The expansion of the oil and gas industry throughout the region has increased the incentives for landowners to lease their oil and gas rights. Landowners sitting atop active oil and gas plays can receive bonuses ranging from $500.00 to $8,000.00 per acre, plus royalty interests on the sale of oil and gas ranging from 12% to 20%. The increase in rates has led many landowners who leased their mineral rights prior to the Marcellus Shale boom to experience a form of “buyer’s remorse,” seeing now that their oil and gas rights could have earned several thousand dollars per acre, plus royalties. Depending on the terms and conditions of the lease, many landowners find it difficult, if not impossible, to cancel or otherwise modify the lease. If the lessor landowner encounters financial difficulties and turns to bankruptcy, Section 365 may enable the landowner to reject his or her oil and gas lease.
The Bankruptcy Code codifies the rights of debtors and creditors with respect to executory contracts and unexpired leases. Section 365 governs the assumption or rejection of an executory contract or unexpired lease. When either party moves to reject an executory contract or unexpired lease, the bankruptcy court must evaluate Section 365, in conjunction with applicable state law, to determine the rights of each party under the Bankruptcy Code. Before Section 365 comes into play, the bankruptcy court must first analyze state law to decide whether Section 365 applies.
Under Pennsylvania law, oil and gas leases encompass a unique set of variables that affect the lessee’s rights to the oil and gas produced. The Pennsylvania Supreme Court constructed a special interpretation of oil and gas leases as a conveyance of inchoate title, which allows exploration only until the lessee produces oil or gas in paying quantities. The production of oil and gas in paying quantities vests in the lessee a fee simple determinable, which includes the vested right to extract oil and gas. Under Pennsylvania law, the production of oil and gas also renders Section 365 moot, since the oil and gas lease is no longer a “lease,” but a vested interest in fee. If a debtor seeks to reject an existing oil and gas lease prior to production of oil and gas in paying quantities, then Section 365 would apply and guide the bankruptcy court in deciding whether or not it should grant rejection.
The key determination for the bankruptcy court in granting or denying a debtor’s request to reject an existing oil and gas lease is whether rejection is in the best interest of the bankruptcy estate. In at least two (2) cases analyzing Section 365 in conjunction with oil and gas leases under Pennsylvania law, the Bankruptcy Courts for the Eastern and Western Districts of Pennsylvania have denied rejection where the debtors failed to introduce concrete evidence or testimony of a firm offer to lease or purchase the debtors’ oil and gas rights. In both cases, the debtors only speculated that they could re-lease their property under more favorable terms, providing minimal evidence in support thereof. It is apparent from both cases that bankruptcy courts require much more than mere speculation before deciding that rejection is in the best interest of the bankruptcy estate. Since the rights of the lessee gas company are also at stake, debtors must make a strong showing that obtaining a more lucrative oil and gas lease is a practical certainty, not just a lofty goal.
Even then, if the debtor proves to the bankruptcy court that rejection is in the best interest of the estate, Section 365(h)(1)(A)(ii) may prevent the debtor from repossessing the property from the lessee gas company. If the debtor rejects a lease under Section 365, the leasehold interest remains intact and the lease remains operative between the parties. Section 365(h)(1)(A)(ii) will almost inevitably create an issue that the bankruptcy courts have yet to decide. If the bankruptcy court grants rejection of an oil and gas lease prior to production of oil and gas in paying quantities, but Section 365(h)(1)(A)(ii) allows the lessee to remain in possession of the property until expiration of the lease term, what happens if the lessee produces oil and gas in paying quantities after rejection but prior to the expiration of the lease term? Under Pennsylvania Law, the lessee has a strong argument that his interest in the oil and gas lease is now a vested as a fee simple determinable. And, provided that the lessee continues producing oil and gas in paying quantities and complies with the terms of the lease, rejection may have no affect on the lessee’s ability to remain in possession.