Interests Get Interesting: Overriding Royalty Interests Characterization in Oil & Gas Bankruptcies

Editor’s Note: The following article, “Interests Get Interesting: Overriding Royalty Interests Characterization in Oil & Gas Bankruptcies,” won the prize for third place in the Eighth Annual ABI Bankruptcy Law Student Writing Competition. Ms. Ortbahn is a recent graduate of the University of North Carolina School of Law in Chapel Hill, N.C.. She is currently a summer associate at Haynes and Boone, LLP in Dallas.

Gas prices have plummeted more than 70 percent in the last two years.[1] This is financially devastating for the oil and gas industry. To cover the “souring energy loans” secured by oil and gas properties and proceeds, U.S. banks have set aside $2.5 billion.[2] Some bankruptcy experts are predicting widespread “carnage” of oil and gas companies, doubling bankruptcy filings.[3] In 2015 alone, 42 energy companies filed for bankruptcy owing more than $17 billion.[4] With such high numbers at stake, creditors and debtors will undoubtedly be battling over what is or is not part of the bankruptcy estate, even before discussing the merits of a proposed restructuring plan or liquidation. In oil and gas bankruptcies, this proves to be an especially complex debate where state law, interpreting contracts and defining property rights meet federal bankruptcy law — particularly surrounding the characterization of transactions.

The process of extracting oil from deep underground is multilayered and complex, and not just because the industry terminology is riddled with acronyms. Oil companies are generally in the business of producing a product, but their financial stakes are placed at different stages or shares of production.[5] Draining hydrocarbons from an oil or gas field, either underwater or underground, produces oil.[6] The site of the drilling is generally subject to an oil and gas lease, a contract between the mineral owner (lessor) and the working interest owner (lessee) who gains the rights to explore, drill and produce oil.[7] The lessee may divide its working interest into fractional interests.[8] The production revenues are then paid out via royalty, overriding royalty interest and lessor royalty interest.[9] These interest-owners own production percentages without bearing the drilling or production costs.[10]

The precise nature of these interests, in the lease, production or profits, is not easily characterized. Bankruptcy courts have had to wrestle with the nature of the interests in order to administer oil and gas companies’ estates. The characterization of interests in an oil and gas bankruptcy is a true gusher once struck,[11] but this article focuses on one type of interest — overriding royalty interests (ORRIs) — and the treatment of such interests under the Bankruptcy Code. ATP Oil & Gas Corp.’s bankruptcy is used as an example in order to illustrate the importance of royalty interest characterization.[12] Part I describes the potential characterization issues unique to overriding royalty interests and introduces the ATP case. Part II discusses the characterization of ORRI transactions as disguised debt financing. Part III uses the ATP bankruptcy to discuss the consequences of ORRI interest characterization to the trustee’s avoidance powers of § 547. Part IV concludes by suggesting that practitioners be bankruptcy-aware when drafting ORRI agreements to anticipate inevitable battles in the next financial distress surge in the oil and gas industry.

I. Characterization of Overriding Royalty Interests

First, what the interest is in must be clear. An overriding royalty interest is “an interest in oil and gas produced at the surface, free of the expense of production, and in addition to the usual landowner’s royalty reserved to the lessor in an oil and gas lease.”[13] The Code defines a “term overriding royalty” as “an interest in liquid or gaseous hydrocarbons in a place or to be produced from particular real property that entitles the owner thereof to a share of production, or the value thereof, for a term limited by time, quantity, or value realized.”[14] As a practical matter, gas comes out of ground by means of production, the product has a gross production value, production costs are subtracted from that gross production value, and the remaining profits are then paid out to interest-holders — first to landowning royalty interests, then, proportionately, to the overriding royalty interests. Adding a “term” to an ORRI just places a cap on the payout to that ORRI-holder.

