A recent bankruptcy court decision denying a royalty owner's motion for summary judgment is highly relevant to any investor that currently owns a term royalty interest or is considering such an investment. The United States Bankruptcy Court for the Southern District of Texas found in NGP Capital Resources Co. v. ATP Oil & Gas Corp. (In re ATP Oil & Gas Corp.), No. 12-3443, 2014 Bankr. LEXIS 33 (Bankr. S.D. Tex. Jan. 6, 2014) that issues of material fact existed regarding whether certain prepetition term overriding royalty transactions were properly characterized as debt financings or real property transactions. While the court's conclusions in ATP were made in connection with a summary judgment decision, the issues raised in the case are of significance to parties currently involved in or considering overriding royalty transactions because the court's opinion opens the door to the possibility that a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") may be able to recharacterize such transactions as loans to the severe detriment of the royalty owners.
Term Overriding Royalty Interests in Bankruptcy
Term overriding royalty interests are oil and gas interests in
which the owner receives a share of oil and gas produced at the
surface, free of the costs of production. Term overriding royalty
interests are limited interests in that they terminate upon the
occurrence of specified conditions, such as the achievement of a
particular volume of production or the realization of a specified
sum from the sale of oil or gas. Term overriding royalty interests
are often described in the industry as being similar to a
"loan" that is repaid through the production or
monetization of oil and gas. Even so, while term overriding royalty
interests may appear to have many characteristics of a loan, they
are generally characterized by state law as transfers of interests
in real property that have a limited duration or amount.
The real property transfer character of these transactions has
important implications in bankruptcy. If a prepetition overriding
royalty interest transaction is characterized as a transfer of real
property (i.e., a sale), then the interest has effectively been
transferred from the debtor's ownership and is not part of the
bankruptcy estate. See 11 U.S.C. § 541(b)(4). The
trustee or DIP, therefore, has no power to sell, assign, or
transfer the interest. Additionally, if the transaction is
considered a sale that is substantially completed prepetition, the
transaction is not subject to the power of a trustee or DIP to
assume and assign or reject executory contracts. Thus, if an
overriding royalty transaction is considered a prepetition transfer
of real property, the transaction will be immune from many of the
powers of a bankruptcy trustee or DIP.
Recognizing the real property transfer nature of an overriding
royalty interest, the Bankruptcy Code provides protection to owners
of certain categories of overriding royalty interests. For
instance, section 541(b)(4)(B) specifically excludes from property
of the estate "any interest of the debtor in liquid or gaseous
hydrocarbons to the extent that ... the debtor has transferred such
interest pursuant to a written conveyance of a production payment
[as defined by section 101(42A)] to an entity that does not
participate in the operation of the property from which such
production payment is transferred...." Because a
"production payment" is defined by section 101(42A) of
the Bankruptcy Code as a type of "term overriding
royalty," this provision specifically excludes certain
overriding royalty interests from property of the estate. However,
the Bankruptcy Code is not the end of the analysis.
Even if an overriding royalty transaction does not fit strictly
within the Bankruptcy Code's provisions related to certain
overriding royalty transactions, the transaction may nevertheless
be excluded from the debtor's estate and therefore protected
based on state law. Conversely, even if a transaction appears to
fit within the Bankruptcy Code's provisions excluding certain
overriding royalty interests from property of the estate, the
transaction may nevertheless fail to qualify as a
"transfer" of an "interest" of the debtor if
the court determines, as a threshold matter, that the overriding
royalty transaction is not a "transfer," but rather a
disguised financing under applicable state law.
Parties frequently go to great lengths to include express
provisions demonstrating the real property transfer character of
the transaction in the underlying transactional documents (which
are typically styled as conveyances and/or purchase and sale
agreements). However, a recent bankruptcy court decision from the
Southern District of Texas calls into question the long-standing
treatment of these transactions as real property
transfers.
NGP Capital Resources Co. v. ATP Oil & Gas Corp. (In re ATP Oil & Gas Corp.)
