Chapter 9 Oh Dear! What Can the Matter Be? What Will Become of My Oil and Gas Lease in Bankruptcy?

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1 Chapter 9 Oh Dear! What Can the Matter Be? What Will Become of My Oil and Gas Lease in Bankruptcy? Judith K. Fitzgerald James W. Kane Tucker Arensberg, P.C. Pittsburgh, Pennsylvania CITE AS 37 Energy & Min. L. Inst. 9 (2017) Synopsis Introduction Oil and Gas Agreements and Interests [1] Mineral Ownership Interest [2] Working Interest [3] Royalty Interests Conclusion Introduction. Bankruptcy may not be the dirty word that it was prior to the implementation of what is commonly referred to as the Bankruptcy Code, the term used to distinguish the 1978 enactment (as amended) from prior iterations of bankruptcy law. 1 The Bankruptcy Code was codified on November 6, 1978 in the Bankruptcy Reform Act 2 and, with numerous amendments, has been in effect as the governing law since it took effect on October 1, Despite its nearly four-decade history, the bankruptcy process is dynamic and many issues remain unresolved. One of those issues is the impact of state law on the determination of what constitutes an interest in property and how that determination will play out in the bankruptcy courts. This chapter will address how oil and gas interests are treated in bankruptcy, discuss the impact of state law in the determination of whether the lease is a true lease or a property interest, and point to cases that arrive at different conclusions based on the underlying state law: 1 11 U.S.C. 101, et seq. 2 Pub. L. No , 92 Stat (November 6, 1978).

2 9.01 ENERGY & MINERAL LAW INSTITUTE Federal bankruptcy law is aimed at providing fair and orderly relief for the honest but unfortunate debtor, who can obtain a fresh start by distributing available assets to creditors and discharging debts left unpaid. 3 It should be noted that a debtor seeking a remedy for all his financial woes through bankruptcy is not guaranteed a solution. A debtor can have his or her case dismissed for acting in bad faith prior to or during the bankruptcy proceeding. Additionally, not all types of debts are subject to discharge. Types of claims that are nondischargeable include claims for child support, alimony, and funds obtained by fraud. While state law determines the validity of a creditor s claim, nondischargeability is governed by federal law in the Bankruptcy Code. In contrast to the commonly known Chapter 7 liquidation and Chapter 13 reorganization processes often utilized by individuals, Chapter 11 bankruptcies are primarily selected by large businesses seeking to reorganize debts and continue operating but can also be a remedy for individuals with large debts. Where the analysis of an individual s estate may often be clear for the vast majority of no-asset Chapter 7s, and the processes in place in various courts well-defined for Chapter 13s, simplicity is not the general rule in Chapter 11 cases. This chapter, which addresses oil and gas leases and their treatment in Chapter 11, will highlight that the myriad issues are anything but clear. Chapter 11 of the Bankruptcy Code is commonly used by large companies in their quest to remain in possession of assets and continue to operate while reorganizing their financial affairs. The Bankruptcy Code provides the debtor with some measure of flexibility in reorganizing its financial affairs. The fundamental purpose of reorganization is to prevent a debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources. 4 The heart of this provision is to enable the parties to negotiate and reach a settlement that will avoid greater losses and, through the reorganization, minimize the adverse consequences that financial failure causes to many people. 3 See In re Jahrling, 816 F.3d 921, 924 (7th Cir. 2016) quoting Grogan v. Garner, 498 U.S. 279, , 111 S. Ct. 654, 112 L. Ed. 2d 755 (1991). 4 See H.R. Rep. No , p. 220 (1977). 238

