Variations in How States Treat Oil & Gas Leases Make Dispositions Complicated

Ability of a debtor to assume, assign, or reject oil and gas “leases” under section 365 of the Bankruptcy Code

Section 365(a) of the Bankruptcy Code (11 U.S.C. § 365) provides that “the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor.” On the face of the statute, it would appear an oil and gas lease may be rejected in bankruptcy as an “unexpired lease.” However, as one court has held, “[t]he term ‘oil and gas lease’ is a misnomer because the interest created by an oil and gas lease is not the same as an interest created by a lease governed by landlord and tenant law.” In re Topco, Inc., 894 F.2d 727, 740, n.17 (5th Cir. 1990).¹ This “misnomer” used by the industry for oil and gas leases, along with inconsistent interpretation by the various states, has created issues regarding whether section 365 is applicable. And, even if the oil and gas lease is not considered a “lease” for purposes of section 365, it might in the alternative be considered an executory contract, and still subject to section 365. As discussed below, these questions are usually decided based on the property laws of the relevant state, with the answer oftentimes hinging on whether oil and gas leasehold interests are considered a vested fee interest in real property. If state law treats oil and gas leases as conveying a vested fee interest (also referred to as a “freehold interest”), it is unlikely they will be deemed an “executory contract or unexpired lease” subject to section 365. See Topco, Inc., 894 F.2d at 740.

Whether an agreement is an “executory contract” is a question of federal law. (see Cameron v. Pfaff Plumbing and Heating, Inc., 966 F.2d 414 (8th Cir.1992)), but is informed to a considerable extent by state law principles the bankruptcy court is bound to respect. In re Aurora Oil & Gas Corp., 439 B.R. 674 (Bankr. W.D. Mich. 2010). Specifically, state law governs the extent of a debtor’s interest in property. See Butner v. U.S., 440 U.S. 48 (1979). This includes the classification of oil and gas leases as freehold or leasehold, which is important in determining whether it may be set aside as an unexpired lease under section 365. See In re Topco, Inc., 894 F.2d at n.17 (stating that, in Texas, oil and gas leases do not constitute unexpired leases subject to section 365).

Are Oil and Gas Leases Unexpired Lease?

Oil and gas leases are usually entitled “Oil and Gas Lease” and the parties are referred to as “lessor” and “lessee,” with a reversionary interest in favor of the grantor. These factors support an argument that section 365 allows rejection of the “lease.” Nevertheless, the majority of state? courts that have addressed whether oil and gas leases are unexpired leases subject to section 365 have determined that they are not. For example, a bankruptcy court indicated that, with respect to oil and gas leases in Texas, they do not constitute unexpired leases subject to section 365 because they convey interests in real property. Matter of Topco, Inc., 894 F.2d 727, n.17 (5th Cir. 1990). An Illinois bankruptcy court likewise concluded the oil and gas lease in question did not constitute an “unexpired lease” within the meaning of section 365(d)(4), where an oil and gas lease grants a freehold estate under Illinois law, rather than leasehold. In re Hanson Oil Co., Inc., 97 B.R. 468, 472 (Bankr. S.D. Ill. 1989).

Interestingly, an Oklahoma bankruptcy court held that oil and gas leases are not unexpired leases subject to section 365 under the real property laws of Oklahoma, although based on slightly different reasoning. See In re Clark Res., Inc., 68 B.R. 358, 359 (Bankr. N.D. Okla. 1986). The court reasoned that an Oklahoma oil and gas agreement grants a profit à ‘prendre rather than a leasehold estate, and thus the unexpired lease portion of 11 U.S.C. section 365, does not apply to the Oklahoma oil and gas lease. “The interest created by an oil and gas lease in Oklahoma is not ‘real estate’ and conveys no interest in land itself, it is a chattel real, an incorporeal hereditament and a profit à ‘prendre which is in the nature of a license to explore by drilling and permits the lessee to capture oil and gas which is then treated as personalty.” Id.

A federal district court in Ohio also found the oil and gas leases in that case were not leases of nonresidential real property within the meaning of sections 365(d)(4) and 365(m), but nevertheless concluded that the bankruptcy court's holding that the leases were forfeited under section 365(d)(4) was erroneous. In re Frederick Petroleum Corp., 98 B.R. 762, 767 (S.D. Ohio 1989). The court believed that “the Ohio courts, if given the opportunity to do so, would characterize the property interest involved as being like or similar to the interest recognized under Oklahoma law.” Id. at 766.

