Bankruptcy Court Rules That Term Overriding Royalty Interests May Be Disguised Loans

23 January 2014 Publication
Author(s): John P. Melko Michael K. Riordan

In an opinion with serious implications for the treatment of overriding royalty interests, a Southern District of Texas Bankruptcy Court ruled that under Louisiana law, an ORRI could be recharacterized as debt rather than a royalty interest, even if the conveyance was facially consistent with an ORRI. An ORRI that is treated as debt would likely have a much lower priority for payment in bankruptcy than an ORRI treated as a royalty interest.

Prior to filing for bankruptcy, ATP Oil & Gas Corp. conveyed numerous ORRIs and net profits interests ("NPIs") to a variety of investors. Each of the conveyances were of interests in Outer Continental Shelf properties and were properly recorded in the real property records of the nearest adjacent county or parish. In each transaction, ATP represented and warranted that it was conveying mineral interests. Its counsel gave opinions that the conveyances were valid and binding upon ATP, and if ATP filed for bankruptcy, the ORRIs would constitute "production payments" that would be excluded from property of the estate under the Bankruptcy Code. Moreover, ATP's secured lenders subordinated their liens specifically to permit the sale of each mineral interest conveyed.

It's important to note that the court's ruling only denied NGP Capital Resources Company's request for a judgment as a matter of law that its ORRIs were mineral interests that it acquired from ATP. The court declined to rule conclusively on the character of NGP's ORRIs, citing fact issues better addressed at trial. However, the court's opinion has serious implications for NGP, other interest holders in the ATP bankruptcy, and all companies selling, buying or financing mineral interests in OCS leases.

The court ruled that NGP's term ORRIs would only be safe from recharacterization as debt if they were: (a) completely consistent with an ORRI under Louisiana law and (b) inconsistent with a loan under Louisiana law. Applying this standard, the court found that NGP's ORRIs could potentially be recharacterized, citing terms in the ORRI transfer agreements providing for subordination of NGP's interest to other interests and termination of the ORRIs upon a specified return on investment as potentially inconsistent with ORRIs under Louisiana law [remember that this was a term ORRI]. The court also held that recharacterization may be appropriate because the "economic substance" of the ORRIs is consistent with an unsecured loan under Louisiana law.

On the other hand, the court found the ORRI transfer agreement contains terms which would appear to be inconsistent with a loan, such as terms providing that royalty payments are contingent upon production and that NGP's rate of return is not guaranteed. However, the court dismissed these terms as "artificial" conditions, holding that NGP's rate of return was effectively guaranteed because there was a very low risk of non-payment. The court stated that: "[a]n ORRI that is virtually certain to be satisfied in full from production is the economic equivalent of [a loan under Louisiana law]." Ironically, ATP abandoned one of its major properties, leaving its ORRI holders in that field unpaid; so much for a return that was "effectively guaranteed."

Most concerning is that almost all of the "fact issues" identified by the court are found within the four corners of the documents, calling into question the essential nature of term ORRIs.

The case is NGP Capital Resources Company vs. ATP Oil & Gas Corp.; Case No. 12-03443; USBC, S. Dist. TX.

If you have any questions regarding the content of this alert, contact Gardere Bankruptcy and Business Reorganization Attorneys John P. Melko ( or 713.276.5727) or Michael K. Riordan ( or 713.276.5178).

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