We recently had the opportunity to speak at the 61^st Mineral Law Institute on the topic of “trending risks on the Outer Continental Shelf (OCS).”  One interesting topic we discussed was the increasingly common practice of conveying non-cost bearing interests (for example, overriding royalty interests, net profit interests or production payments) to working capital lenders and service providers as part of a package to raise additional capital or develop promising oil and gas fields.  But this practice – which may first have seemed like a low-risk strategy for funding operations – has quickly spiraled out of control for some companies that have become unable to pay these interest owners.  As a result, bankruptcy is sometimes the only option.

In the recent ATP Oil & Gas Corporation (ATP) bankruptcy case currently pending in the United States Bankruptcy Court, Southern District of Texas bearing case no. 12-36187, ATP attempted to recharacterize these types of transactions as contractual financing deals rather than conveyances of interest in property – presumably attempting to bring the interests back into the bankruptcy estate thereby increasing the value of the estate and leaving the override/net profit holders with just an unsecured claim.  The bankruptcy court was asked in several adversary proceedings (term for a lawsuit in bankruptcy) to decide whether holders of such non-cost bearing interests own property rights in minerals or instead whether ATP was allowed to bring the interests back into the bankruptcy estate because such conveyances of overrides etc. did not transfer real property.

The specific question before the court in NGP Capital Resources Co. v. ATP Oil & Gas Corp was whether certain conveyances of term overriding royalty interests and net profit interests were sales of minerals or other property rights versus loans, or “disguised financings.”  NGP sought a ruling that certain pre-bankruptcy transactions between ATP and NGP were true sales of real property interests.  On January 6, 2014, the bankruptcy court ruled against NPG.  According to the bankruptcy judge, certain provisions in the conveyance instruments were inconsistent with an overriding royalty interest under Louisiana law; therefore, he concluded that a genuine issue of material fact exists whether these conveyances constituted the sale of a property interest or instead constituted a financing arrangement.  See NGP Capital Resources Co. v. ATP Oil & Gas Corp. (In re ATP Oil & Gas Corp.), 12-03443, 2014 WL 61408 (Bankr. S.D. Tex. Jan. 6, 2014).

The conveyances at issue in NGP Capital were all labeled “Conveyance of Term Overriding Royalty Interest.”  So, how could an instrument that is labeled a conveyance of an override, be something else, like a loan or other debt instrument?  Judge Isgur wrote that (despite the labeling) the transactions “appear to have some characteristics that resemble a debt instrument and others that resemble a real property conveyance.”  In other words, the court ignored the parties’ label and subjective intent and held that further inquiry was needed to uncover the parties’ intent as to the legal effects of the conveyance (although he never suggested what further inquiry could be had or what more could possibly be shown).  NGP Capital, 2014 WL 61408 at pp. *5-7.

According to Judge Isgur, that summary judgment was inappropriate because NGP failed to show that the transaction is wholly consistent with a Term ORRI (defined in the opinion as overriding royalties that terminate after payment of a specified sum, or upon occurrence of certain conditions) and also that there is at least one inconsistency with a debt instrument under Louisiana law.  Instead, he held that a fact intensive inquiry beyond the summary judgment stage is required to determine the transaction’s character.  The judge described this as the “recharacterization standard.”  Judge Isgur ruled that there is a genuine issue of material fact whether the conveyance provisions regarding (i) NGP’s subordinated interest in production from applicable wells and (ii) NGP’s ORRI payment termination provision (or dissolving condition) are consistent with a Term ORRI under Louisiana law.  Judge Isgur further ruled that because NGP’s risk of nonpayment “was quite, low,” there is a genuine issue of material fact as to whether the NGP conveyances are consistent with the definition of a loan and the economic substance of a debt instrument under Louisiana law (although he did not explain why his same rationale would not apply to any overriding royalty conveyance or, more specifically, how the NGP conveyances here would differ materially from any overriding royalty conveyance in the same property).

Because the court ruled only on the very narrow issue of the character of these specific transactions between NGP and ATP and not the real nature of the interest conveyed by ATP, that issue remains unsettled (and will likely be discussed in later blogs).  Nonetheless, this opinion leads to the somewhat startling conclusion that it may be possible to “recharacterize” such transactions in bankruptcy.  Furthermore, as the NGP case shows, the risk-shifting/certainty component may be critical to a judge’s characterization (or recharacterization) of a transaction.  It is worth asking, however, whether is it proper or even possible for the court to ascribe worth for the contracting parties?  In addition, does this mean that parties to such mineral right transactions should require additional security to avoid these results?  Given this backdrop, be on lookout for additional information exploring suggested ways to protect your mineral interests and assets in (and out of) bankruptcy proceedings.