A Lease by Any Other Name: Section 365 and Oil and Gas Leases

Words can sometimes be deceiving. This is one of the lessons learned by the debtor in the recent Tayfur decision.[1] Although the case ultimately applied a different subsection of § 365 of the Bankruptcy Code,[2] the Third Circuit underscored an important fact in oil and gas law: A mineral lease[3] is not always a true lease. Thus, a mineral lease will not always fall within the ambit of § 365, and therefore it may not always be rejected in bankruptcy.

What Is § 365?

Section 365 of the Bankruptcy Code is entitled, “Executory contracts and unexpired leases,” and represents one of the most powerful provisions of the Code itself.[4] Specifically, § 365(a) permits the trustee or debtor in possession to reject an executory contract or unexpired lease.[5] In other words, a debtor has the unilateral ability to get out of an in-effect contract because it is burdensome, unfair or otherwise economically beneficial to do so[6] — something it cannot do absent the Bankruptcy Code.[7]

But It’s Called a Lease! Why Can’t I Reject It?

Property interests in oil and gas law are plentiful and complex. Of interest here is the mineral lease, which conveys a working interest to the mineral lessee. This working interest permits the lessee “to work on the leased property to search, develop, and produce oil and gas.”[8] But the use of the word “lease” is misleading; not all oil and gas leases convey a leasehold interest.

Whether a lease is considered to be an “unexpired lease” under § 365 of the Bankruptcy Code is a matter of state law.[9] To further complicate matters, states do not uniformly agree as to whether oil and gas leases are true leases that can be assumed or rejected in bankruptcy. Some states, known as non-ownership states, hold that the owner of a mineral interest does not own the oil or gas until it has actually been captured.[10] Thus, many non-ownership states characterize an oil and gas interest as a profit a prendre, the right to enter property and take something away.[11] Other states, referred to as ownership-in-place jurisdictions, hold that the owner of land atop oil or gas owns those minerals so long as they remain under that land.[12] In these states, an oil and gas interest is akin to a fee simple determinable, which terminates if an adjoining owner captures the minerals.[13]

How an oil and gas interest is characterized in a jurisdiction heavily influences whether or not an oil and gas lease is considered a true lease subject to rejection under § 365.[14] In Arkansas,[15] Kansas,[16] Michigan,[17] Minnesota,[18] Pennsylvania[19] and Wisconsin,[20] oil and gas leases are characterized as profits a prendre or licenses, and are subject to rejection in bankruptcy. Conversely, in Illinois,[21] Kentucky,[22] New Mexico,[23] Oklahoma,[24] Texas[25] and Utah,[26] they fall outside the influence of § 365 and are generally characterized as fee interests. In Louisiana[27] and Ohio,[28] the law is unsettled. Thus, in the remaining states — those with courts that have yet to consider the application of § 365 to mineral leases — whether the jurisdiction is a non-ownership or an ownership-in-place state is a fair predictor of how a decision might come down. In the former jurisdictions, § 365 is likelier to apply than in the latter.

Conclusion

With energy bankruptcies seemingly increasing in frequency, it is likely that we will see more debtors who are party to mineral leases seeking to reject them pursuant to § 365. Whether or not these debtors will be successful in doing so will be a product of the law of the state governing the lease, providing some debtors with more options in bankruptcy than others.