Fullop, Matter of, s. 91-3733 and 91-3782
| Decision Date | 19 October 1993 |
| Docket Number | Nos. 91-3733 and 91-3782,s. 91-3733 and 91-3782 |
| Citation | 6 F.3d 422 |
| Parties | Bankr. L. Rep. P 75,440, 21 UCC Rep.Serv.2d 757 In the Matter of Henry Robert FULLOP, Debtor. Charles E. JONES, Successor Trustee to Gibson D. Karnes, Trustee, Appellant-Cross-Appellee, v. SALEM NATIONAL BANK, Appellee-Cross-Appellant. |
| Court | U.S. Court of Appeals — Seventh Circuit |
Terrell L. Sharp (argued), Mt. Vernon, IL, for Charles E. Jones.
Robert E. Shaw (argued), Mitchell, Neubauer & Shaw, Mt. Vernon, IL, Roger L. Vetter, Jones & Ottesen, Belleville, IL, for Salem Nat. Bank.
Before EASTERBROOK and KANNE, Circuit Judges, and PELL, Senior Circuit Judge.
"[O]il and gas financing is a strange world of its own." Woodward v. Wright, 266 F.2d 108, 115 (10th Cir.1959). In attempting to convert dreams of black gold to hard cash, aspiring capitalists split the property interest in oil into "more fragments than the atom or the rainbow." B. Clark, The Law of Secured Transactions Under the UCC p 13.01 at 13-2 (2d ed. 1988). This case requires us to examine the scope of one of those fragments--a lessee's rights under an oil and gas lease--and determine the requirements a secured creditor must meet to perfect its interest in the oil extracted under such a lease. Pursuant to the Bankruptcy Act's "strong arm" powers, 11 U.S.C. Sec. 544(a), the debtor, Henry Fullop, filed and Charles Jones, as trustee, maintained this action seeking to avoid Salem National Bank's lien on oil extracted pursuant to an oil and gas lease. The district court affirmed the bankruptcy court's holdings that the Illinois Uniform Commercial Code (UCC) applied to the oil upon extraction and accounts resulting from its post-petition sale, and that the Bank met the requirements for a perfected security interest under Article 9 of the UCC. We affirm as modified herein.
Under Illinois law, a fee simple in real property consists of both a mineral estate and a surface estate, which may be severed from each other. Jilek v. Chicago, Wilmington & Franklin Coal Co., 382 Ill. 241, 47 N.E.2d 96, 98 (Ill.1943). The owner of the mineral estate may lease that property right to another for the purposes of exploration and production of oil and gas. The lessee is responsible for the work necessary to produce oil--such as drilling the well, pumping any oil located, and providing storage tanks. The lessee's rights under the oil and gas lease are known as a "working interest." Illinois Nat. Oil & Gas Co. v. Sinclair, 373 Ill. 581, 27 N.E.2d 450, 451 (Ill.1940). The working interest includes "the portion of the oil and gas that may be produced from the premises after the royalty for the share paid to the landlord is first deducted." Bates v. Mansfield, 212 Ill.App.3d 69, 156 Ill.Dec. 73, 75, 570 N.E.2d 549, 551 (1991). The lessee will often assign this working interest to a financier as collateral for a loan, the proceeds of which will be used for the initial exploration and the subsequent oil production. Once production begins, the lessee may execute transfer and division orders calling for the direct payment of oil sale proceeds from third party purchasers to the lender.
In this case, four types of documents evidenced the relationship between the Bank and the debtor, Henry Fullop.
First, the debtor executed and delivered to the Bank two collateral promissory notes dated February 1, 1985 and totaling over $690,000. One note included a provision which granted the Bank a lien on "Various oil and gas leases, and any and all collateral now or hereafter in the Bank's possession[,] together with all additions, accessions, substitutions, exchanges, proceeds, product, offspring, rents, profits, and all proceeds of any of the foregoing." The other note, through similar language, also created a lien on assignments of various oil and gas leases and also referenced as collateral existing security agreements, dated December 29, 1982 and September 30, 1982.
Second, the Security Agreements granted the Bank an interest in specific assignments of oil and gas leases, which were listed by name and number, and in any future leases acquired by the debtor. For example, the September 30, 1982 Security Agreement provides:
Henry Fullop ... (hereinafter called Debtor), for valuable consideration, receipt of which is hereby acknowledged, hereby grants and transfers to THE SALEM NATIONAL BANK, Salem, Illinois, (hereinafter called Bank), a security interest in the property described below, together with any and all additions and accessions thereto (hereinafter collectively called Collateral):
Assignments of the following Oil & Gas Leases
VentersStanton Comm. 1 # 741C Thelma Worrell # 1
# 52679
Rister Comm. # 1 781C Carl Short # 1 & # 2
10465
Kenneth Short # 1 800C Carl Short # 3 & # 4
10531
Smothers Comm. # 1 897C Ralph English # 1
23742
Etienne Comm. # 1 927C King Mattingly
3913
Robinson # 2 928C KingCarrier
3932
Simpson # 1, # 2, & # 3 975C Elmer Emmerson
2115
Unknown 2123
and any acquired leases in the future.
