Navigating Oil and Gas Lease Issues

By Kirk B. Burkley

(Previously published in the ABI Journal)

It is almost universally accepted that many of the blue collar jobs that have been lost over the last couple of years are never coming back. Without getting into the political issues surrounding the exploration and drilling for oil and natural gas, the business of leasing oil and gas rights has been one of the only lifelines supporting rural communities, individuals and farmers. In particular, shale formations such as the Marcellus shale stretching along the Appalachian Basin from West Virginia through Pennsylvania and into New York, as well as through small parts of eastern Ohio and Western Maryland, have been an economic boom for the region. Some of the other significant shale gas plays have been developed in Texas, Oklahoma, Colorado, Montana, North Dakota, Illinois, Arkansas and Alabama.

Development of the shale plays are producing enormous wealth for otherwise distressed communities, and interesting issues arise when oil and gas leases intersect with the Bankruptcy Code. In particular, the energy boom that has followed the natural gas development in many of the shale formations has been fast and furious in many instances, with energy companies stepping over each other to negotiate with landowners in rural communities to lease as many acres of oil and natural gas rights as possible. As the leasing of oil and gas rights in these areas has been compared to a modern-day gold rush, many of these transactions are consummated without proper due-diligence and documentation to perfect the lessee’s rights, which leaves many open issues if the individual landowner files for bankruptcy, such as: What are the rights of competing interests in land such as prior mortgages and subsequent oil and gas lessees? Can a landowner reject an oil and gas lease in bankruptcy? Finally, can the trustee sell real property free and clear of the interest of an oil-and-gas lessee? While case law is still developing and often depends on the particulars of state law and theories of property ownership, this article will provide a general overview of these important issues and how to navigate them in consumer bankruptcy cases.

A natural gas lease is typically initiated by the parties signing a lease agreement, which is consummated when the landowner receives a “lease bonus” or “delay rental” payment. The purpose of this payment is to provide consideration to the landowner for the period in which the gas company does not actually develop the property. It is intended to “keep the lease alive” while the gas company decides whether it will exercise any of the rights granted by the landowner or lessor under the lease’s terms and conditions. The delay-rental payment is often in the form of a “paid-up” lease, which means that the gas company has decided to pay all delay rentals contemplated by the lease in one lump-sum payment, typically within 90 days of the date the lease was signed. The delay-rental payment typically covers a period of five years and is calculated on a per-acre basis during the gas lease development process.

In addition to the lease bonus payment, most individuals have the ability to negotiate the percentage used to calculate the royalty payment. For example, Pennsylvania law requires that an owner who leases his or her oil and gas rights receive a royalty equal to at least one-eighth of the value of the oil or gas produced and sold, less certain costs and expenses as provided for in the lease.

It is important to be aware that when an individual signs an oil and gas lease, he or she is conveying more than simply rights to the oil and gas that lay hundreds or thousands of feet below the surface. Inherent with the lease of oil and gas rights is also the lessee’s right to enter upon the surface of the property to explore and drill for the minerals that are being sought-after. After all, what good is it to acquire the rights to oil and gas reserves if one does not have the right to drill a well and the ability to capture and reduce the oil and gas to possession? The lessee also has the right to transport the oil and gas by pipeline across the surface of the land for the purpose of taking the product to market. It is often this real property interest that creates many of the issues that arise in the bankruptcy context.

The rights of competing interests in land such as the property owner, mortgagees and oil and gas lessees are intriguing, to say the least. It becomes even more interesting given the somewhat inconsistent law of varying jurisdictions based on similar fact patterns.

Common practice is that a real estate lender takes a mortgage as security for the repayment of the loan. The mortgage becomes void upon payment or performance according to the stipulated terms.If the mortgagor defaults the mortgage can foreclose on the mortgage. However, an oil and gas lessor’s rights come in three general parts. First, the company is to have the exclusive right to search for oil and gas underlying the leased premises. Next, the company has the right to enter the property-owner’s lands to conduct drilling operations for the purpose of producing oil and gas from the leased premises. Lastly, as mentioned, the lessee has the right to transport the oil and gas by pipeline across the subject property. In contrast, the landowner typically has the fundamental right to use and enjoy his or her property. These competing interests make proper due-diligence and documentation necessary for identifying, sorting out and protecting the various interests.

The treatment of oil and gas leases in bankruptcy will often depend on their treatment under relevant state law. For example, some jurisdictions hold that a landowner may own the subsurface mineral rights or oil and gas rights. These jurisdictions, such as Alabama, Arkansas, Colorado, Michigan, Mississippi, Montana, New Mexico, Ohio, Pennsylvania, Tennessee, Texas and West Virginia, are called “ownership-in-place” states. Other jurisdictions, including California, Illinois, Indiana, Kentucky, Louisiana, New York, Oklahoma and Wyoming, are called “non-ownership” states, and the landowner is not considered to actually “own” the oil and gas rights under the surface. Therefore, the landowner cannot “sell” or convey a fee interest in the oil and gas but is limited to leasing or transferring the exclusive right to search for and produce oil and gas from under the lands of the leased premises. In an “ownership-in-place” state, an oil and gas lease is actually not a true lease, but is a sale of a fee simple interest in the oil and gas underlying the leased premises. Although “ownership-in-place” states transfer a fee-interest through a document (often called a lease agreement), the fee interest is not vested at the time of the signing of the lease.5 The lessee or gas company will only vest upon the commencement of drilling operations and the production of oil and gas in paying quantities from the leased premises, or from lands unitized with the leased premises. Therefore, even in “ownership-in-place” jurisdictions in the bankruptcy context the rights of the parties may be drastically different depending on whether the lessee’s rights have vested in the minerals.

