TRANSACTIONAL: Financial Restructuring: Oil and gas "leases" and farmout agreements in bankruptcy proceedings

by King & Spalding

Most people think of an oil and gas mineral “lease” as, so named, a lease. However, this common thinking is not necessarily accurate, both with respect to state and federal law and in particular in the bankruptcy courts in the United States. In categorizing the ownership rights of a mineral interest grantee at state law (or federal law for federal leases), several important effects in a bankruptcy proceeding are at play, particularly under certain of the recent modifications made to the United States Bankruptcy Code (“Code”) that impose strict time limits on the decision to “assume” or “reject” a lease of real property.

In reality, the law is far from settled as to whether a “lease” of a mineral interest is in fact a lease and/or executory contract for purposes of the Code. While the answer appears reasonably settled in Texas (a mineral interest is typically held to be neither a lease nor executory contract under the Code, but rather a “fee simple determinable” interest), [1] there remains open a meaningful debate with respect to mineral interests in Louisiana. There, most recent bankruptcy case law holds that the conveyance of rights is a conveyance of real property rights, not a lease (but there is a debate over whether those rights involve an “executory contract” under the Code). [2]

Why does this characterization matter? The Code requires that a bankruptcy debtor must decide, within 120 days after filing a bankruptcy petition, whether to assume or reject a lease or executory contract on “nonresidential real
property.”[3] This time limit may be extended, without the lessor’s consent, up to a total of 210 days from the bankruptcy filing, by order of the bankruptcy court. [4] However, should the debtor fail to take action prior to the expiration of the 120-day period, or fail to assume a lease within either the 120 period, or if extended, the 210-day period, the lease may be terminated as to the bankruptcy debtor. [5] Thus, a lessor will either have his lease assumed, and all obligations brought current (as provided by bankruptcy law requiring a cure of defaults upon “assuming” a contract), or the lease will essentially be terminated and the lessor will be free to release the mineral interest rights to another party. [6] However, if the mineral “lease” is determined to be a real or personal property right, and not a “lease” or executory contract, the limitations imposed by the Code will not apply and a “lessor” cannot demand cure of all prepetition obligations and a decision on assumption of the “lease.”

The problem in categorizing the rights and obligations inherent in a document entitled “Lease” is a question centered on state-law property rights, and of what interest is being conveyed by virtue of a typical oil and gas “lease.” Different state laws yield different results in the context of applying bankruptcy law. As noted, in Texas such a property interest is labeled a “fee simple determinable” interest, and at least one decision in Louisiana considered the rights conveyed as real property rights, not leasehold or mere contractual rights. This same result has been obtained in at least some decisions applying Oklahoma, Ohio, and Illinois law, but there are also conflicting decisions in those jurisdictions. [7]
In contrast, courts applying Kansas, Wisconsin, and Minnesota law have held that oil and gas leases are executory contracts subject to Section 365. [8]

The outcome is even less clear in states like North Dakota and Pennsylvania that do not have a recent history of hydrocarbon development and the corresponding legal disputes that would provide court decisions. There is some indication that Pennsylvania may treat oil and gas leases as providing a “fee simple determinable” interest, similar to Texas, and that North Dakota may likewise treat oil and gas leases as a conveyance of a real property ownership interest, but a dearth of recent case law leaves substantial uncertainty. [9]

This issue is also not well settled with respect to Outer Continental Shelf (OCS) leases. The typical federal lease merely provides rights to extract minerals, and expressly states that no ownership rights in a mineral interest are being conveyed. Thus, the government will typically argue that the lease is a “lease” for purposes of the Code, and that all applicable bankruptcy limitations (as discussed above) apply. The United States has, at a minimum, a good textual argument based on the terms and conditions of the typical lease document granting such rights.

The Code also has special provisions, in Code Section 541(b)(4), that protect parties that receive a conveyance by way of a farmout or production payment. The Code recognizes that these transfers are a transfer of a property interest, and will not include such rights as the property of a debtor who conveyed such interests originally. The Code limits the ability of a debtor to exercise turnover powers inherent in the Code, as well as limiting claims that the property is being held, effectively, for the benefit of the debtor.

As oil and gas development continues to progress in states without a recent history of hydrocarbon production, courts will be confronted with whether they will follow approaches like Texas and Louisiana in interpreting their respective mineral, contract, and property laws.
[1] See In re River Prod. Co. v. Webb (In re Topco, Inc.), 894 F.2d 727, 739 n.17 (5th Cir. 1990); see also Terry Oilfield Supply Co., v. Am. Sec. Bank, N.A., 195 B.R. 66, 70 (S.D. Tex. 1996) (“A mineral lease is a determinable fee. It is not a lease or other form of executory contract that a debtor may accept or reject.”).
[2] Compare In re WRT Energy Corp., 202 B.R. 579, 583-84 (W.D. La. 1996) (holding that a mineral lease in Louisiana is not an executory contract) with Texaco, Inc. v. La. Land & Exploration Co., 136 B.R. 658, 668 (M.D. La. 1992) (holding that a mineral lease in Louisiana is an executory contract).
[3] 11 U.S.C. § 365(d)(4).
[4] Id. § 365(d)(4)(B).
[5] Id. § 365(d)(4).
[6] Id. § 365(b)(1) (requiring a debtor to cure defaults or provide adequate assurance of cure as a condition to assuming an executory contract or unexpired lease).
[7] See, e.g., In re Frederick Petrol. Corp., 98 B.R. 762, 767 (S.D. Ohio 1989) (holding that Section 365 did not apply); see also In re Hanson Oil Co., 97 B.R. 468, 470 (Bankr. S.D. Ill. 1989) (same); In re Heston Oil Co., 69 B.R. 34, 36 (N.D. Okla. 1986) (same). But see In re Gasoil, Inc., 59 B.R. 804, 808-809 (Bankr. N.D. Ohio 1986) (holding that Section 365 did apply).
[8] In re J.H. Land & Cattle Co. Inc., 8 B.R. 237 (Bankr. W.D. Okla 1981) (applying Kansas law); In re Myklebust, 26 B.R. 582 (Bankr. W.D. Wis. 1983); In re Huff, 81 B.R. 531 (Bankr. D. Minn. 1988).
[9] See Marshall v. Forest Oil Co., 47 A. 927 (Penn. 1901); Nantt v. Puckett Energy Co., 382 N.W. 2d 655 (N.D. 1986) (“Oil and gas leases are interests in real property in North Dakota” that are subject to the rule against perpetuities).

 Mark W. Wege
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 Eric M. English
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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