3 oil and gas interests in bankruptcy 9.01 When a bankruptcy is filed, an estate is created that consists of all property and property interests of the debtor, with limited exceptions. 5 This principle is axiomatic, but here is a case decided not long after the Bankruptcy Code took effect that sets out the general rule: The defendant s contention that a distinction exists between the property of the debtor and the estate of the debtor is without merit. There can be no estate prior to the filing of a petition in bankruptcy. The commencement of such a case creates an estate which is made up of all legal or equitable interests of the debtor in property. 11 U.S.C. s 541(a)(1). Thus, when one enters bankruptcy, the property of the debtor is the property of the estate. 6 An individual debtor has choices when seeking bankruptcy as a solution to his financial woes. Under Chapter 13, an individual develops a plan to repay all or almost all of his debts under a payment plan. This payment plan allows the debtor to remain in possession of all or almost all of his assets and stops any existing foreclosure actions. A debtor seeking a solution under Chapter 7 will keep all of his exempt assets but will have his nonexempt assets liquidated to pay creditors. Chapter 7 is open to individuals and companies as long as certain other requirements are met. Prior to undertaking a deeper analysis of treatment of oil and gas interests, it is important to distinguish between the varying types of oil and gas interests which may come before our bankruptcy courts. Oil and gas interests that may be analyzed, and to differing results, are often considered in three general categories: (1) mineral ownership interests; (2) working interests in a lease; and (3) royalty interests. Understanding the differences in these interests is important to bankruptcy law because what constitutes property of the estate is governed by federal law, but what constitutes an interest in property is governed by applicable non-bankruptcy law. So whether an interest under a lease becomes property of the estate is of the utmost importance to a determination of what disposition may be made of that interest U.S.C In re A. J. Nichols, Ltd., 21 B.R. 612, 614 (Bankr. N.D. Ga. 1982). 239

4 9.02 ENERGY & MINERAL LAW INSTITUTE Property interests are created and defined by applicable non-bankruptcy (that is, generally, state) law. Unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding. Uniform treatment of property interests by both state and federal courts within a state serves to reduce uncertainty, to discourage forum shopping, and to prevent a party from receiving a windfall merely by reason of the happenstance of bankruptcy. 7 The justifications for application of state law are not limited to ownership interests; they apply with equal force to security interests, including the interest of a mortgagee in rents earned by mortgaged property Oil and Gas Agreements and Interests. One of the most important, yet most difficult, question regarding a Chapter 11 bankruptcy as it relates to oil and gas leases is the application (or non-application) of Section 365 of the Bankruptcy Code. Section 365 is titled Executory Contracts and Unexpired Leases. On its face, from the title alone, one may be led to believe that the underlying provisions of this section would contain all the answers necessary for the application of bankruptcy to oil and gas leases that are still in effect. They are, after all, unexpired leases. And the very first provision of the section gives a clear and distinct ability to the trustee in bankruptcy, subject to the court s approval, to either assume or reject any executory contract or unexpired lease of the debtor. It is no surprise that the interpretation and application of section 365 has become a topic of concern. The oil and gas leases of an exploration and production company (E&P Company) are the underlying assets through which everything else functions. Without valid leases, there are no rights to operate producing wells, and no established leasehold by which to pursue more exploration for future producing wells. In short, there is no way to produce revenue. The leases are the base assets by which E&P Companies 7 Lewis v. Mfgrs. Nat l Bank, 364 U.S. 603, 609 (1961), 81 S. Ct. 347, 350, 5 L. Ed. 2d Butner v. United States, 440 U.S. 48, 54-55, 99 S. Ct. 914, (U.S. 1979) (footnotes omitted)(superseded in part on other grounds by Pub. L ). 240

5 oil and gas interests in bankruptcy 9.02 generate revenue not only for themselves, but for the landowners and any other parties with financial interests tied to the leases and/or wells. On the flip side, if the bankruptcy is used as a means of restructuring, there could be scenarios in which a company would be seeking to reject leases as a means of dropping existing financial burdens if the company s owners believe that the leases can be renegotiated at lower royalty rates. The oil and gas lease suffers simply because its name includes the word lease. While, as stated above, section 365 controls unexpired leases, a court must not accept this application only on the basis of the title of the document, but, rather, based on a determination of the actual interest that the lease conveys. To perform a proper analysis of the interest conveyed, examination of state law and how it treats the lease must be undertaken. In most instances, the law of the state where the oil and gas is located is applied. The fact that different state laws are used in various courts, and the courts may not sit in the state whose law governs, has resulted in varying precedents across the country. At its core, the question is whether these interests are real property interests or personal property rights. The choice will determine whether an oil and gas lease is, as it says, a leasehold conveyance, or whether its actual function is a conveyance of property with a reversionary interest. In turn, the result of this analysis will establish whether section 365 can be applied to an oil and gas lease in bankruptcy. A leasehold is subject to section 365 and its provisions governing the right to assume or reject unexpired leases, whereas the conveyance of property is not subject to the same rules. [1] Mineral Ownership Interest. The mineral ownership interest is in many ways the most simple. In general, it can be described as a fee simple ownership of the oil and gas rights underlying a property together with the right to explore and produce products from the oil and gas. Usually, exploration and production rights derive from a complete purchase of property in fee simple but could also be accomplished through a severance of the oil and gas estate by a mineral deed. In the view of a bankruptcy court, a mineral ownership interest is governed by section 541 of the Bankruptcy Code as constituting property of the estate. A mineral ownership interest is not subject to treatment under section 365 and is not capable of being rejected in a bankruptcy proceeding. 241

