Is a Net Profits Interest A “Royalty”? A Step Toward Clarification – From NY Yet!

19 April 2017 Bankruptcy Talk Publication
Author(s): John P. Melko

I’ve not been a fan of several notable oil & gas opinions from courts in the 2d and 3d Circuits. A long ago transplanted Yankee myself, this has nothing to do with provincial rivalries. I just think that some very good courts in those cases fundamentally got the law wrong when it came to Texas mineral law. So I was pleased to read Judge Bernstein’s Good Friday 2017 Memorandum Opinion Granting in Part and Denying in Part Motion by LL&E Royalty Trust for Relief from the Automatic Stay in the Breitburn Energy Partners LP jointly administered cases.

The facts are a bit convoluted, but in a nutshell, Breitburn and several non-debtor affiliates (collectively, “Breitburn”), pre-petition, filed a Declaratory Judgment action in Texas state court against LL&E seeking a determination that amounts paid to LL&E under rights held by LL&E under a document styled “Conveyance of Overriding Royalty Interests” (the “Conveyance Agreement”) were correct. Disputes had arisen over the calculation of those payments by Breitburn to LL&E under the Conveyance Agreement. LL&E, also pre-petition, filed an 8 count counterclaim. While the minerals giving rise to the disputed payments are in Florida, the Conveyance Agreement provides that it is governed by Texas law, except to the extent that Florida law “mandatorily” applies. In court, the parties agreed that Florida law was not materially different than Texas law. Breitburn filed for Chapter 11 relief in the SDNY, and the state court put the entire matter on hold, even as to non-debtor counterclaimants, pending stay relief by the bankruptcy court.

As part of its suite of first day motions, Breitburn included a Motion of Debtors Pursuant to 11 U.S.C. §§ 105(a), 363(b), and 541 for Entry of Interim and Final Orders (I) Authorizing Payment of All Funds Relating to Royalty Interests and (II) Directing Financial Institutions to Honor and Process Checks and Transfers Related to Such Royalty Interests. These motions have become standard operating procedure in O&G chapter 11 cases, and are virtually always uncontested. These motions recognize that under the law of most states, and certainly Texas, working interests and royalty interests are not property of the estate, and in situations where the debtors act as seller for oil & gas produced from the leases, the proceeds attributable to those other holders’ portion are proceeds of the non-debtors’ interests, and thus not property of the estate. This position is entirely consistent with Bankruptcy Code sections 541 (b) (4) and 101 (21A). Just as ubiquitous, however, is the position taken by most O&G debtors shortly after the approval of first day motions, that cash held by the debtors representing disputed royalty payments are not property of the estate, but rather a “claim” within the meaning of 101 (5), and that position was taken later on by Breitburn.

LL&E filed a stay relief motion just about 2 months after the petition date, to which the Debtors objected, in part, making the “claim” argument. The bankruptcy court quickly noted the inconsistency between the Debtors’ first day motion and its response, but the judicial estoppel argument had not been raised. The bankruptcy court also quickly recognized that the “royalty” payments in dispute looked like net profits interests, due to the calculations needed to derive the amount payable under the conveyance Agreement.

After a survey of Texas case law and secondary sources, in the part of the Memorandum Decision dealing with nature of the mineral interests in dispute, the bankruptcy court held that whether a “royalty” included net profits interests, as well as the precise nature of royalties was not entirely clear under Texas law, and permitted those counts of the Declaratory Judgment case, and the related counterclaim, along with certain other counts, to proceed to trial in the Texas state court:

In addition…, the question of whether LL&E holds a property right or a mere unsecured contract claim in the amount of unpaid net profits is unsettled under Texas law, and the determination of the Texas courts will assist this Court and ultimately contribute to a resolution of the dispute [citation omitted].

While some might quibble with the court’s reluctance about net profits interests, allowing a state court in another jurisdiction to adjudicate the nature of property interests under that state’s laws is the right call.

Judge Bernstein’s Memorandum Decision can be found here.

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