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In re Semcrude L.P.

United States Court of Appeals, Third Circuit

July 19, 2017

In re: SEMCRUDE L.P., et al., Debtors
v.
J. ARON & COMPANY, et al ARROW OIL & GAS, INC., et al ANSTINE & MUSGROVE, INC; ARROW OIL & GAS INC; BEASLEY OIL COMPANY; BLAKE EXPLORATION LLC; BRADEN-DEEM INC; CALVIN NOAH, d/b/a Calvin Noah Oil Company; CMX INC; CASEY MUSGROVE OIL CO, INC; CENTRAL OPERATING INC; CLARK EXPLORATION COMPANY; CORAL COAST PETROLEUM INC; CRAWLEY PETROLEUM CORP; DC ENERGY INC; D.E. EXPLORATION INC; DAVIS PETROLEUM INC; DAYSTAR PETROLEUM INC; DK OPERATING INC; DOUBLE EAGLE EXPLORATION INC; DRILLERS AND PRODUCERS INC; DUNCAN OIL PROPERTIES INC; FAIRFIELD OIL & GAS CORP; THE GLOCO LLC; GMX RESOURCES INC; GRA EX, LLC; GREAT PLAINS ENERGY, INC; GROUND DEVELOPMENT CO; HERMAN L LOEB, LLC; H.I. INC; J&D INVESTMENTS, LLC; JACK EXPLORATION, INC; KAHAN & ASSOCIATES INC; KEITH F. WALKER OIL & GAS CO., LLC; KINGERY DRILLING CO; KLM EXPLORATION COMPANY INC; LANCE RUFFEL OIL & GAS CORPORATION; LANDMARK RESOURCES INC; LARIO OIL & GAS CO;L&J OIL PROPERTIES, INC; LD DRILLING, INC; LITTLE BEAR RESOURCES, INC; MCCOY PETROLEUM CORPORATION; MCGINESS OIL COMPANY OF KANSAS; MESA EXPLORATION COMPANY, INC; MID-CONTINENT ENERGY CORPORATION; MOLITOR OIL, INC; MULL DRILLING COMPANY, INC; MURFIN DRILLING COMPANY, INC; MUSGROVE ENERGY INC; MUSTANG FUEL CORP; NYTEX ENERGY LLC; OIL COMPANY OF AMERICA INC; OKLAHOMA OIL & GAS MANAGEMENT INC; PICKRELL DRILLING COMPANY, INC; PROLIFIC RESOURCES, LLC; RAMA OPERATING COMPANY, INC; RANDON PRODUCTION COMPANY INC; RED OAK ENERGY INC; RITCHIE EXPLORATION INC; RJ SPERRY CO; ROSS HOENER, INC; SEEKER, LLC; SHORT & SHORT, LLC; SNYDER PARTNERS; STEPHENS & JOHNSON OPERATING CO; TEMPEST ENERGY RESOURCES LP; TEX-OK ENERGY LIMITED PARTNERSHIP; TGT PETROLEUM CORPORATION; THREE-D RESOURCES, INC; THOROUGHBRED ASSOCIATES, LLC; TRIPLEDEE DRILLING CO., LLC; TRIPOWER RESOURCES, LLC; VIKING RESOURCES, INC; V.J.I. NATURAL RESOURCES INC; VEENKER RESOURCES, INC; VESS OIL CORPORATION; VINCENT OIL CORPORATION; W.D. SHORT OIL COMPANY, LLC; WELLCO ENERGY, INC; WELLSTAR CORPORATION; WHITE EXPLORATION INC; WHITE PINE PETROLEUM CORPORATION, Appellants In re: SEMCRUDE L.P., et al., Debtors BP OIL SUPPLY COMPANY
v.
SEMGROUP, L.P., et al Star Production, Inc; LSC Production Company, Appellants In re: SEMCRUDE L.P., et al., Debtors J. ARON & COMPANY
v.
SEMGROUP, L.P., et al IC-Co, Inc., Appellant In re: SEMCRUDE L.P., et al., Debtors IC-CO, INC; WEOC, INC.; RESERVE MANAGEMENT INC
v.
J. ARON & COMPANY IC-CO, Inc., Appellant

          Argued April 4, 2017

         Appeal from the United States District Court for the District of Delaware (D. Del. Nos. 1-14-cv-00038, 1-14-cv-00039, 1-14-cv-00040, 1-14-cv-00041, 1-14-cv-00357 & 1-14-cv-00358) District Judge: Honorable Sue L. Robinson.