6 9.02 ENERGY & MINERAL LAW INSTITUTE [2] Working Interest. Consideration of working interests in a lease is an area where application of state law tends to become more difficult in bankruptcy. When a mineral ownership interest owner enters into an oil and gas lease on his or her property, he creates a working interest owner who has the right (for a defined term) to explore and produce the oil and gas owned by the mineral ownership interest owner. The defined term of the lease is often phrased as a term of years and for as long as production on the land continues in paying quantities. In the context of a bankruptcy, this term is important not so much related to the number of years left or the fact that a lease in production can extend for an unidentified period of time, but because there is a definite ending. After the primary term of the lease, the secondary term of production will last only as long as production can continue. Stated another way, inasmuch as oil and gas are non-renewable resources, they will absolutely be depleted, and therefore, there will come a time where production must cease. The end of production may be even earlier than total depletion as producers will certainly cease operations when the quantity of production is insufficient to pay what is required to satisfy the terms of the lease. As such, working interests will revert back to the mineral ownership interest owner upon the expiration of the lease. A conveyance of the property is treated as a fee simple determinable interest in many jurisdictions, including Texas. 9 This is an important distinction from other jurisdictions because the working interest owner has its own legal interest in the land, albeit subject to the reversionary interest. However, it is not a leasehold interest and is therefore not subject to section 365. Other states, such as Michigan, have followed the opposite analysis, and construe oil and gas leases as giving the right to use the property, but not to create a separate estate. The United States Bankruptcy Court for the Western District of Michigan specifically noted its awareness that this is a significant difference from the law of Texas and several other oil and gas states. 10 The United States Bankruptcy Court for the Middle District of Pennsylvania takes a somewhat different approach and looks to the facts of 9 See In re Topco, 894 F.2d 727 (5th Cir. 1990). 10 Frontier Energy, LLC v. Aurora Energy, Ltd. (In re Aurora Oil & Gas Corp.), 439 B.R. 674, 680 (Bankr. W.D. Mich. 2010) (denying reconsideration). 242

7 oil and gas interests in bankruptcy 9.02 operations in determining the type of estate created by the conveyance. The decision in In re Powell, concluded that under Pennsylvania law, pursuant to the decision in T. W. Phillips v. Jedlicka, 11 prior to the actual production of oil and gas, no freehold estate has vested. 12 The Jedlicka Court described the situation as such: 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. Calhoon, 201 Pa. at 101, 50 A. at 968; Jacobs, 332 F. Supp. 2d at A fee simple determinable is an estate in fee that automatically reverts to the grantor upon the occurrence of a specific event. Brown, 435 Pa. at 18, 255 A.2d at 511. The interest held by the grantor after such a conveyance is termed a possibility of reverter. Higbee Corp. v. Kennedy, 286 Pa. Super. 101, 428 A.2d 592, 595 (1981). Such a fee is a fee simple, because it may last forever in the grantee and his heirs and assigns, the duration depending upon the concurrence of collateral circumstances which qualify and debase the purity of the grant. Id. at 595 n. 4 (quoting Slegel v. Lauer, 148 Pa. 236, 241, 23 A. 996, 997 (1892)). 13 As is clear in looking at these few cases, a working interest may be subject to rejection in bankruptcy in some states and not in others. To further complicate the matter, the type of ownership interest and ability to reject may be a wholly factual analysis of whether or not the lease has been in operation for the production of oil and gas. To understand the applicability of section 365 to a working interest, a bankruptcy practitioner must evaluate the facts of each case and assess how the laws of the applicable state will affect the ultimate conclusion of the nature of the working interest. 11 T. W. Phillips v. Jedlicka, 615 Pa. 199 (Pa. S. Ct. 2012), 12 In re Powell, 482 B. R. 873, 878 (Bankr. M.D. Pa. 2012), order vacated in part, No. 3:13-CV-00035, 2015 WL (M.D. Pa. Nov. 10, 2015) ( if, at the time bankruptcy was filed and there was no oil or gas produced as is true in this case then contract principles would apply including an interpretation of whether this was an executory contract or lease. ). 13 Jedlicka, supra, 615 Pa. at

