The SemCrude Bankruptcy's Many Lessons For Energy Traders

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1 Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY Phone: Fax: The SemCrude Bankruptcy's Many Lessons For Energy Traders Law360, New York (August 24, 2015, 3:18 PM ET) -- In 2008, SemCrude LP and related entities filed voluntary petitions for relief under Chapter 11 of the U.S. Bankruptcy Code. In connection with the SemCrude bankruptcy, a dispute arose between dozens of oil producers that sold oil to SemCrude and two downstream purchasers (J. Aron & Co. and BP Oil Supply Co.) that purchased the same oil from SemCrude. The downstream purchasers filed adversary proceedings in SemCrude s bankruptcy case, seeking various forms of declaratory relief with respect to their rights in the disputed oil and their obligations (if any) to the producers. The producers also filed adversary proceedings, alleging that the downstream purchasers violated the producers liens in the oil and conspired with SemCrude in order to defraud the producers. Following discovery on a number of factual issues, the bankruptcy court Mark D. Sherrill issued proposed findings of fact and conclusions of law (FFCL) and recommended summary judgment in favor of the downstream purchasers on all counts.[1] After the producers objected, the U.S. District Court for the District of Delaware rendered a final judgment.[2] On July 30, 2015, the court fully adopted the bankruptcy court s FFCL, overruled all objections of the producers, and granted the downstream purchasers motions for summary judgment. This article examines the key holdings of the court. Background Prior to its bankruptcy, SemCrude traded physical oil and financial derivatives with the downstream purchasers under International Swaps and Derivatives Associationmaster agreements that, among other things, provided for payment netting with respect to all physical oil transactions between the parties; on a monthly basis, either SemCrude or its counterparty would pay the other the net amount owed between the parties with respect to all physical oil transactions between them during the preceding month. When SemCrude defaulted under both agreements around the time of its bankruptcy in July 2008, the downstream purchasers terminated the ISDA master agreements (and all physical oil and financial derivatives transactions thereunder) and calculated the resulting early termination payments. Under the respective agreements, J. Aron owed SemCrude about $90 million, and BP Oil owed SemCrude about $10 million. Bankruptcy Court Proceedings

2 At the time of the SemCrude bankruptcy, the debtors had not yet paid the producers for oil the debtors had purchased on credit in June and July of In addition to filing claims for the oil in bankruptcy court, the producers also filed claims against the downstream purchasers, alleging that they violated the producers liens in the oil and conspired with SemCrude in order to defraud the producers. While these proceedings were pending, the downstream purchasers filed adversary proceedings and motions for summary judgment in the bankruptcy court seeking to tender the final net amounts they owed to SemCrude under their trading agreements (the tendered funds), and seeking declaratory judgment that the tendered funds fully released the downstream purchasers from any claims of SemCrude or the producers in the disputed oil. On June 28, 2013, the bankruptcy court issued its proposed FFCL that recommended summary judgment in favor of the downstream purchasers, including the following specific recommendations: The downstream purchasers took the oil free and clear of the producers liens as buyers for value pursuant to Uniform Commercial Code Alternatively, the downstream purchasers took the oil free and clear of the producers liens as buyers in the ordinary course of business pursuant to UCC The producers common law tort and equitable claims for conversion, tortious interference, unjust enrichment, money had and received, fraud and accounting, and disgorgement failed as a matter of law. The producers objected to each of these findings and contended that the bankruptcy court did not have the requisite related to jurisdiction to enter the FFCL. District Court Decision In response to the producers objections, the court issued an opinion and order on July 30, The most substantial objections and the court s response are discussed below. Related to Jurisdiction According to the producers, the bankruptcy court did not have jurisdiction over the proceedings because the downstream purchasers claims did not have any conceivable effect on the SemCrude bankruptcy estate (a requirement for bankruptcy court related to jurisdiction under U.S. Court of Appeals for the Third Circuit jurisprudence). The producers argued that the bankruptcy court based its finding of jurisdiction solely on the downstream purchasers indemnity claim against SemCrude, and that this claim was contingent upon filing another intervening lawsuit, meaning that the claim did not have a direct conceivable effect on the bankruptcy estate. In response, the court noted that the producers objection focused narrowly on one claim in the downstream purchasers proceedings, and ignored several other claims for declaratory relief that did directly impact the bankruptcy estate. Specifically, the court found that the claims seeking to define competing rights in the tendered funds would necessarily affect the rights of the SemCrude estate to those claims, which would also affect the distribution to which other creditors were entitled. As a result, the court found that the downstream purchasers claims would have a direct impact on the SemCrude bankruptcy estate, without a subsequent intervening lawsuit. Therefore, the bankruptcy