          Blake H. Bailey Paul D. Moak Basil A. Umari McKool Smith, Peter S. Goodman Sarah O. Jorgensen Michael R. Carney Hugh M. Ray McKool Smith, Lewis T. LeClair, McKool Smith, Adam G. Landis Matthew B. McGuire Landis Rath & Cobb, Counsel for Anstine & Musgrove Inc., et. al. (The Associated Producers)

          Don A. Beskrone Stacy L. Newman Ashby & Geddes, Boaz S. Morag Rishi Zutshi Thomas J. Moloney, Cleary Gottlieb Steen & Hamilton One Liberty Plaza, Counsel for J. Aron & Co.

          James S. Carr Melissa E. Byroade David Zalman, Monica Hanna Kelley Drye & Warren, Kevin M Capuzzi Jennifer R. Hoover Benesch Friedlander Coplan & Arnoff, Counsel for BP Oil Supply Co.

          Ian C. Bifferato Thomas F. Discoll, III Bifferato, Kevin G. Collins Barnes & Thornburg, Mark D. Collins John H. Knight Michael Romanczuk Zachary I. Shapiro Richards Layton & Finger, L. Katherine Good Whiteford Taylor & Preston, Maris J. Kandestin DLA Piper, Garvan F. McDaniel Hogan McDaniel, R. Stephen McNeill Potter Anderson & Corroon, Travis A. McRoberts Akin Gup Strauss Hauer & Feld, Benjamin L. Stewart Bailey Brauer, Mark Stromberg Stromberg Stock, W. Robert Wilson, Counsel for Semcrude LP.

          Charles J. Brown, III Shannon Dougherty Humiston Gellert Scali Busenkell & Brown, Counsel for Star Production Inc., LCS Production Co.

          Hartley B. Martyn, Martyn & Associates, Duane D. Werb Werb & Sullivan, Counsel for IC Co. Inc.

          Before: AMBRO, JORDAN, and FISHER, Circuit Judges.

          OPINION

          AMBRO, Circuit Judge.

         Appellants, who are oil producers, sold their product to SemGroup L.P. and affiliates (including SemCrude L.P.), midstream oil and gas service providers and the Debtors in the underlying Chapter 11 cases. SemGroup sold oil to and traded oil futures with Appellees, downstream oil purchasers. The producers took no actions to protect themselves in case of SemGroup's insolvency. The downstream purchasers did; in the case of default, they could set off the amount they owed SemGroup for oil by the amount SemGroup would owe them for the value of the outstanding futures trades. Accordingly, when SemGroup filed for bankruptcy, the downstream purchasers were paid in full while the oil producers were paid only in part.

         Because the oil producers did not take precautionary measures to ensure payment in case of SemGroup's insolvency, all they have to rely on are local laws they contend give them automatically perfected security interests or trust rights in the oil that ended up in the hands of the downstream purchasers. But the parties who took precautions against insolvency do not act as insurers to those who took none. Accordingly, we affirm the grant of summary judgment in the downstream purchasers' favor.

         I. Background

         SemGroup's Two Businesses

         SemGroup L.P. and its subsidiaries (jointly and severally referred to as "SemGroup") provided "midstream" oil services. It purchased oil from producers and resold it to downstream purchasers. It also traded financial options contracts for the right to buy or sell oil at a fixed price on a future date. At the end of the fiscal year preceding bankruptcy, SemGroup's revenues were $13.2 billion.

         Two of SemGroup's operating companies, SemCrude, L.P. and Eaglwing, L.P., purchased oil from thousands of wells in several states and from thousands of oil producers, including from Appellants, producers located in Texas, Kansas, and Oklahoma. The producers act on behalf of many parties who have interests in the oil at the wellhead. These interest owners include the person or entity who owns the land in fee simple, and thus owns the rights to the minerals. That person or entity transfers the mineral rights to an oil company through a lease. The company holds the "working interest"-the right to drill and sell the oil from the leased land. The working-interest owners appoint an operator to work the well. Most of the producers in this appeal are owners of working interests or operators.