The nature of an ORRI and its treatment in bankruptcy, like most property interests, is dependent on state law.[15] As with conveyances and contracts, not all ORRIs are identical. Lawyers who draft the instruments may do so by considering the context of the deal, intent of the parties, the history of ORRIs in their jurisdiction and the jurisdiction’s law.[16] Because it is an interest conveyed by contract in a product that is extracted from real property but is (often) paid for up-front by the interest-holder, an ORRI can be characterized as one of four things: an executory contract, an unexpired lease,[17] “disguised financing” (an unsecured loan) or a real property interest. Bankruptcy courts may, if consistent with state law, recharacterize a transaction as to its true economic substance — looking beyond the “four corners” of the instrument.[18]

As ATP Oil & Gas exemplifies, the debtor-in-possession or trustee will likely argue that (1) the ORRI is an executory contract or unexpired lease[19] or (2) the ORRI is a “disguised financing arrangement.”[20] In either case, the ORRI is property of the estate, opening up options under the Code, including recovering preferential payments to better the debtor’s finances for either reorganization or liquidation and protection via the automatic stay.[21]

ORRI-holders have argued that the interest is a real property interest and not property of the debtor’s estate.[22] This argument relies on § 541(b)(4)(B), which, in recognizing the real property-transfer nature of an ORRI, specifically excludes certain ORRIs from the property of the estate.[23] However, even if the transaction fits within § 541(b)(4)(B), the bankruptcy court may determine that the transaction is “disguised financing” and fails to qualify as a “transfer” of interest.[24] But if the transaction is not excluded under § 541(b)(4)(B), state law provisions may protect the nondebtor interest-owner and exclude the interest from the debtor’s estate.[25]

These are not battles over insignificant fractions of interests. In the ATP bankruptcy, ATP received more than $700 million in cash for conveying ORRIs.[26] NGP purchased ORRIs for $65 million to be repaid until the purchase price was satisfied plus 13.2 percent interest annually.[27]

II. ORRIs as “Disguised Debt Financing”

At least one bankruptcy court decision has left the door open for debtors-in-possession and trustees to argue that certain ORRIs are, in economic substance if not in linguistic form, a financing arrangement rather than a real property interest. In NGP Capital Res. Co. v. ATP Oil & Gas Corp., ATP, the debtor, sought recharacterization of pre-petition transactions involving ORRIs as disguised unsecured debt-financing arrangements in order to bring them into ATP’s estate to the detriment of the ORRI-holder, NGP.[28] The U.S. Bankruptcy Court for the Southern District of Texas had to determine whether the ATP-NGP ORRI transactions were real property conveyances, as the documents themselves suggested, or whether the transactions were, based on the “economic substance of the transaction,” debt instruments under state law.[29] Because the court addressed these issues in response to the ORRI-holder’s motion for summary judgment, the court merely had to decide that a genuine dispute remained.[30]

However, the court provided some guidance for evaluating the nature of term ORRI transactions under Louisiana law.[31] Under Louisiana law, “the parties’ intent as to the legal effects of their contract have no bearing on whether those legal effects are in fact created.”[32] Louisiana courts have ignored the parties’ labeling of agreements as determinative of the interest created, relying on the substance and nature rather than linguistic style of the transaction.[33]

The ATP-NGP transaction has characteristics of both a debt instrument (“disguised financing”) and a real property conveyance. Thus, the court evaluated the substance of the ATP-NGP ORRI transaction to determine whether it fell into one of the following categories: (1) transaction is “wholly consistent with both a debt instrument and a Term ORRI under Louisiana law;” (2) “neither wholly consistent with an ORRI nor is it wholly consistent with a debt instrument;” (3) “wholly consistent with a Term ORRI and has at least one inconsistency with a debt instrument;” or (4) “wholly consistent with a debt instrument and has at least one inconsistency” with a Term ORRI.[34]

The court found three of five contested terms of the transaction to be consistent with a Term ORRI under Louisiana law, suggesting that a real property interest characterization is appropriate.[35] The court found the subordinated interest provision and the interest rate-based formula used to define the ORRI’s terminating condition to be inconsistent with an ORRI, leaving genuine issues of fact.[36] More importantly, the court found several consistencies with the transactions being a loan; therefore, the “disguised financing” argument survived summary judgment.