Conversely, the court in Aurora Oil & Gas Corp. considered oil and gas leases rental agreements to use real property and therefore “leases” within the meaning of section 365. The court emphasized the differences, citing state law:

Michigan treats a lessee’s interest as a leasehold or profit á prendre, but not a freehold estate. In this significant respect, Michigan departs from the law of Texas and several other oil and gas states that apparently regard a lessee’s interest under an oil and gas lease as a freehold or fee.

In re Aurora Oil & Gas Corp., 439 B.R. at 678.

Are Oil and Gas Leases Real Property Interests?

State laws characterizing the nature of oil and gas leases can be analyzed to speculate whether a lease in any given state might be rejected in bankruptcy, but the answer is not clear in most instances. Many courts have addressed whether oil and gas leases are “real property” interests,² and the Fifth Circuit in Matter of Topco, Inc., 894 F.2d 727, n.17 (5th Cir. 1990), indicated this classification would be determinative of whether the lease can be rejected in bankruptcy; however, the other bankruptcy courts cited above analyzed whether oil and gas leases are freehold real property interests (as opposed to leasehold interests which may also be considered a type of real property) – not simply whether or not an oil and gas lease is real property. While potentially helpful in guessing what a court might hold, we do not think classification as “real property” is necessarily determinative of whether a lease will be rejected under section 365; and, unfortunately, there is not a lot of caselaw addressing the freehold – leasehold dichotomy in the context of oil and gas leases.³ We note that in those states that have determined oil and gas leases are personal property, we believe there is an increased likelihood such leases would be rejected in bankruptcy under section 365.

Are Oil and Gas Leases Executory Contracts?

Those seeking to apply section 365 to an oil and gas leasehold interest may alternatively argue that the documents underlying the interest are executory contracts.⁴ “Though neither the Bankruptcy Code nor the predecessor Bankruptcy Act defines the term ‘executory contract,’ many courts have adopted the Countryman definition [being that an executory contract is one under which the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete perform would constitute a material breach excusing the performance of the other],⁵ or some variation of it.”⁶ Id. “However, because [the oil and gas lessor] often has nothing more to do than ‘sit back and collect royalty payments’ or wait for the reversion to occur by operation of law, the Countryman definition typically prevents finding conveying documents to be executory contracts.” See id. (citations omitted).

Courts in some jurisdictions have concluded that oil and gas leases are executory contracts,⁷ while other courts have determined they are not.⁸ Interestingly, in interpreting Louisiana law which classifies an oil and gas lease as real property, the bankruptcy court in Texaco Inc. v. Louisiana Land and Exploration Co., 136 B.R. 658, 668 (M.D. La. 1992), states that while a mineral lease constitutes “real rights,” this court concludes that the Louisiana mineral lease is an “executory contract” within the meaning of section 365(a). Other courts have been critical of this decision. For example, another Louisiana bankruptcy court declined to follow Judge Parker's interpretation of executory contracts in Texaco, holding that “the mineral leases at issue in the present case do not constitute ‘executory contracts’ within the Countryman definition as adopted by the 5th Circuit.” In re WRT Energy Corp., 202 B.R. 579, 584 (Bankr. W.D. La. 1996). The court in WRT Energy also concluded that oil, gas, and mineral leases vest the lessee with real rights, which “clearly supports a finding that the [oil, gas, and mineral lease] is not an unexpired lease within the meaning of section 365 of the Bankruptcy Code. Id.

Does Classification of an Oil and Gas Lease Hinge on Production?

A Pennsylvania bankruptcy court has concluded oil and gas leases are initially an executory contract, but that the classification changes once production is obtained. In re Powell, 482 B.R. 873 (Bankr. M.D. Pa. 2012), order vacated on other grounds in part, 2015 WL 6964549 (M.D. Pa. 2015).⁹ The court reasoned that if gas had been produced prior to the bankruptcy filing, then section 365 would not apply because at that point, the gas company would have been vested with a fee simple determinable interest (apparently, akin to a vested fee or freehold interest) in the oil and gas – so effectively the gas company would have been producing its own gas. Id. ¹⁰ Under this reasoning, the interest is characterized as a lease or an executory contract under section 365 is moot. Id. ¹¹