         After purchase, SemGroup moved the oil via trucks and pipelines and stored it in major aggregation centers in Oklahoma, Kansas, and elsewhere. Per industry custom, SemGroup purchased the oil on credit, paying for it on the 20th day of the month following the sale. For example, oil purchased in January would be paid for on February 20.

         SemGroup always paid the producers for the oil in full until the bankruptcy filing. It then resold the product to downstream purchasers, including to Appellees, J. Aron & Company and BP Oil Supply Co., both large oil distributors. SemGroup expressly warranted to the downstream purchasers that it sold them oil "free from all royalties, liens, and encumbrances." See, e.g., Conoco General Provisions § B, J.A. 2505. Again, per industry custom the downstream purchasers bought the oil on credit, with payment due the 20th of the following month. J. Aron and BP had no communication with the thousands of oil producers from whom SemGroup purchased the oil and only knew of the existence of some of the larger producers. J. Aron and BP dispute whether they even purchased any of Appellants' oil and contend that Appellants cannot trace the oil they sold, as it was mixed with millions of barrels of oil from innumerable other producers.

         Until the bankruptcy filing, J. Aron and BP paid in full for the oil they bought. BP also sold oil to SemGroup, so when payment was due they would net out their obligations- i.e., if BP bought $10 million from SemGroup and SemGroup bought $8 million from BP, then BP would just pay $2 million to SemGroup.

         In addition to midstream oil services, SemGroup also traded oil futures with J. Aron and BP. This trading strategy lead to SemGroup's insolvency. Essentially SemGroup bet that the price of oil would drop, while J. Aron and BP wanted to secure a low price of oil in the event that prices would rise. SemGroup would win the bet if the oil price dropped while J. Aron and BP would win if the price rose. The (simplified) mechanics are as follows.

         SemGroup sold what are known as call options. In exchange for an upfront premium, the purchaser of the call option received the right to purchase oil at a specified price and date. To illustrate, if in December J. Aron purchased the right to buy 10, 000 barrels of oil at $50 a barrel on March 1, but the market price that date was $45 a barrel, that option was worthless because J. Aron could buy oil at a cheaper price on the market; the $50 buying right did not save J. Aron money. SemGroup therefore would make money: it received the upfront premium J. Aron paid for the option, but did not end up losing the bet because it would not have to sell oil at less than market price. Conversely, if the market price on March 1 was $55 a barrel, J. Aron would be "in the money"-SemGroup would have to sell J. Aron 10, 000 barrels of oil at $50 a barrel, $5 below the market rate. SemGroup thus would lose $50, 000 dollars on the option because, if J. Aron did not have the buying right, SemGroup could have sold that oil on the market for the going price of $55. These options did not "physically settle." That is, SemGroup would not actually sell these oil barrels; it would just owe J. Aron $50, 000.

         SemGroup's gambling strategy was in stark contrast with hedging oil prices. To hedge a drop in the price of oil, SemGroup could have acquired put options-the right to sell oil at a specified price. This would protect them against price drops while still allowing them to take advantage of selling at high oil prices.

         As it turns out, SemGroup was a bad gambler. Oil prices rose throughout 2007 and 2008. Its CEO believed that eventually oil prices would drop. So each time SemGroup lost money on these options, rather than realize the financial loss, it would sell more options to cover the loss. This is referred to as "rolling" in the industry, and is essentially doubling down on a lost bet. For example, if SemGroup lost $1 million on the March 1 trade, it would resell new options and collect $1 million in new premiums, thus betting that the price of oil would drop on a date in the future. SemGroup thought that, if it kept "rolling" these options, eventually the price of oil would drop and all the options would be worthless. If that happened, SemGroup would have acquired all of these upfront premium payments at no cost. This doubling-down strategy had a downside, however. Rolling options greatly increased SemGroup's exposure to future losses. By July 2008 it was exposed to a potential $2.8 billion loss if the option bets did not pay off.

