Oil and Gas Secured Transactions in Kansas
| Publication year | 2017 |
| Pages | 22 |
November 2017
Joseph A. Schremmer
I. Introduction
Oil and gas financing in Kansas is common, but not commonsense.[1] Often the complexities become apparent after the price of oil has fallen and lenders must defend the priority of their claims in bankruptcy and foreclosure proceedings. Successfully handling oil and gas secured transactions in Kansas requires understanding two bodies of law: Article 9 of the Kansas Commercial Code (Article 9 or UCC) and Kansas real property law. This article surveys the creation, perfection, priority, and enforcement of consensual liens in oil and gas property under both sets of rules. Liens under joint operating agreements and statutory oil and gas liens are outside the scope of this article.[2]
A secured transaction is a business arrangement by which a borrower gives collateral to the lender to guarantee payment of an obligation. [3] The lender's interest in the collateral is a lien, in this case a consensual lien.[4] A lien lasts until the debt or duty it secures is performed.[5] A lien attaches only to the debtor's interest in the collateral. [6] The lienholder can enforce it by taking or selling the collateral in satisfaction of the debt if the debtor defaults on its obligation.
In Kansas, consensual liens in real property are called mortgages, while those in personal property are security interests. Article 9 governs security interests in personal property and fixtures.[7]Kansas real property law governs mortgages in real property.[8] Oil and gas lending implicates both security interests and mortgages because the collateral in an oil and gas transaction generally include real and personal property. Oil and gas property, such as oil and gas leases, wells, production equipment, and related contracts, are more valuable when integrated together in a producing lease or unit. Because the producing unit's value is greater than the sum of its parts, lenders want to secure exploration and production operating loans with liens on all the property necessary to operate the unit in the event of default. If the lender has to foreclose, it can repossess all the property necessary to operate the producing unit and sell it together for more than it would bring piecemeal.
The components typically needed to operate the producing unit include the debtor's interest in the oil, gas, or other minerals in place and as produced and any proceeds of production; oil and gas lease or leases; oil, gas, and injection wells; surface and downhole equipment for producing, treating, and storing oil and gas; oil and gas gathering and transmission pipelines; and associated contracts such as oil or gas purchase contracts and operating and exploration contracts. Debtors in the oilfield services sector tend to offer moveable equipment like drilling and well-servicing rigs as collateral. This list is not exclusive. Parties to oil and gas financing transactions often execute an instrument (commonly called a "Mortgage, Security Agreement, and Financing Statement") describing all of the above property as well as general categories like "all other real and personal property of the debtor."
II. Attachment: Creating a Lien
A lien must first attach in the collateral to be enforceable. The term attach is used "to describe the point at which property becomes subject to a security interest."[9] Under Article 9, a security interest attaches when it becomes enforceable against the debtor with respect to the collateral, unless an agreement expressly postpones the time of attachment.[10] A security interest is considered enforceable against the debtor, and third parties, with respect to the collateral when value has been given; the debtor has rights in the collateral or the power to transfer rights in the collateral to the secured party; and the debtor has authenticated a security agreement that describes the collateral or possession of the collateral is in the secured party under the security agreement.[11]
A lien in real property is effective when the debt arises and a written instrument creating a lien in the real property, typically a mortgage, is signed by the owner of the property (the mortgagor).[12] There are otherwise no special formalities to create a mortgage in real property.[13] In addition to satisfying these basic formal requirements, security agreements and mortgage agreements usually define the parties' respective rights and obligations as to the collateral, define the events of default by the debtor, and circumscribe the secured party's enforcement rights. Section V on lien enforcement describes certain provisions often included in security and mortgage agreements for these purposes.
III. Perfection of Liens and the Effect of Perfection or Nonperfection
Perfecting a mortgage or security interest in oil and gas property is necessary to give notice to and maintain priority over subsequent lienholders and purchasers of the property. Correctly classifying the property serving as collateral is crucial to proper perfection. Drafters must first determine whether the intended collateral is real or personal property. That determines the applicable body of law.[14] Article 9 controls security interests in collateral that is personal property and fixtures.[15]Non-UCC Kansas real property law controls perfection of mortgages in real property.[16] Perfecting a mortgage in real property in Kansas is fairly straightforward. Under Kan. Stat. Ann. § 58-2221, the mortgagee must record the written instrument creating the mortgage, signed by the mortgagor, in the office of the register of deeds for the county where the property is located.[17] Recording provides constructive notice of the mortgage to the public.[18] Unless and until recorded, the mortgage is only enforceable between the parties.[19]
A. Article 9 and Choice of Law
For security interests in personal property and fixtures, determining the manner of perfection under Article 9 is more complex. The first issue is to determine which state's version of Article 9 applies. Under Kan. Stat. Ann. § 84-9-301(1), the law of the location of the debtor generally controls perfection, the effect of perfection or nonperfection, and the priority of security interests. But the law of the jurisdiction in which the wellhead is located governs the manner and effect of perfection and the priority of a security interest in as-extracted collateral (oil and gas, discussed below), regardless where the debtor is located.[20] Under revised Article 9, the perfection of a security interest in goods (a particular type of collateral, discussed below) is governed by the law of the debtor's location, but the effect of perfection or nonperfection and the priority of security interests in goods is determined by the law of the location of the goods.[21] The drafters of the 2000 revisions to Article 9 intentionally divorced the question of perfection from the effect of perfection or nonperfection and relative priorities of security interests in goods in order to address situations where goods owned by an out-of-state debtor, but located in Kansas, become subject to a non-UCC Kansas statutory lien (e.g., an execution lien or oil and gas mechanic's lien). When that happens, the law of the debtor's location determines whether the security interest is properly perfected, but Kansas law determines the relative priority of the security interest and the statutory lien.[22]
B. Methods of Perfecting Article 9 Security Interests
Once we determine which state's Article 9 applies, the next issue is how to perfect a security interest in the collateral under that law. This issue requires classification of the collateral. Article 9 requires different manners of perfection for different collateral classifications. The most common types of collateral in oil and gas transactions are goods, equipment, fixtures, accounts, and as-extracted collateral. Goods are "all things that are movable when a security interest attaches."[23] Goods other than inventory, farm products, or consumer goods are considered equipment.[24] Fixtures are another subcategory of goods. Fixtures are defined as goods "that have become so related to particular real property that an interest in them arises under real property law."[25] Goods specifically do not include oil, gas, or other minerals before extraction.[26] Accounts are rights to payment of a monetary obligation for, among other things, property that has been sold or services rendered.[27] As-extracted collateral is a special category created specifically for oil and gas and mining transactions, and is discussed in detail below.
There is often uncertainty in classifying common types of oil and gas collateral for perfection purposes, which begets uncertainty in how to properly perfect a lien in those types of collateral. The remainder of this section discusses the classification of typical collateral in oil and gas transactions. Table A summarizes the primary method of perfection for common collateral types.
1. Liens in Oil, Gas, or Other Minerals as Produced
Oil, gas, or other minerals that have not been extracted, i.e., that are in place in the ground, are specifically excluded from Article 9's definition of goods.[28] Official Comment 4 to Kan. Stat. Ann § 84-9-102 explains that "oil, gas, and other minerals that have not been extracted from the ground are treated as real property, to which this Article does not apply." A lien in oil, gas, or other minerals in place is thus a mortgage in real property and is perfected under Kan. Stat. Ann. § 58-2221 by recording the signed mortgage instrument in the office of the register of deeds for the county where the land is located.
Once extracted however, oil, gas, or other minerals become personal property, specifically goods, that are subject to Article 9. When...
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