The question about whether oil and gas leases are “executory contracts” has been decided, at least by one court, based on the moment in which the oil and gas lessee’s freehold estate vested, which is not necessarily the moment the lease is executed. This rationale presents a risk that courts may initially consider an oil and gas lease to be an executory contract. The Pennsylvania bankruptcy court’s decision is based on the characterization of oil and gas leases under Pennsylvania law. In this respect, the law in most states and cases we have reviewed do not indicate that vesting of oil and gas leasehold rights might be delayed. However, in Pennsylvania and West Virginia, which are the states that appear to have made such a determination, the oil and gas freehold estate vests at the time production begins, or at the time oil and gas is found.¹²

Conclusion

The risk that an oil and gas lease will be rejected in the event of a filing under section 365 of the Bankruptcy Code depends primarily on the relevant state’s property laws, so there is no certainty of outcome.. Debtors or potential purchasers of an oil and gas lease should thoroughly examine the property laws of the governing state and, if available, any relevant bankruptcy court decisions applying those respective state laws in the context of section 365 to properly assess the risk of rejection.

¹But see Texaco Inc. v. Louisiana Land & Expl. Co., 136 B.R. 658, 665 (M.D. La. 1992), stating that the reasoning in Topco was dicta.

²Within the Tenth Circuit, the majority of courts have concluded that oil and gas leases are real property rights. See, e.g., Gaddis v. McDonald, 633 P.2d 1102 (Colo. App. 1981) (overriding royalty interest in respect to oil and gas leases is real property interest); Terry v. Humphreys, 1922-NMSC-013, 27 N.M. 564, 203 P. 539 (an oil and gas lease for a period of five years, or as long thereafter as oil and gas, or either of them, is produced from said land by the lessee, conveys “real property”); Dame v. Mileski, 80 Wyo. 156, 340 P.2d 205 (1959) (overriding royalty interest reserved by assignor of oil and gas lease was real property); Chase v. Morgan, 9 Utah 2d 125, 339 P.2d 1019, 1021 (1959) (oil and gas leases are real estate); c.f. First Nat. Bank v. Dunlap, 1927 OK 67, 122 Okla. 288, 254 P. 729 (interest of lessee under oil and gas lease is not “real estate”); High Plains Oil, Ltd. v. High Plains Drilling Program-1981, Ltd., 263 Kan. 1, 946 P.2d 1382 (1997) (Oil and gas leases are personal property).

Within the Fifth Circuit, courts have generally concluded that oil and gas leases convey real property rights. See, e.g., In re WRT Energy Corp., 202 B.R. 579, 137 O.G.R. 315 (Bankr. W.D. La. 1996) (holding that oil and gas interests in Louisiana grant “real rights,” rather than “personal rights,” thereby preventing their characterization as unexpired leases); Rogers v. Ricane Enterprises, Inc., 772 S.W.2d 76 (Tex. 1989) (an oil and gas lease conveys an interest in real property as does an assignment of all or a portion thereof); Nygaard v. Getty Oil Co., 918 So. 2d 1237, 1241 (Miss. 2005) (indicating that Mississippi would follow Texas law in interpreting the nature of oil and gas leasehold rights).

States within the Eighth Circuit have likewise have generally determined that oil and gas leases are interests in real property. See Coral Prod. Corp. v. Cent. Res., Inc., 273 Neb. 379, 730 N.W.2d 357 (2007) (an interest in an oil and gas lease is an interest in real property to the extent that it grants the lessee the right to remove minerals from the land); ANR W. Coal Dev. Co. v. Basin Elec. Power Co-op., 276 F.3d 957, 965 (8th Cir. 2002) (overriding royalty holders have an interest that is a form of real property under North Dakota law); Greene Cty. v. Smith, 148 Ark. 33, 228 S.W. 738 (1921) (indicating oil and gas leases are real property, which is defined as including not only the land itself but also buildings and all rights and privileges appertaining thereto). We note that we are not aware of any state cases in South Dakota, Iowa, Minnesota, or Missouri that clearly address this question.