First, the court found that the transaction resembled an unsecured loan by analogizing the function of the document to the definition of a loan under Louisiana law.[37] In Louisiana, a “loan” is a contract in which the receiving party agrees to repay the other party “the same numerical amount … regardless of fluctuation in the value of currency.”[38] NGP argued that ATP’s obligation to make ORRI payments is “entirely contingent on the production of oil.”[39] The court rejected this reasoning that because the risk of nonpayment was so low, ATP “effectively guaranteed repayment of the purchase price and the agreed upon rate of return.”[40] Thus, “[a]n ORRI that is virtually certain to be satisfied in full from production is the economic equivalent of an ‘obligation to repay.’”[41]

Second, the court found that the ATP-NGP transaction could be characterized as a loan under generally accepted accounting principles (GAAP), because the “underlying expected cash flow for repayment was significantly greater than the contractual obligation.”[42] This was evidenced by a $700,000 “make-whole” payment from ATP to satisfy a “guaranteed 16% return”; the court found this to suggest that the “condition” that NGP would only receive payments “if and when production occurred” was likely an artificial condition.[43]

The court also examined the actions of the parties in reference to the transactions, finding that they treated the transaction as a loan for tax purposes and in their public SEC filings.[44]

III. Avoidance of Preferential Transfers of ORRI Interests Under § 547

As suggested above, the characterization of ORRI interests shapes the remedies available to the trustee in administering the estate. Crucially, if the ORRI is characterized as a disguised financing arrangement rather than a real property interest, the trustee may seek to avoid payments on those contracts that fell within the preference period — bringing assets back into the estate.[45]

The bankruptcy system works to treat equally creditors within the same class; [46] one such equal treatment method is preference avoidance.[47] Section 547(b) permits a trustee to “avoid any transfer of an interest of the debtor in property” for the benefit of a creditor, on account of an antecedent debt, made while debtor was insolvent, within 90 days before filing (if to insider, one year), and that gives the creditor more than it would have received in a chapter 7 liquidation.[48] In energy bankruptcies, litigation swells around whether the interest transferred during the preference period is property, and if so, if it is the property of the debtor, and then whether the transfer was on account of an antecedent debt.

The ATP case again provides an example. The ATP trustee brought § 547 claims against Diamond Offshore Co. (Diamond) and TM Energy Holdings LLC.[49] In May 2009, ATP granted Diamond an ORRI in exchange for converting about $116 million in accounts payable and increased periodically by drilling services later provided by Diamond.[50] About one month before filing, ATP made two transfers totaling around $1.76 billion to Diamond.[51] The court held that this conveyance was on account of an antecedent debt. Issues of fact still remained as to whether those alleged preferential transfers were “transfer[s] of an interest of the debtor in property.”[52]

The parties pushed for the court to conclusively characterize the ORRI assets as a prerequisite to asserting § 547(b) claims, but Judge Marvin Isgur rejected that argument and held that recharacterization was “unnecessary to sustain … [the trustee’s] § 547 claims” in order to survive a motion to dismiss.[53] Judge Isgur reasoned:

[T]he Court could … find that an ORRI payment made by ATP to each ORRI holder constitutes a “transfer of the debtor’s interest in property” made “on account of an antecedent debt” under § 547 [of] the Bankruptcy Code, without deciding whether the underlying instruments constitute an overriding royalty interest or disguised debt instrument under Louisiana law.

Relying on the Fifth Circuit’s broad definition of “antecedent debt,”[54] the court held that “a debt need not arise from a loan for purposes of § 547(b)” so long as the other requirements of the section are met.[55]

The Code does not define “interest of the debtor in property.” The Supreme Court has explained that the term means “that property that would have been part of the estate had it not been transferred before the commencement of the bankruptcy proceedings”[56] and considered it to be synonymous with “property of the estate.”[57] State law next determines whether the property is an asset of the debtor.[58] The question then becomes whether the transferred funds, proceeds of oil production, “diminished or depleted ATP’s estate.”[59] The debtor is presumed to have an interest in the property so long as the debtor has control over the funds.[60] The ATP court carefully limited the property at issue to the “funds that ATP transferred to each ORRI holder” rather than the underlying instruments.[61]

However, the court did hint that the mechanics of a transfer that would constitute a “transfer of an interest in the debtor’s property.”[62] ATP could have incurred a debt if it used an ORRI-holder’s share of the proceeds to pay for other expenses by (1) borrowing funds from a separate ORRI trust account, (2) failing to comply with the ORRI’s escrow requirements or (3) failing to use traceable funds to comply with the payment schedule.[63] If any of those occurred and ATP then made a payment to an ORRI-holder out of its own funds, the payment would be a “transfer of an interest in the debtor’s property” and the trust doctrine would not protect the transfer from § 547.