One question that often arises is whether a landowner can reject an oil and gas lease in bankruptcy, which depends on whether an oil and gas lease will be considered an executory contract or an unexpired lease. It requires (1) an analysis of the legal and contractual nature of the oil and gas lease, (2) the status of the development of the oil and gas rights leased and (3) most importantly, the construction and interpretation of the applicable state law. It is a well-settled principle that state law governs the decision of property and contract matters in bankruptcy. While the Code provides a debtor with rights regarding executory contracts and unexpired leases, applicable state law ultimately determines whether oil and gas leases constitute executory contracts or unexpired leases.

For example, in In re Gasoil, Inc.,6 the court held that an oil and gas lease in Ohio constitutes an unexpired lease of non-residential real property and subject to the restrictions of 11 U.S.C. § 365(h). However, in In re J.H. Land & Cattle Co. Inc., the court held that a Kansas oil-and-gas lease was an executory contract and may in fact be rejected by the debtor (trustee) under § 365 with court approval. The court opined that the oil-and-gas lease was an interest in personal property (i.e., license to enter and search for oil and gas) rather than a possessory real property interest.7 Courts in Wisconsin and Minnesota, respectively, have held that gas leases are unexpired leases of real property under state law, and hence must be considered an unexpired lease in bankruptcy and subject to the protections of § 365(h).8 The treatment and characterization of an oil-and-gas lease ultimately determines whether one may assert a right of possession and seek protection provided for by § 365(h), which provides that a debtor/lessor cannot reject a lease of real property and divest the lessee of its rights under the lease.

In the Marcellus shale fairway of Pennsylvania, when production is obtained under an oil-and-gas lease, the lessee obtains a “fee simple determinable” interest.9 Thus, in Pennsylvania and other “ownership-in-place” states, an oil-and-gas lease that has vested is not even subject to assumption or rejection under § 365 because, at that point, the lessee owns the fee interest in the oil and gas. In actuality, the term oil and gas “lease” in “ownership-in-place” states is somewhat of a misnomer because the interest created by the “lease” is a vested fee interest and is not the same as an interest created and governed by landlord-tenant laws. In these “ownership-in-place” states, such as Texas and Pennsylvania, § 365 does not govern the divestiture of oil-and-gas leases in bankruptcy. In “ownership-in-place” jurisdictions, once the mineral interest vests the lessee obtain fee interest that cannot be divested under § 365.10 Practitioners should take note that even prior to vesting in many “owner-ship-in-place” jurisdictions, it is likely that the restrictions of § 365(h)(1) apply because the interest granted via the lease is a possessory interest in real property.

Regardless of whether an oil-and-gas lease is truly a lease and subject to § 365, is the trustee permitted under the Code to sell real property free and clear of the interest of the oil-and-gas lease? Typically, if applicable state law permits a sale free and clear of such leases, then § 363 may permit a sale free and clear of the lessee’s interest. Specifically, § 363(f)(1) permits the sale of property free and clear of such an interest if the property could be sold free and clear of such interest under applicable nonbankruptcy law. In almost every state, it is well settled that the title of a purchaser at a sheriff’s sale relates back to the date of the mortgage and defeats all intervening estates and interests acquired subsequent to the mortgage.11 It naturally flows that a sheriff’s sale on a prior mortgage destroys a subsequently granted interest in that same land. In In re Dulgerian,12 the court held that an easement recorded after a mortgage had been assigned to the purchaser could be divested under § 363(f)(1) because under the state foreclosure law, “upon foreclosure, a mortgage takes the property subject only to the liens and encumbrances thereon at the time the mortgage was granted; any encumbrances on the land that postdate the mortgage are eliminated.” Regardless of what theory-of-ownership state in which a property was located, if the lessee has not vested its rights in the oil-and-gas rights by way of production, any interest (as most often represented by a recording of a memorandum of lease in the office of the recorder of deeds) could be divested. Additionally, in Hill v. MKBS Holdings LLC (In re Hill),13 the court held that the debtor’s property could be sold free and clear of a real property lease under § 363(f) despite the protections of § 365(h). To the extent that a court may construe an oil-and-gas lease as a lease of real property or an intervening estate that would otherwise entitle the lessee to remain in possession upon rejection under § 363(h), the property could be sold free and clear of an oil-and-gas lease pursuant to § 363(f) and the lessee would not be entitled to remain in possession under § 365(h). Of course, the oil-and-gas lessee has options, and in many instances, the oil-and-gas company may just elect to pay off the mortgagee and then deduct that amount from future royalty payments. The oil-and-gas company may also purchase the mortgage, foreclose and then become the owner of the land. In most consumer cases, the amount of the mortgage may make these options economically feasible.

In addition to a sale under § 363(f) (1), the trustee may also be permitted to sell free and clear under § 363(f)(4), which provides that a debtor’s property may be sold free and clear of an interest in property if the interest is subject to a bona fide dispute. Although the Code does not define what constitutes a bona fide dispute, case law suggests that courts look to “whether there is an objective basis for either a factual or legal dispute as to the validity of the asserted interest.” 14 Section 363(f)(4) could prove to be the basis for a very powerful argument when faced with an oil-and-gas lease in bankruptcy, because the determination as to whether the gas company-lessee has vested by way of production or the commencement of drilling operations is a very litigious area and may be the basis for a § 363 sale.

Do not to wonder. Perform your due diligence, and identify whether there is a prior mortgage. Did the mortgagee ever intend to hold as security the subsurface mineral rights? Resolution may be as simple as obtaining a subordination agreement for the mineral rights from the mortgagee. It is much easier to properly perfect a security interest than it is to litigate whether a subsequent encumbrance on a property may be divested by a previously recorded mortgage or even rejected under § 365 in bankruptcy.

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