³We are aware of the following cases addressing this issue: Cravens v. Hubble, 375 Ill. 51, 52, 30 N.E.2d 622, 623 (1940) (“An oil and gas lease which remains in force as long as oil and gas are produced, involves a freehold”); Alphonzo E. Bell Corp. v. Listle, 74 Cal. App. 2d 638, 646, 169 P.2d 462, 467 (1946) (referring to an oil and gas lease, the court stated “She was thereby immediately vested with a present interest in the land, an estate tantamount to a freehold”); In re Clark Res., Inc., 68 B.R. 358, 359 (Bankr. N.D. Okla. 1986) (Oklahoma oil and gas agreement grants a profit à ‘prendre rather than a leasehold estate); In re Aurora Oil & Gas Corp., 439 B.R. at 678 (Michigan treats a lessee’s interest as a leasehold or profit á prendre). Ralston v. Thacker, 932 S.W.2d 384, 387 (Ky. Ct. App. 1996) (“An oil and gas lease is an interest in real estate generally termed a ‘chattel real’ and is an estate less than freehold or fee-simple interest. “); Pearson v. Black, 120 S.W.2d 1075 (Tex. Civ. App. 1938) (title to all gas, coal and other minerals granted by oil and gas lease constituted a “freehold estate” in lands being a “determinable fee estate”); Somont Oil Co. v. A & G Drilling, Inc., 2002 MT 141, 310 Mont. 221, 49 P.3d 598 (appearing to treat the lessee as acquiring a fee simple determinable estate) (overruled on other grounds). See also infra note 12, indicating oil and gas leases include a freehold estate under Pennsylvania law, but that the vesting of this estate is delayed until production is obtained. However, if oil or gas is produced, a fee simple determinable is created in the lessee. See Sabella v. Appalachian Dev. Corp., 2014 PA Super 237, 103 A.3d 83, 101 (2014).

⁴See Oil and Gas Interests, Commercial Bankruptcy Litigation § 8:45.

⁵See, e.g., In re Kemeta, LLC, 470 B.R. 304 (Bankr. D. Del. 2012); In re Midwest Portland Cement Co., 174 Fed. Appx. 34, 46 Bankr. Ct. Dec. (CRR) 45 (3d Cir. 2006); In re Grand Chevrolet, Inc., 26 F.3d 130 (9th Cir. 1994); In re Sunterra Corp., 361 F.3d 257, 42 Bankr. Ct. Dec. (CRR) 222, 51 Collier Bankr. Cas. 2d (MB) 1276, Bankr. L. Rep. (CCH) P 80068 (4th Cir. 2004); Matter of Chicago, R. I. & P. R. Co., 604 F.2d 1002, 1004, 5 Bankr. Ct. Dec. (CRR) 618, 21 C.B.C. 305, Bankr. L. Rep. (CCH) P 67225 (7th Cir. 1979) (Bankruptcy Act case); Jenson v. Continental Financial Corp., 591 F.2d 477, 481, Bankr. L. Rep. (CCH) P 67051 (8th Cir. 1979) (Bankruptcy Act case). See also, In re Ravenswood Apartments, Ltd., 338 B.R. 307, 46 Bankr. Ct. Dec. (CRR) 16, Bankr. L. Rep. (CCH) P 80455, 2006 FED App. 0002P (B.A.P. 6th Cir. 2006); Dollar Development I, LLC v. Village Green Properties, Ltd., 2006 WL 572709 (W.D. Mich. 2006); In re Helm, 335 B.R. 528, 45 Bankr. Ct. Dec. (CRR) 281, 55 Collier Bankr. Cas. 2d (MB) 817 (Bankr. S.D. N.Y. 2006); In re FV Steel and Wire Co., 331 B.R. 385, 45 Bankr. Ct. Dec. (CRR) 119, 61 Env't. Rep. Cas. (BNA) 1566, 35 Envtl. L. Rep. 20196 (Bankr. E.D. Wis. 2005); In re Nickels Midway Pier, LLC, 332 B.R. 262, 45 Bankr. Ct. Dec. (CRR) 163, 55 Collier Bankr. Cas. 2d (MB) 236 (Bankr. D. N.J. 2005), aff'd in part, rev'd on other grounds in part and remanded, 341 B.R. 486, 46 Bankr. Ct. Dec. (CRR) 126, 55 Collier Bankr. Cas. 2d (MB) 1854 (D.N.J. 2006), order aff'd, 255 Fed. Appx. 633, 49 Bankr. Ct. Dec. (CRR) 35 (3d Cir. 2007).

