Drilling Down: A Deeper Look into the Distressed Oil & Gas Industry Part 3—The Ability to Assume or Reject Oil and Gas Leases

Contributed by Charles Persons
Today’s blog article, which looks at the ability of a debtor to assume, assign, or reject oil and gas “leases” under section 365 of the Bankruptcy Code, is the third in the Weil Bankruptcy Blog series, “Drilling Down,” where we review issues at the intersection of the oil and gas industry and bankruptcy law. In Part One, we provided an overview of the oil and gas industry and a discussion of some of the unique challenges currently facing this sector. In Part Two, we discussed specific oil and gas property interests and their treatment in bankruptcy. In Part Four, we will dive into how certain financing arrangements specific to the realm of oil and gas may be considered a “disguised financing” vs. a “true sale of interests.” 

Part Three: The Ability to Assume or Reject Oil and Gas “Leases”

“The 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)

The oil and gas world embraces a language all its own. It’s a language that is wrapped in history and littered with unique terms of art, acronyms, and, as we shall discuss, at least one pervasive “misnomer.” The industry’s unconventional language, coupled with inconsistent state laws, gives rise to one of the most confusing issues in oil and gas bankruptcies – whether or not section 365 of the Bankruptcy Code is applicable to oil and gas conveyances.
Section 365(a) of the Bankruptcy Code provides that a debtor in possession may assume or reject any executory contract or unexpired lease of the debtor. At first blush, the provision would appear to have the potential for profound effects in an oil and gas bankruptcy. Working interests are conveyed by means of a “lease,” and the owners of mineral interests and working interests are often referred to as lessors and lessees. Additionally, working interests share two important characteristics with the typical leasehold interest – they are created directly from the freehold interest and they last for a finite period of time. Thus, where the debtor has conveyed a valuable real property interest pursuant to an oil and gas “lease,” section 365(a) would on its face appear to provide the debtor with the opportunity to reclaim its interest, either through rejection of the “lease” itself or rejection of the contract conveying the interest.
Regrettably, the analysis is not so simple. Whether the interest conveyed is a vested, freehold real property interest or a leasehold interest subject to the provisions of section 365 is a matter for state law interpretation. In other words, an oil and gas “lease” may or may not be a lease. Additionally, the document conveying the interest may or may not be considered executory, even when it contains a reversionary interest in favor of the grantor. Thus, a bankruptcy practitioner must consider several factors in determining whether section 365 is applicable to the oil and gas conveyance.
The Oil & Gas “Lease” as an Unexpired Lease
Describing the conveyance of an oil and gas interest as a “lease” has a tendency to “give the impression to the uninformed that the ‘oil and gas lease’ is of the same genus as the common law ‘lease’ of land.” Unfortunately for bankruptcy practitioner, the reality is not so straightforward, as the “use of the term ‘lease’ is more in ‘deference to custom’ than a description of the legal relationship involved.” The nature of the interest granted is independent of any language in the conveying document – only the identity of the interest being conveyed and the applicable governing law determines the appropriate classification of the interest. Proper treatment of an oil and gas “lease” under the rubric of the Bankruptcy Code can only be considered after the nature of the interest is determined under applicable non-bankruptcy law.
As discussed in Part Two of this series, certain oil and gas interests – like working interests, term overriding royalty interests, production payments, or net profits interests – do not exist in perpetuity. Instead, the rights conveyed by the working interest typically revert back to the mineral interest owner if certain terms and conditions are not met. This type of conditional conveyance can be classified in two ways – either as a freehold conveyance with a reversionary interest in favor of the original owner or as a leasehold conveyance. From a functional standpoint, the two types of conveyance may appear similar, but their treatment in the bankruptcy context is greatly affected by their classification.
Notwithstanding how the conveyances and interests are titled, in many jurisdictions, so-called oil and gas “leases” actually grant the working interest holder a “fee simple determinable” in the minerals. By taking a fee simple determinable, the recipient of the working interest in such jurisdictions is actually being granted its own freehold interest in the minerals, not a leasehold interest that exists as a subset of the mineral interest holder’s freehold rights in the minerals. One such example is Texas, where an oil and gas “lease” conveys a vested real property right in fee simple determinable. As the Fifth Circuit made clear in Topco, “state law determines whether these contracts constitute unexpired leases subject to Section 365. In Texas, they do not.”