3 court did have related to subject matter jurisdiction over the downstream purchasers claims. Fraud Claims The producers alleged that the downstream purchasers defrauded them by engaging in a scheme to trick SemCrude into gambling on financial derivatives and using unpaid-for oil as collateral. Under SemCrude s contracts with the producers, SemCrude did not have to pay for crude oil for up to 50 days after acquiring it. The producers also alleged that the downstream purchasers were aware of this credit arrangement and entered into a scheme to take the producers oil without SemCrude being able to pay. These allegations were based largely on testimony from several of the downstream purchasers employees stating that in mid-2008, the downstream purchasers were aware of SemCrude s financial instability. In response, the court stated that this knowledge by itself did not elevate the downstream purchasers sale of financial derivatives to SemCrude to the level of fraud. The court stated further that the downstream purchasers could not have known that SemCrude did not actually pay the producers for their oil. At best, the court added, the evidence cited by the Producers indicates that the [downstream purchasers] were aware of the Debtors imminent default, and took unilateral steps to mitigate their potential exposure. There was no evidence to suggest that the downstream purchasers used any tricks, cunning or dissembling that allowed them to gain an advantage over the producers. As a result, the court entered summary judgment sua sponte in favor of the downstream purchasers with respect to all fraud-based claims (including aiding and abetting fraud and conspiracy to commit fraud). Buyer for Value Defense The producers objected to the bankruptcy court s proposed finding that the downstream purchasers took the disputed oil free and clear of all liens as buyers for value (BFV) under Section of the Uniform Commercial Code. The bankruptcy court found that the downstream purchasers fulfilled all necessary elements of a BFV defense by demonstrating that (1) the producers purported liens in the oil were unperfected, (2) the downstream purchasers gave value for the oil, and (3) the downstream purchasers did not have any actual knowledge of the producers alleged security interests. The producers specifically objected to the first and third elements of the BFV defense. As an initial matter, the court looked to whether the producers had a perfected security interest in the disputed oil. The producers argued that under certain Kansas and Texas state Uniform Commercial Code provisions, they had automatically perfected liens in the oil they delivered to SemCrude. Because multiple states had a connection to the SemCrude bankruptcy and their laws differed on the issue of perfection, the bankruptcy court conducted a choice of laws analysis. Relying on the Restatement (Second) of Conflict of Laws, the bankruptcy court found that the conflict of laws provision of its own state (Delaware) applied. Under Delaware law, the jurisdiction in which a debtor is located governs the issue of perfection. Because the relevant SemCrude entities were located in either Delaware or Oklahoma, the UCC provisions of those states determined whether the producers had properly perfected their liens. Under Delaware and Oklahoma law, unlike Texas and Kansas, a party must perfect its lien by filing a UCC-1 financing statement (i.e., there is no automatic perfection provision). Therefore, because the producers had not filed UCC financing statements with respect to the disputed oil, they had not

4 perfected their liens in the oil. The court rejected the producers remaining arguments regarding the application of the UCC to their lien rights and agreed with the bankruptcy court s proposed finding in the matter of perfection. Second, the producers disputed the bankruptcy court s proposed finding that the downstream purchasers took delivery of the oil without actual knowledge of the producers liens. The court relied on its earlier analysis, finding that because the parties did not dispute that SemCrude purchased the oil from the producers on credit, the downstream purchasers could not have known at the relevant time that the debtors had not paid the producers. The court cited a U.S. Court of Appeals for the Fifth Circuit case in which the date of purchase was the applicable time for analyzing actual knowledge under the BFV defense. Even if, as alleged, the downstream purchasers knew where the producers were located, the lien laws of those states and the identities of those sellers, the court still found that there was no evidence that they actually knew that they had purchased oil from SemCrude subject to the producers liens. Further, SemCrude sold the disputed oil to the downstream purchasers with an express warranty that it was unencumbered further evidence that the downstream purchasers did not have actual knowledge of the producers' liens. As a result, the court found that the bankruptcy court properly recommended summary judgment upholding the downstream purchasers BFV defense. Buyer in the Ordinary Course of Business Defense The producers also objected to the bankruptcy court s proposed finding that the downstream purchasers took the disputed oil free and clear of all liens as buyers in the ordinary course of business (BIOC) under Section of the UCC. The bankruptcy court found that the downstream purchasers satisfied all elements of the BIOC defense because they (1) bought the oil in good faith, (2) without knowledge that the sale violated the rights of the producers in the goods, (3) in the ordinary course of business, and (4) not in total or partial satisfaction of a money debt. The producers disputed all elements of the BIOC defense but the second. The court quickly shot down the producers objection on the first element of the BIOC defense, regarding the downstream purchasers lack of good faith. This argument relied on the same facts underlying the producers theory of fraud (that the downstream purchasers allowed SemCrude to gamble on derivatives using the producers oil as collateral, knowing that SemCrude would be unable to pay the producers), which the court already determined was not supported by the record. With respect to the third element of the BIOC defense, under the UCC, a buyer must purchase the goods from a person in the business of selling goods of that kind. The producers conceded that SemCrude was an oil seller, but argued that SemGroup the parent entity that traded with the downstream purchasers was merely a holding company that was not in the business of selling oil. In overruling the producers objection, the court looked to the definition of person under the UCC, which is broadly defined to include agencies and instrumentalities, among other things. This is to say that the person that sells the goods in the ordinary course of business is not necessarily limited to the unitary legal entities that are parties to the transaction and, thus, the UCC s definition of person is broad enough to encompass the SemCrude-parent relationship for purposes of the BIOC defense. The producers also argued that the downstream purchasers transactions with SemCrude were not in the ordinary course of business because their trading documentation included cross-product netting. Here, the bankruptcy court was careful to distinguish between the payment netting that occurred with