In a third form of document, the debtor assigned to the Bank his working interest in various oil and gas leases. The following is an example of the assignments of working interests in oil and gas leases:
KNOW ALL MEN BY THESE PRESENTS: That the undersigned, Henry Fullop, of Carmi, Illinois 62821, hereinafter called Assignor, for and in consideration of Ten and no/100 dollars ($10.00) and other valuable consideration, ... does hereby sell, assign, transfer and set over unto
SALEM NATIONAL BANK for account of Henry Fullop, hereinafter called Assignee, a 1/8th working interest in and to the following described oil and gas leases, covering lands situated in White County, Illinois, to-wit:
1. Oil & Gas Lease dated April 10, 1980, from Burnedine Etienne and Richard Etienne her husband ..., Lessors, to Henry Fullop, Lessee, recorded in Book 145, Pages 493-495 of the records of the White County Recorder;
. . . . .
INSOFAR as the above leases cover the following described land; The Southeast Quarter of the Northwest Quarter (SE 1/4 NW 1/4) of Section Twenty (20), Township Three (3) South, Range Eight (8) East, containing forty (40) acres more or less;
together with the rights incident thereto and the personal property thereon, appurtenant thereto, or used or obtained in connection therewith.
The assignment shall be effective as of the first date of the runs.
The Assignment shall be effective as of September 1, 1981. EXECUTED this 30th day of September, 1981.
s/Henry Fullop.
Some of the assignments appeared as absolute transfers of the working interests. However, others indicated that the assignment to the Bank was for the account of Fullop or contained the following provision: "The proceeds from this interest shall apply to a note to the [Bank] until such time as said indebtedness is liquidated, at which time the [Bank] shall re-assign said interest to [Fullop]." Notwithstanding the language of these documents, the parties agree that the assignments were not absolute, but rather were intended to serve as security for the Bank loans. The Bank recorded the assignments in the real estate records of the counties in which the wellheads of each of the working interests were located.
The oil produced under the leases was purchased at the wellhead by third parties, and, pursuant to the fourth type of document, transfer and division orders executed by the debtor, the proceeds attributable to the debtor's share of the working interest were paid directly to the Bank. The following exemplifies the content of the transfer and division orders:
We, the undersigned, hereby certify and warrant that we have transferred, as indicated below, oil production from the ETIENNE COMM. # 1 located in the County of White, State of Illinois described as follows: SE 1/4 NW 1/4 Section 20-3S-8E, White County, Illinois Effective September 1, 1981, and until further written notice from either party, Rock Island is authorized to purchase, ... the oil produced from the above lease and to make payments therefor as follows:
To whom transferred:
Salem National Bank A/C Henry Fullop
Division of Interest:
.09570313 [Working Interest]
The Bank applied the funds it received under the transfer and division orders to the notes and remitted the balance to Fullop.
On September 30, 1985, Fullop filed a petition for bankruptcy in the United States Bankruptcy Court for the Southern District of Illinois. This act constituted default under the terms of the notes, and the Bank stopped remitting to him the balance of the oil sale proceeds. Instead, the Bank began paying the operating expenses related to assigned working interests and applying the balance to Fullop's outstanding notes.
Three years later, Fullop, acting as debtor-in-possession, filed an adversary complaint seeking to avoid, under 11 U.S.C. Sec. 544(a)(1), the Bank's liens relating to the oil and gas leases. In particular, the complaint sought to recover post-petition payments made to the Bank by the purchasers of the oil runs. When the bankruptcy proceeding was converted to a Chapter 7 liquidation on January 26, 1989, the appointed trustee was substituted as plaintiff, and he later was replaced by the current trustee, Charles E. Jones.
Under Sec. 544(a)(1) the trustee possesses the same rights as a hypothetical judicial lien holder, which permits him to avoid all liens and security interests that are unperfected at the time of the bankruptcy petition's filing. 1 The trustee conceded that the Bank had a valid and perfected lien on the oil and gas prior to its extraction from the ground, as those interests constitute a real property interest subject to the real estate recording statutes. However, the trustee contended that the Bank's perfected lien did not extend to the gas and oil upon its extraction and...
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