Oil and gas royalties are held in constructive trust and do not become property of a chapter 11 debtor, according to a nonprecedential opinion by the Third Circuit regarding Colorado law.
The circuit’s December 1 opinion raises several interesting questions:
(1) If the debtor spent the royalties by paying secured lenders and other creditors, what remedy is available to the royalty owners who did not receive their royalties?
(2) At the outset of a chapter 11 case, may a debtor use royalties as cash collateral by providing adequate protection?
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The Unpaid Royalties
The chapter 11 debtor was an oil and gas producer with leases in Colorado. The Colorado leases provided for the debtor to pay royalties to the owners of the mineral rights. According to the owners of the mineral rights, the debtor did not pay more than $24 million in royalties for several years before bankruptcy.
After confirmation of a chapter 11 plan, the debtor objected to the secured proofs of claim filed by the royalty owners. The debtor objected that the claims should be classified as general, unsecured claims.
The bankruptcy court agreed, sustained the objections and classified the claims as nonpriority unsecured claims. The district court affirmed, but the royalty owners appealed successfully to the Third Circuit.
Debtor’s Property or Not?
The owners contended on appeal that the royalties owing to them never became estate property. The outcome depended on both state and federal law, according to Circuit Judge David J. Porter.
Section 541(d) of the Bankruptcy Code provides:
Property in which the debtor holds . . . only legal title and not an equitable interest . . . becomes property of the estate . . . only to the extent of the debtor’s legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.
Colorado Revised Statute § 38-30-107.5 provides that “[a]ny conveyance. . . of a royalty interest in minerals . . . creates a real property interest which vests in the holder . . . of such interest the right to receive the designated royalty share of the specified minerals . . . in accordance with the terms of the instrument.”
Reading the two statutes together, Judge Porter said that property will not become estate property if “a debtor holds only legal title to but not an equitable interest in property” Consequently, he said that Colorado creates “a real property interest” in the royalty owners’ “designated share of royalties.”
When the debtor leased mineral rights, Judge Porter said that the debtor “did not have an equitable interest in the Royalty Claimants’ designated share of the proceeds that it received from the sale of those resources.” Instead, he said that a “real property interest” vested in the claimants.
The debtor argued that the claimant’s notion about royalties never becoming estate property would create “a new super priority” and would “completely circumvent the bankruptcy process.”
In response, Judge Porter said that excluding the royalties from estate property was “not a new invention in bankruptcy law; it is explicitly provided for in the code,” citing Section 541(d). He said that the “code contemplates that a debtor in bankruptcy may be holding property that equitably belongs to another and provides that such property should not be disbursed to creditors along with the debtor’s own.”
Having decided that the debtor did not have an equitable interest in the royalties, Judge Porter next dealt with the question of whether the royalty owners were entitled to a constructive trust as a matter of Colorado law. He decided against applying federal common law on constructive trust because “we are not faced with any uniformity concerns or a uniquely federal program.”
(Note: Judge Porter also might have quoted Justice Neil M. Gorsuch who wrote for the Supreme Court in Rodriguez v. Federal Deposit Insurance Corp., 40 S. Ct. 713, 716 (Sup. Ct. Feb. 25, 2020), that “cases in which federal courts may engage in common lawmaking are few and far between.”)
In Colorado, Judge Porter said that constructive trusts are defined “broadly” to “prevent unjust enrichment.” In the case on appeal, he said that a constructive trust may be imposed because the debtor would be “unjustly enriched” if it were “permitted to retain the benefit of property that belongs to the Royalty Claimants.”
The debtor countered by arguing that it did not retain the royalties for its own benefit but paid the proceeds to secured lenders. Judge Porter rejected the argument, saying that “the elements of unjust enrichment are satisfied even if [the debtor] later distributed the property.”
Furthermore, Judge Porter said that “the underpaid royalties were not property of [the debtor’s] bankruptcy estate to distribute with priority to secured lenders.” (Note: This statement by Judge Porter may weigh on the bankruptcy court’s decision after remand regarding the remedy owing to the claimants.)
The DIP Challenge Order
Regardless of the claimants’ right to a constructive trust, the debtor contended that the claimants lost any remedy because they failed raise a timely objection to the so-called DIP financing order that allowed 75 days for creditors to object to the terms of the debtor’s use of cash collateral.
Judge Porter said that one argument rebutted the debtor’s contention: The DIP loan agreement was secured by a first-priority lien on the debtor’s assets, but “those liens do not extend to property that was never part of [the debtor’s] estate in the first place,” he said.
Remedy on Remand
Judge Porter vacated the order of the district court and remanded to the bankruptcy court “for further proceedings consistent with this opinion.”
With regard to remand, Judge Porter said it would be the claimants’ “responsibility of identifying the funds that they assert to be equitably theirs.” If the claimants carry their burden, he went on to say that “the Bankruptcy Court shall “consider whether the equitable remedy of a constructive trust is appropriate as to each Royalty Claimant.”
Oil and gas royalties are held in constructive trust and do not become property of a chapter 11 debtor, according to a nonprecedential opinion by the Third Circuit regarding Colorado law.
The circuit’s December 1 opinion raises several interesting questions:
(1) If the debtor spent the royalties by paying secured lenders and other creditors, what remedy is available to the royalty owners who did not receive their royalties?
(2) At the outset of a chapter 11 case, may a debtor use royalties as cash collateral by providing adequate protection?