         Liquidity Problems, Setoff Rights, and the Bankruptcy Filing

         SemGroup had to pledge cash collateral to margin accounts to cover its exposure on the options. The cash in these margin accounts assured the trading counterparties that SemGroup could pay for any loss on the options. The margin exposure was calculated by the "mark to market" method- the amount SemGroup would owe the counterparty if the option liquidated that day. As SemGroup's exposure on these options increased, so did its margin requirements. Eventually it ran out of funds to meet those margin obligations, causing its bankruptcy.

         Before the bankruptcy, J. Aron and BP started buying oil from, and trading options with, SemGroup. In November 2007, J. Aron entered into a master agreement governing its relationship with SemGroup, and in April 2008 BP entered into a similar arrangement. Under the agreements, in the event of SemGroup's default J. Aron and BP could set off any outstanding amount due for oil purchases with the amount owed on options trades. Until SemGroup's default, J. Aron and BP always paid in full for their oil purchases and never exercised a setoff right.

         Through the late spring and early summer 2008, oil prices kept rising and SemGroup continued losing on its trades. It failed to receive additional financing to meet its ever-increasing margin obligations. On July 17, 2008, as set out in their agreement, J. Aron asked SemGroup for adequate assurance of performance and that SemGroup meet certain credit-support thresholds. When SemGroup did not respond, J. Aron called a default. The parties thus set off the outstanding amounts due. J. Aron owed to SemGroup $435 million in oil purchases, and SemGroup owed to J. Aron $345 million in outstanding options trades. Accordingly, J. Aron owed $90 million, the net amount after the oil and options were set off.

         On July 22, 2008, soon after J. Aron called the default, SemGroup filed for bankruptcy. This triggered a default as to BP, so it also set off the prepetition amount it owed SemGroup for oil less the amount SemGroup owed it for the options trades. Consequently, BP owed $10 million.[1]

         Bankruptcy Proceedings

         Following its Chapter 11 filing, more than a thousand oil producers were unpaid. Oil producers, purchasers, and SemGroup's lending banks inundated the Bankruptcy Court with adversary proceedings and motions to distribute SemGroup's assets. The Court established omnibus procedures to determine the producers' rights and priorities versus the banks, with a single adversary proceeding for each state where the producers sold product. The relative priority of the producers and downstream purchasers was preserved for later rulings.

         In those rulings, the Bankruptcy Court first held that the lending banks' security interests in SemGroup's assets took priority over any purported lien or trust rights granted under state law. It certified appeals directly to our Court as matters of first impression, 28 U.S.C. § 158(d)(2), but the producers and lending banks settled while the appeals were pending. By stipulation, the producers reserved their right to pursue their claims against the downstream purchasers and to appeal these rulings in the future.

         Meanwhile, J. Aron and BP filed separate adversary proceedings where they sought to tender the amount they owed to the bankruptcy estate in exchange for a release from all liability. The producers also filed nearly 30 separate lawsuits against J. Aron and BP in state and federal courts. These suits were transferred to the Bankruptcy Court for resolution. In September 2009, it confirmed the reorganization plan by which J. Aron and BP's tendered funds were turned over to the producers for full payment of oil delivered between July 2 and July 21, 2008.[2] The tendered funds also paid off 12.9% of the amount owed for oil sold from June 1 to July 1, 2008.

         After a discovery process involving more than 100 parties, over 150 depositions, and millions of pages of documents, J. Aron and BP moved for summary judgment against the Appellant-Producers (hereafter, the "Producers"). The Bankruptcy Court filed proposed findings of facts and conclusions of law recommending summary judgment in favor of J. Aron and BP. It concluded in exceptional depth and easily understood language that there was no evidence of fraud and that J. Aron and BP purchased the oil from SemGroup free of any purported security interest either as (1) buyers for value, or (2) as buyers in the ordinary course. In re SemCrude, L.P., 504 B.R. 39, 44 (Bankr. D. Del. 2013). The District Court overruled the Producers' objections to the Bankruptcy Court's recommendation and adopted it. In re Semcrude, L.P., No. 14-CV-41 (SLR), 2015 WL 4594516 (D. Del. July 30, 2015).

         Summary of ...


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