8 9.02 ENERGY & MINERAL LAW INSTITUTE [3] Royalty Interests. The third type of interests, which have their own subsets, are royalty interests. Within the category of royalties, the courts have identified four groups: the lease royalty owner, the overriding royalty interest, the net profits interest, and production payments. The lease royalty owner is, as the name suggests, the owner of the royalty interest under the lease itself. This person will earn a pre-determined percentage of the production from the oil and gas, but has no right to attempt to produce the oil and gas. Typically, this interest is owned by the landowner, who has signed an agreement with an E&P Company to enter the land and produce the oil and gas in exchange for an upfront payment and a future royalty. As this is generally a purely beneficial interest owned by the landowner, the question is less can it be rejected and more could it be lost if a working interest owner in the lease rejects a lease in bankruptcy. The second grouping is the overriding royalty interest. An overriding royalty interest is often used as a form of payment between companies. Often reserved in a sale of leases or granted to secure financing, the overriding royalty payment is a commonly used method of sharing a non-working interest in a leasehold. The third type of royalty interest is the net profits interest. The net profits interest is very similar to the overriding royalty interest. It is a nonoperating share of the profits that is separated out of the working interest. The net profits interest is distinguished from the overriding royalty because it is not a fractional share of production free from costs of development like the overriding royalty interest, but is a percentage only of the net profits from the total operation. The final royalty interest is the production payment. A production payment is another interest that does not include any right for the owner to participate in the actual operations of the working interest owner, similar to the overriding royalty interest and the net profits interest. The production payment, however, will generally terminate upon the production of a specified volume of product or upon the payment of a pre-determined amount of money. The Bankruptcy Code defines production payment as a term overriding royalty that can be satisfied in cash or in kind, contingent on the production of a liquid or gaseous hydrocarbon from particular real property, and from a specified volume, or a specified value, from the liquid or gaseous hydrocarbon produced from such property, and determined without 244

9 oil and gas interests in bankruptcy 9.03 regard to production costs. 14 This definition fits with the general practice of viewing production payments essentially as term overriding royalty interests. Section 541 (b)(4)(b) specifically addresses production payments by making them an exclusion to property of the estate. There is, however, an exception to the exclusion which references sections 365 and 542. Those sections provide the possibility for production payments to be brought back into property of the estate. So despite clear language that excludes production payments from property of the estate, further analysis must be done as the statutory language of the Bankruptcy Code enables arguments on both sides. Here, then, is another situation where it is unclear how each court will rule each time. The overriding royalty interests, net profit interests, and production payments are carved out of, and subject to, the will of the of the working interests. Like the landowner holding the royalty interest, they are more likely to support assumption of the lease and oppose its rejection because of the potential future earnings. How the bankruptcy court treats each interest involves a factual analysis that can differ district by district as the courts apply state law. The result of that analysis is what determines the rights each interest holder owns Conclusion. State law clearly has a large impact on the determination of how each oil and gas interest is treated and how that determination will play out in the bankruptcy courts. Questions such as whether an interest will be considered to be property of the estate and whether leases and interests can be rejected pursuant to section 365 must be at the forefront of any practitioner s mind before appearing in bankruptcy court. The facts surrounding each interest must be reviewed and the applicable state law must be applied. This state law by state law focus can result in many different strategies and outcomes for many E&P Companies, as their interests are spread across multiple states. Despite all the possible, varied results, one important tip for the practitioner is to take the steps necessary to identify each interest, research each applicable state law, and then look to the Bankruptcy Code sections to best advise the client of the applicable analysis and likely outcome of rulings from the court. 14 See 101(42A). 245

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