Restructuring

Co-Authored by Jessica Schauwecker, Summer Associate at Weil Gotshal & Manges, LLP in Dallas.
Restructuring professionals and distressed debt traders that are new to the oil and gas industry have not had only to deal with the reality of oil price fluctuations, but they have also had to learn an entirely different deal vocabulary.  Leases that are not really leases, farmout agreements that have nothing to do with farming, royalties that are actually ownership interests in the production, rather than a mere contractual obligation to pay, and working interests that are also ownership interests in production, but which require actual work and the payment of costs to maintain.  Moreover, rights and property interests may be different – both inside and outside of bankruptcy –depending on which state law applies.   The Oklahoma Supreme Court recently issued an opinion of interest to those who practice and invest in this industry, as it could substantially affect the value of certain bargained for rights (although any temptation to ascribe the holding to the peculiarities of the law applicable to oil and gas should be resisted).

In American Natural Resources, LLC v. Eagle Rock Energy Partners, L.P., the Oklahoma Supreme Court declared void a party’s contractual option to participate in the future drilling of wells in an “area of mutual interest” agreement, based upon an obscure, antediluvian rule of the common law, which dates back to seventeenth-century England (well before the discovery of oil and gas as a commodity).  And what was this ancient rule that deprived this party of its bargained-for option to participate in the future drilling of wells in the specified “area of mutual interest?” It was the rule “long cherished by law professors and dreaded by most law students: the infamous rule against perpetuities.”
For most lawyers trained in the common law system, it is impossible to forget that cruel right-of-passage in law school:  the process of learning the rule against perpetuities.  But when struggling to grasp the rule’s ancient jargon and sometimes bizarre applications, law students bear in mind one saving consolation: surely the first year property exam is the last time any lawyer will ever encounter the rule against perpetuities. Surely the rule will never apply to any real life, modern-era scenario. Indeed, many law professors state as much in their classrooms; the rule against perpetuities is a dying breed, soon to be extinct. At least eighteen states have already abolished the rule, and many others have extended the vesting period or significantly curtailed the rule’s application. The rule against perpetuities is hardly relevant today, right?
Well, it turns out the rule against perpetuities remains not only relevant, but potentially lethal to the grant of certain future interests in property, at least in some U.S. jurisdictions.  While most lawyers can probably still recite the rule from memory, as a reminder, the basic rule against perpetuities can be simply stated as follows:

No interest is good unless it must vest, if at all, not later than twenty-one years after some life in being at the creation of the interest.

