating Co. by pointing out that NGP did not have a right of foreclosure and so the transaction was not necessarily a mortgage.

The court next considered whether the transaction was consistent with an unsecured loan. Judge Isgur determined that the definition of a loan provides for the unconditional obligation to repay the money loaned. In this case, ATP was expressly not obligated to repay any amount of money to NGP. Instead, ATP's obligation to make payments was entirely contingent on the production of oil. However, Judge Isgur held that an ORRI that is virtually certain to be satisfied in full from production is the economic equivalent of an "obligation to repay." Thus, a fact issue existed as to whether the transaction was consistent with the loan under Louisiana law.

Finally, the court looked at the economic substance of the transaction. The court determined that the transaction is properly characterized as a loan under general accounting principles when the underlying expected cash flow for repayment is significantly greater than the contractual obligation such that the seller retains the pricing and production risk. The court found that the parties' filings with the Securities and Exchange Commission described the transaction as a loan with NGP's filings even referring to a "guaranteed 16% return." As a result, the court found a fact issue as to whether the transaction was consistent with a loan under Louisiana law.

In the final analysis, the court refused to find that the transaction was a term ORRI as a matter of law. The matter will accordingly proceed to trial at which point the court will determine as a matter of fact whether the transaction should be recharacterized as a loan. Given the amount in controversy and the significance of this issue to the industry, the ultimate decision will possibly rest with the 5th Circuit Court of Appeals. Until then, the uncertainty will likely lead to litigation in other bankruptcies involving energy companies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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