A recent case in in the United States Bankruptcy Court for the Western District of Michigan provides a counterpoint to the Texas view. Considering an oil and gas lease conveying a royalty interest to the plaintiffs, the Frontier Energy court found that “oil and gas leases in Michigan, such as each of the Agreements under consideration, are ‘rental agreement[s] to use real property’ and therefore ‘leases’ within the meaning of Section 365 [of the Bankruptcy Code].” The Michigan court drove home the differences, stating, “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.” The Michigan Bankruptcy Court’s determination that Frontier’s interest was merely an unexpired lease forced the debtor to decide whether it wanted to assume (which required a sizable cure) or reject the lease.
The two opinions illustrate the difficulty facing the bankruptcy practitioner untrained in the realm of oil and gas. The conveyances considered in the Topco and Frontier Energy decisions may well appear similar on their face, and the documents evidencing the conveyances could easily have looked nearly identical. And yet the two outcomes could not be more different. “[O]il and gas leases considered to be freehold estates by the governing state law do not constitute ‘unexpired leases’ under the Bankruptcy Code and therefore Section 365 does not govern their assumption or rejection. . . . However, in states where oil and gas leases constitute leasehold interests rather than freehold interests, Section 365 does govern their disposition.”
The Document Conveying the Oil & Gas Interest as an Executory Contract
The conveyance of an oil and gas interest does not happen without documentation. As such, practitioners arguing for the application of section 365 to an oil and gas interest often argue in the alternative that if the interest is not an unexpired lease, the document or documents conveying the interest are nonetheless executory.
The Code does not define the term “executory contract.” At minimum, Congress intended the term to refer to contracts “in which performance is due to some extent on both sides,” and this concept has been further refined by bankruptcy courts through the prism of the “Countryman definition” of executory contracts. However, not all obligations to perform meet the standards considered by the Countryman definition. For instance, “[t]he general rule is that a contract is not executory where the only obligation of a party to a contract is the payment of money.” Likewise, the reversionary aspect of an oil and gas conveyance is not typically considered an obligation for future performance under the Countryman definition, as this reversion occurs by operation of law, rather than by a lessee’s affirmative performance.
Considered under the Countryman rubric, the majority of courts have held that documents conveying oil and gas interests are not executory contracts, and are thus beyond the scope of section 365. Where an oil and gas interest is vested (that is to say, on a property where production has begun), “[i]t is well settled by many courts that an oil and gas lease is not an executory contract because the rights conveyed are an interest in real estate and not truly a lease.”
One instance of the general rule not being applicable is where a working interest is conveyed but oil or gas had not been produced as of the petition date. Because the conveyance of a working interest is subject to the lessee producing oil and gas, the law in some jurisdictions holds that until oil and gas is actually produced, the real property interest conveyed does not vest. The bankruptcy court for the Middle District of Pennsylvania recently concluded that under Pennsylvania state law that, “until oil or gas is produced, no freehold estate vests in the lessee. Logically then, 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.” The Powell court continued its explanation, holding:

Had gas been discovered prior to the bankruptcy filing, the conversion of the instrument to a determinable fee would have terminated its qualification as a ‘lease’ under § 365 because the Lessees would have had the right to extract their gas from the Debtor’s property. Moreover, if gas had vested in Lessees prior to bankruptcy filing, the executory nature of the contract would cease, and we, again, would be talking about the law of real property rather than an executory contract.

However, the Powell decision is not applicable in all jurisdictions. Certain jurisdictions, like Texas, hold that by operation of law, an oil and gas interest vests in the lessee as soon as the interest is conveyed. In such jurisdictions, the instrument conveying the oil and gas interest is never executory, and thus, section 365 never comes into play.  Like so many other oil and gas bankruptcy issues, the outcome all depends on where the debtor or creditor happens to be drilling.
Conclusion
All of this may leave the bankruptcy practitioner’s head spinning like a rotary table on a drilling rig. Determining the applicability of section 365 starts with the identification of the precise oil and gas interest in question and a thorough understanding of how the applicable non‑bankruptcy law in effect classifies that specific interest – tasks that must be completed before bankruptcy considerations come into play. There are no shortcuts, and the unpredictable realm of oil and gas law doesn’t allow for bright line rules.