⁶See Matter of C & S Grain Co., Inc., 47 F.3d 233, 26 Bankr. Ct. Dec. (CRR) 939, Bankr. L. Rep. (CCH) P 76395 (7th Cir. 1995) (“For purposes of the Bankruptcy Code, an executory contract is one in which the obligations of each party remain substantially unperformed.”); In re Mirant Corp., 440 F.3d 238, 46 Bankr. Ct. Dec. (CRR) 13, 55 Collier Bankr. Cas. 2d (MB) 1050, Bankr. L. Rep. (CCH) P 80453 (5th Cir. 2006) (holding that Congress intended the term “executory contract” in the Bankruptcy Code to refer to a contract on which performance remains due to some extent on both sides); Cameron v. Pfaff Plumbing and Heating, Inc., 966 F.2d 414 (8th Cir. 1992) (holding that “performance remains due to some extent,” as a definition of an “executory contract,” is equivalent to the Countryman definition); Turner v. Avery, 947 F.2d 772, 22 Bankr. Ct. Dec. (CRR) 495, Bankr. L. Rep. (CCH) P 74349 (5th Cir. 1991) (holding that an attorney's contingent fee contract is executory if further legal services must be performed by the attorney before the matter may be brought to a conclusion); Gibson v. Resolution Trust Corp., 51 F.3d 1016, 26 U.C.C. Rep. Serv. 2d 547 (11th Cir. 1995) (recognizing that courts have characterized executory contracts as those with “remaining reciprocal obligations”); cf. In re Becknell & Crace Coal Co., Inc., 761 F.2d 319, 322 (6th Cir. 1985) (“[E]xecutory contracts involve obligations which continue into the future…. They include leases, employment contracts and agreements to buy or sell in the future.”) (quoting source omitted); In re General Development Corp., 84 F.3d 1364 (11th Cir. 1996) (approving the use of the “functional approach,” under which “the question of whether a contract is executory is determined by the benefits that assumption or rejection would produce for the estate”).

⁷See Texaco Inc. v. Louisiana Land and Exploration Co., 136 B.R. 658, 668 (M.D. La. 1992).

⁸See Laugharn v. Bank of America Nat. Trust & Savings Ass'n, 88 F.2d 551 (9th Cir.1937).

An Oklahoma bankruptcy court, held that oil and gas leases are not executory contracts subject to section 365, based on Oklahoma property law related to oil and gas leases. See supra In re Clark Resources, Inc., 68 B.R. 358 (Bkrtcy. N.D. Okl. 1986). Where the lessee’s only remaining obligation was payment of money and the lessor’s only remaining obligation is to defend their title and not interfere with lessee’s operations, the court apparently concluded this would not satisfy the Countryman definition pertaining to executory contracts, as neither party is “saddled with complex obligations to perform” and “[b]reach of these duties by the lessor or lessee would not excuse performance by the party not in breach, but would merely abate the obligation of the non-breaching party for as long as the breaching party was in breach.” See id. at 359-360.

⁹The Court apparently rejected the Bankruptcy Court's determination that an oil and gas lease conveys as a matter of law, up until the point of production, an inchoate right that is subject to rejection under section 365– instead, one must look to the terms of the instrument to determine what interest has been conveyed.

¹⁰The court references the Pennsylvania Supreme Court’s decision in T.W. Phillips Gas and Oil Co. v. Jedlicka, 615 Pa. 199, 42 A.3d 261 (2012), which constructed a special interpretation of an oil and gas lease as conveying a title that is inchoate and allowing exploration only until oil or gas is found, regardless of the linguistics used in the lease. “If development during the agreed upon primary term is unsuccessful, no estate vests in the lessee. If, however, oil or gas is produced, a fee simple determinable is created in the lessee, and the lessee's right to extract the oil or gas becomes vested.” Id. at 267.

¹¹But oil and gas had not been produced at the time of the bankruptcy filing. Instead of analyzing whether the oil and gas lease was an executory contract, the In re Powell court concluded that the lease was an "unexpired lease" agreement "to use real property" and was subject to section 365(m) of the Bankruptcy Code. See also In re Tayfur, 505 B.R. 673, 682–83 (Bankr. W.D. Pa.), aff'd, 513 B.R. 282 (W.D. Pa. 2014), aff'd, 599 F. App'x 44 (3d Cir. 2015).

¹²E.g., In re Powell, 482 B.R. 873, 175 O.G.R. 187 (Bankr. M.D. Pa. 2012), order vacated on other grounds in part, 2015 WL 6964549 (M.D. Pa. 2015) (“Until oil or gas is produced, no freehold estate vests in the lessee.”); Hutchinson v. McCue, 101 F.2d 111 (C.C.A. 4th Cir. 1939)(under West Virginia law, lessee under oil and gas lease for fixed term and as long thereafter as oil shall be produced and rentals paid acquires in the first instance a mere license or inchoate right to go on the land and explore for oil and gas, but after oil or gas is found, the lessee acquires a vested interest therein); Headley v. Hoopengarner, 60 W. Va. 626, 55 S.E. 744 (1906) (the lessee has no vested estate therein until it is discovered).