001 Mbank Abilene, N.A. v. Westwood Energy, Inc.

CASE OF THE MONTH

Richard F. Brown

 
This month we begin a new feature of our newsletter in which we will bring you a brief summary of a recent case which may have widespread significance for our readers. This month’s case is:
 
MBank Abilene, N.A. v. Westwood Energy, Inc., _ S.W.2d _ (Tex. App.–Eastland 12/31/86). Westwood, as the operator, held a lien under the operating agreement against the interest of each of the nonoperators who failed to pay his share of the lease operating expenses. The lien also extended to the nonoperator’s interest in the oil and gas produced and the proceeds from the sale of such oil and gas. Westwood never recorded the operating agreement. The nonoperator, Stroube Exploration, Inc., then incurred a debt to MBank and secured that debt by a deed of trust on its interest in the property. Stroube also assigned to MBank its interest in the oil and gas produced. Stroube defaulted on its loan with MBank and also stopped paying operating expenses. Issue: Who has the first lien, the bank or the operator? Held: the operator. Even though the operating agreement was not recorded, several instruments in Stroube’s chain of title, and thus in MBank’s chain of title, referred to the existence of the operating agreement. It is well-settled that a purchaser is bound by every recital, reference and reservation contained in or fairly disclosed by any instrument which forms an essential link in the chain of title under which he claims. The case is significant because, although operating agreements are infrequently recorded, it is quite common for assignments early in the life of a property to be “subject to” an operating agreement. For operators, this suggests that the operator may be ahead of the seemingly well-secured institutional lender to the nonoperator, and that the operator’s lien is an effective tool to recoup well costs from productive properties. For banks and other institutional lenders, this suggests first that, on producing properties, it may be prudent to insist on proof of payment of drilling and completion costs, before including the property in the borrowing base. Second, if the lender does not monitor the payment of operating costs, the lender’s “first lien” may be effectively eroded into a second lien position.