5 respect to the physical oil transactions on a monthly basis versus the cross-product netting that only occurred upon termination of the ISDA master agreement and the physical oil and derivatives transactions thereunder and calculation of the early termination payment. The bankruptcy court did not determine whether cross-product netting was in the ordinary course of business, but instead found that it was irrelevant because that netting did not occur until SemCrude defaulted under the ISDA master agreement. The relevant point in time for determining BIOC status was when the physical oil transactions took place, and actions that occur after the sale do not retroactively strip a part of BIOC status. As a result, the court agreed that the downstream purchasers acquired the oil in the ordinary course of business, whether or not cross-product netting constituted the ordinary course of business. Under the last element of the BIOC defense, the downstream purchasers must not have acquired the oil in satisfaction of a pre-existing debt. According to the producers, the cross-product netting arrangement permitted the downstream purchasers to acquire oil from SemCrude as collateral for debt owed to them by SemCrude under the financial derivatives transactions between them. However, the bankruptcy court rejected this argument because the debt under the financial derivatives transactions did not arise until SemCrude s default and upon termination of the financial derivatives transactions. Therefore it was not a pre-existing debt at the time the oil transactions were entered into. At most, the financial derivatives transactions gave rise to a future debt, meaning that the oil was not acquired as a security for a money debt, which can only refer to a debt that is already in existence. The producers further argued that, because the downstream purchasers rolled their call options with SemCrude (meaning that SemCrude effectively renewed its call option for a fee), SemCrude s derivatives losses were building month to month as price volatility increased. However, the court did not agree with this contention. It clarified that SemCrude s potential exposure on financial derivatives was growing, not its losses. If the market had changed course, the downstream purchasers could just have easily been liable to SemCrude. The court found that the debt did not exist until SemCrude defaulted in July 2008; prior to that time, SemCrude s liability on the derivatives was merely projected. As a result of this analysis, the court found that the bankruptcy court s recommendation of summary judgment upholding the BIOC defense in favor of the downstream purchasers was warranted. Conclusion Based on the analysis set forth above, the court overruled all of the producers objections, and adopted all of the bankruptcy s court s FFCL. The court issued an order granting summary judgment in favor of the downstream purchasers on all counts. Key Takeaways for Energy Firms This Delaware district court decision coming seven years after the SemCrude bankruptcy is yet another reminder of the many lessons for participants in the energy production, trading and marketing industry that have stemmed from bankruptcy. This court decision is a very timely one given the distinct possibility of financial distress in the markets in coming months. It is apparent that the downstream purchasers employed robust risk management practices that included appropriate transaction documentation and credit risk management in the form of netting agreements, collateral and exposure management, and it is reasonable to assume that they conducted

6 appropriate counterparty due diligence and credit monitoring during their relationship with SemCrude. Those practices certainly played a role in the positive result for the downstream purchasers in this matter. The producers might have avoided significant exposure to SemCrude through similar practices. At the same time, it is notable that sophisticated market participants that protect themselves with sound risk management practices are not necessarily charged with the knowledge of, or responsibility for, their counterparties activities. The mere trading of derivatives with SemCrude, awareness that it purchased crude on credit, and possible awareness of its financial distress were not sufficient to create a material question of fact to support a fraud claim. There are some very important takeaways from the court s determination regarding lien perfection and enforcement as well. As discussed above, SemCrude involved parties and activities conducted in multiple jurisdictions, and in the end it was the UCC as in effect in the states of Delaware and Oklahoma (where the relevant SemCrude entities were located) that governed the producers lien rights, and not the laws of Kansas or Texas where a number of the other parties were located and where a number of the transactions were performed. This decision, as with others in the SemCrude bankruptcy, demonstrates that it is critical for market participants to understand the availability and legal enforceability of liens and other legal remedies against counterparties with whom they may be taking on significant exposure. A greater understanding of those rights and remedies by the producers in the SemCrude matter may have improved their chances of defeating both the buyer for value and buyer in the ordinary course of business defenses. By Mark D. Sherrill, Travis C. McCullough and Cheryl I. Aaron, Sutherland Asbill & Brennan LLP Mark Sherrill is a partner in Sutherland's Washington, D.C., office. Travis McCullough is a counsel in Houston and a former managing director and associate general counsel at JPMorgan, where he served as lead senior counsel for the company s commodities business in Europe, the Middle East and Africa. Cheryl Aaron is an associate in Washington. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] See In re Semcrude LP, 504 B.R. 39 (Bankr. D. Del. 2013). [2] 2015 WL All Content , Portfolio Media, Inc.