In an uncommon move for an operator in chapter 11, ATP Oil &
Gas Corporation ("ATP") went on the offensive against its
royalty investors soon after the commencement of its bankruptcy
case, and it indicated that it would seek to recharacterize a
number of overriding royalty interest transactions as debt
financings. Before determining whether the overriding royalty
interests were excluded from property of ATP's estate under the
terms of the Bankruptcy Code, the court first sought to determine
whether certain purported overriding royalty transactions were
actually real property conveyances (as the documents themselves
suggested) or whether they were debt instruments (based on the
"economic substance" of the transactions) under
applicable state law.
Some of the contested transactions involved NGP Capital Resources
Company ("NGP"). Prepetition, ATP and NGP entered into a
series of agreements that the parties characterized as overriding
royalty transactions (the "ORRI Transactions"). Under the
ORRI Transactions, NGP purchased term overriding royalty interests
("Term ORRIs") related to six leases on two properties
for a total purchase price of $65 million. Pursuant to the relevant
documents, the Term ORRIs would remain in effect until the
cumulative royalty payments received by NGP equaled the original
purchase price plus interest at a "Notional Rate" of 13.2
percent per year. Further, if ATP was late in making payments, NGP
could impose a default rate of 14.5 percent per year. In effect,
these provisions virtually guaranteed NGP a certain rate of return
regardless of the rate of production, oil and gas prices, or
ATP's interest in the leases. In fact, due to the structure of
the interest rate provisions, NGP actually stood to earn more from
the agreement if oil and gas production was low. In other words,
the interest rate provisions effectively shifted the risk of loss
on the investment to ATP.
ATP argued, among other things, that the interest rate provisions
were inconsistent with the definition of a term overriding royalty
interest under Louisiana law. NGP countered that the text of the
Louisiana Mineral Code was broad enough to encompass a term
override with these types of provisions. The bankruptcy court
ultimately rejected NGP's argument that Louisiana law was as
broad as NGP suggested and went on to examine the transaction's
provisions in detail to determine whether they were consistent with
the transfer of an overriding royalty interest under Louisiana
law.
As an initial matter, the court rejected the proposition that the
ORRI Transactions were secured financing transactions. However, the
court found that at least four aspects of the transactions
resembled an unsecured debt financing transaction. First, the
parties treated the NGP transaction like a loan, and NGP
represented it as one to the public. Second, the transaction had
several characteristics of a loan under accounting standards,
including GAAP. Third, the parties treated the transaction as a
loan for tax purposes. Fourth (and most importantly), because of
the interest rate provisions, income from the Term ORRIs did not
fluctuate based upon the revenues from the properties. Rather,
NGP's rate of return remained relatively constant. Thus,
although the court found that ATP was expressly not obligated to
repay any amount to NGP and its obligation to make payments was, on
the face of the documents, entirely contingent on the production of
oil, it also concluded that the economic substance of the
transaction appeared to make the production condition "an
artificial one." As the court noted: "An ORRI that is
virtually certain to be satisfied in full from production is the
economic equivalent of an 'obligation to repay'" or an
unsecured loan.
Conclusion
While the court's ruling in ATP was a denial of
NGP's summary judgment motion and NGP may ultimately prevail at
trial, the issues raised in the case are of significance to parties
entering into overriding royalty transactions. Specifically, the
ATP decision suggests that despite artful drafting and the
long-standing treatment of such transactions as real property
transfers, a bankruptcy trustee or DIP may be able to
recharacterize a Term ORRI transaction as an unsecured financing,
to the detriment of the royalty owner. Further, given ATP's
success in surviving a motion for summary judgment, there is the
potential that more debtors may take a similar approach,
potentially adding more uncertainty to transactions that were once
thought to be untouchable in the oil and gas industry.
ATP may eventually be regarded as an extraordinary
situation, but time will tell if there is indeed any lasting
precedent generated. Accordingly, parties entering into overriding
royalty transactions should review the court's ruling in
ATP to better understand the risks, and structure their
transactions to minimize those risks.
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.