In a recent opinion delivered by Judge Huennekens in the case of In re Alpha Natural Resources Inc., et al.,[1] the bankruptcy court permitted the debtor, Alpha Wyoming Land Co., to reject a settlement agreement that required the payment of a royalty, the amount of which was based on a percentage of the coal mined and subsequently sold by the debtor from various areas in the state of Wyoming. The counterparties to the agreement (the “objectors”) argued, unsuccessfully, that the payments under the agreement were not merely contractual obligations owed by the debtor, but constituted an interest in real property that was conveyed as of the execution of the agreement, and therefore was not subject to rejection under § 365 of the Bankruptcy Code. In order to reach its conclusions with respect to the nature of the obligation, the bankruptcy court first analyzed the nature of the obligation under applicable state (Wyoming) law.
The objectors argued that the payment obligations set forth in the agreement were an “overriding royalty” interest and as such must be treated as an interest in the underlying property as a matter of law.[2] However, under Wyoming law, an overriding royalty interest can be either a contractual payment right or a nonpossessory interest in real property, depending on the language of the conveyance document creating the interest. The court found that in order for an overriding royalty interest to be more than a mere right to payment, the originating instrument must contain sufficient words to show an intention to convey, such as “transfer,” “sell” or “assign,” or the document must otherwise indicate a “specific intention” to convey the property.[3] In Alpha Natural Resources, the agreement was “devoid of any words of conveyance” and did not show a clear intention to transfer a real property interest.[4]
The court also looked at the duration of the “royalty” obligation as compared to the life of the underlying mineral lease.[5] Because the duration of the obligation was longer than the initial term of the underlying lease, the obligation in the Agreement was “temporary” and did not have the permanent nature of a royalty interest. Upon determining that the agreement was merely contractual in nature, and finding that the agreement both was not necessary for the debtor’s ongoing restructuring efforts and placed an unnecessary burden on the debtor’s estate, the court approved the rejection of the agreement, and the objectors lost any revenue stream from the “royalty” obligation thereunder.[6]
In cases where an obligation to pay royalties is a contract right, a pre-petition claim for unpaid royalties will generally be treated as an unsecured claim in a bankruptcy case. However, some states (including Texas, North Dakota and New Mexico) provide for statutory liens to protect oil and gas royalty owners under certain circumstances.[7] In this situation, the lien attaches to the production and the proceeds thereof, and will be treated as a purchase-money security interest for purposes of priority. Moreover, had the obligation been deemed a royalty interest that was a conveyance of real property, the interest would have been excluded from the debtor’s estate.[8] Finally, royalty owners may have additional protections if the underlying lease provides for termination of the lease after nonpayment of royalties because those clauses are enforceable in some states. The automatic stay under § 362 does not preclude automatic termination based on failure to pay royalties,[9] and in jurisdictions that treat such leases as conveyances of real property, the ipso facto clause of § 365 will not apply.
The moral of the story is that when drafting overriding royalty agreements that will survive a bankruptcy case, it is important to ensure that the agreement contains operative words of conveyance and demonstrates an intent by the parties to make a conveyance of an interest in the property itself. It is also important to understand the property laws of the state in which the property is located, as such laws may differ from state to state.
[1] In re Alpha Natural Resources Inc., 555 B.R. 520 (Bankr. E.D. Va. 2016).
[2] Id. at 525-26.
[3] Id. at 527-28.
[4] Id.
[5] Id. at 528.
[6] Id. at 529-30.
[7] Royalty owners are generally treated as lienholders when they are given a right to a percentage of production, as is common in the case of oil production. Royalty owners paid in cash, as is typical in gas production, are generally not deemed to be lienholders under the statute. These statutes are typically not applicable to coal royalty-holders, and it would be extremely rare for a coal royalty-holder to receive a royalty-in-kind in any event.
[8] This exclusion from estate property has an express statutory basis in the oil and gas context, 11 U.S.C. § 541(b)(4)(B), and is simply an application of state real property law in the coal context (i.e., the overriding royalty interest is “carved out” of the interest conveyed to the debtor).
[9] Automatic lease termination, however, is likely to provide protection to the holders of overriding, as opposed to traditional, royalty interests.