If the ORRI agreement created a real property interest owned by the ORRI-holders, then any breach by ATP under the instruments would incur a debt payable to the ORRI holders.[64] If ATP were to have diverted the ORRI property (proceeds) for its own use and then replenished the property by paying the ORRI-holders, the replenishment payment would have been antecedent because each alleged preferential transfer was a result of an earlier liability.[65] Even if the ORRI is entirely consistent with a real property interest, it does not preclude a court from finding that the transaction “constituted a payment of a ‘debt’ under the Bankruptcy Code.”[66] If however, the ORRI agreement was a debt instrument, the analysis is simpler. The sole issue becomes “whether — when the payments were made to the ORRI-holders — the payments were made from the ORRI-holder’s own property or from ATP’s property.”[67] It simply becomes a factual tracing question.

IV. ATP’s ORRI Transactional Lessons

Both memorandum opinions explored in the paper by ATP are victims of their procedural posture; the court did not have to come to a final conclusion, but only had to find that issues remained as to the characterization.[68] However, Judge Isgur’s opinions provide guidance to parties in oil and gas transactions. The opinions suggest that, despite the historical treatment of ORRIs as property interests and without regard to the intent of the parties as evidenced by the four corners of the instrument, a careful trustee or DIP may successfully recharacterize an ORRI transaction as unsecured disguised financing. The recharacterization of ORRIs can result in large amounts being clawed back into the estate to the benefit of other creditors; almost $2 billion was at stake in the two transactions discussed above.[69] The nature of state law surrounding ORRIs and defining “loans” may be crucial to practitioners drafting or amending existing ORRIs to better protect ORRI-holders when under the looming threat of oil and gas bankruptcy.[70]

Purchasers of ORRIs, to protect their interests from becoming part of a debtor’s bankruptcy estate, should push to include in the conveyance more explicit terms regarding the nature of the ORRI. This could prevent creative trustees and DIPs from arguing counter to what the parties originally intended in a bankruptcy. While the court may disregard the characterization later, it may consider the document as evidence of intent.[71] For example, in the conveyance from ATP to Diamond, it is clear that the parties intended to convey an ORRI. What is not clear is what the parties believe the ORRI is; the only explicit mention of the nature of the ORRI is buried in the document: “The Overriding Royalty conveyed hereby is a non-operating, non-expense-bearing limited overriding royalty interest in and to the Subject Interests (being a real property interest), free of all cost, risk and expense….”[72] That is as clear as crude oil.

Likewise, parties should be aware that the structure of the transaction could be closely examined. As ATP illustrates, courts can decide that although the documents called the transaction a sale and the parties intended for it to be a sale, it cannot be a sale under the law because it is, in substance, a loan.[73] Using Judge Isgur’s analysis as a guide, parties should strive to structure with terms wholly consistent with a sale and inconsistent with a loan to maximize clarity about what would, or would not, be part of a bankruptcy estate.[74] Practitioners must consider the terms of the agreement, particularly seemingly guaranteed rates of return, conditional payment terms, and obligations to repay if no production, all of which may not be wholly consistent with a sale. To limit § 547 claims, ORRI interest-purchasers should seek to establish processes that segregate the funds to minimize the debtor’s control, either in an escrow account or by detailed accounting and reporting standards.

Likely, in the rising numbers of oil and gas bankruptcies, the courts will have to look at the economic structure of the transaction to determine what is really being conveyed. This brings great uncertainty to transactions that are ubiquitous throughout the industry. Practitioners should be aware of these potential issues, not only as they arise in bankruptcy proceedings, but also in drafting the document to best protect their client’s interest.