So how did the application of this rule cause a party to an “area of mutual interest agreement” to lose the benefit of its bargained-for option to participate in the future drilling of wells?  The explanation requires a description of the facts involved in American Natural Resources.
American Natural Resources (ANR) entered into an “area of mutual interest” (AMI) development agreement with Encore Operating (Encore), which provided, among other things, that ANR would have the right to participate in all future wells drilled in the AMI at any time, regardless of whether or not the parties held a current lease as of the date of signing. Subsequently, when Eagle Rock Energy Partners (Eagle Rock) acquired Encore’s interest in the AMI and completed seventeen wells without permitting ANR to participate, ANR sued Eagle Rock for breach of contract.  Eagle Rock, however, argued that there could be no breach of contract when the future participation provision was void because it violated the rule against perpetuities.
Oklahoma still adheres to the common law rule against perpetuities, at least with respect to the granting of future interests in real property.   Under the common law rule, a future interest must be certain either to vest or fail within twenty-one years after some life in being at the time of creation of the future interest. ANR argued that, for purposes of the rule, a business entity, such as an LLC, could serve as the required life in being, so that the future participation provision in the AMI development agreement would be valid so long as the right to participate was guaranteed to vest or fail within twenty-one years of the death, or dissolution, of the ANR LLC entity. The Supreme Court of Oklahoma disagreed. The court held that, while a business entity such as an LLC or corporation may be considered a “person” under certain areas of law, an entity cannot serve as a “life in being,” regardless of whether the entity is to exist for a specific or perpetual duration or whether it is comprised of one or multiple members or owners. Only the lives of human beings may be used in measuring the permissible period of vesting. Consequently, in the case of a future interest pertaining to a business entity, there can be no life in being, and so such interest must vest or fail within twenty-one years of creation in order to satisfy the rule against perpetuities.
Oklahoma law does grant a limited exception to strict application of the rule against perpetuities in the context of future mineral interests. Because mineral leases and joint operator agreements have a built in duration based on cessation of production or some other determinable event, option provisions contained therein pose no risk of continuing indefinitely, and so are held to comply with the rule against perpetuities. The AMI agreement at issue in American Natural Resources, however, was a standalone contract, and the future participation provision applied to wells drilled on both existing and future leases. Effectively, the court reasoned, such provision would have enabled ANR to participate in future wells ad infinitum. Thus the AMI agreement did not fall within the future mineral interest exception, and the future participation provision was void under the rule against perpetuities.
In Oklahoma, as in many states that still cling to the common law rule against perpetuities, future interests that violate the rule may be reformed and validated by means of the cy pres doctrine. Cy pres allows an instrument to be effectuated as closely to its literal intent as possible, while reforming the instrument only enough so as to satisfy the rule against perpetuities. ANR argued that, if the future participation provision in the AMI agreement did, in fact, violate the rule against perpetuities, it should have been reformed under cy pres rather than voided and struck from the contract. However, because ANR had failed to assert cy pres in the district court proceedings, the Supreme Court of Oklahoma held that the company could not raise the issue as error upon appeal. Thus the court did not address the merits of ANR’s argument to reform and save the future participation provision by means of cy pres, and the future participation was completely struck from the contract.
Despite what professors may tell their wide-eyed, aspiring young law students in first year property, the rule against perpetuities remains alive and well not only in Oklahoma, but in many other jurisdictions. Texas has codified the common law rule, with the possibility of reforming infringing future interests under cy pres (Tex. Prop. Code § 112.036). New York, too, adheres to the common law approach by treating as a legal nullity any future interest that runs afoul of the rule against perpetuities, although strict application is waived in certain contexts, such as lease renewal options (N.Y. Est. Pow. & Trust § 9-1.1; see, e.g., Bleeker St. Tenants Corp. v. Bleeker Jones LLC, 945 N.E.2d 484 (N.Y. 2011)). In most jurisdictions that utilize the common law “life in being” to measure the permitted vesting period, the measurement life is limited to the life of a human being, regardless of whether or not business entities are considered “persons” for other legal purposes (see, e.g., Metro. Transp. Auth. V. Bruken Realty Corp., 492 N.E.2d 379 (N.Y. 1986)).
California is one of thirty states that have adopted the Uniform Statutory Rule Against Perpetuities (Cal. Prob. Code, § 21200). Whereas the common law rule voids any future interest that might vest or fail outside the permitted vesting period, the Uniform Rule employs a “wait and see” approach under which future interests violate the rule only if they do in fact vest or fail outside the allotted period. Additionally, the Uniform Rule permits future interests that vest or fail within ninety years of creation, as well as interests that comply with the traditional twenty-one years after a life in being vesting period. The United Kingdom, too, has adopted a “wait and see” approach under the Accumulations and Perpetuities Act of 2009. The Act also extends the vesting period to a flat 125 years after creation and prohibits application of the rule against perpetuities in pension plans and certain commercial contracts.
While most lawyers may have suppressed their traumatic recollections of the rule against perpetuities, it is important to remember that the rule lives on in many jurisdictions, and that it just might be the demise of unsuspecting future interests or options that disregard its parameters. And so drafters beware: if your latest future option provision is not guaranteed to vest or fail within twenty-one years of the death of some actual, living, human being, the unforgiving wrath of the rule against perpetuities may very well strike it down.