Don’t Assume It’s a Lease! Applying § 365 to Oil and Gas Conveyances

The rise in energy-sector bankruptcies has brought the question of whether oil and gas conveyances can be assumed or rejected under § 365 of the Bankruptcy Code to the surface. Issues related to assumption and rejection are particularly difficult in the energy sector because “[t]raditional property concepts are difficult to apply in the oil and gas context. Can one be said to ‘own’ something that is not necessarily quantifiable and to which one’s neighbor can gain legal title by ‘capture’?” [1]

The Sabine Oil & Gas case, decided early last year, allowed an exploration company to reject so-called midstream pipeline contracts.[2] The case received a good deal of attention because it provided a new incentive for exploration and production companies to file for bankruptcy: They may now be able to reject unfavorable pipeline contracts, which the Sabine judge believed did not run with the land under Texas law.[3] But Sabine is only one of many decisions regarding the treatment of oil and gas-related agreements in bankruptcy.

This article lays out the legal landscape of cases deciding whether oil and gas “leases” can be assumed or rejected using Bankruptcy Code § 365. Section 365 of the Code deals with two types of conveyances: unexpired leases and executory contracts.[4] Courts have considered whether oil and gas “leases” fall within the scope of § 365 by asking whether these conveyances meet either definition.[5]

Is It a Lease?

To determine whether an oil and gas conveyance is a lease, courts look to state law. The results, dependent as they are on state law, are necessarily mixed. Some states do not consider these conveyances to be unexpired leases. In Texas, for example, these contracts are held to convey interests in real property. Thus, an agreement conveying a so-called “leasehold” in actuality is a conveyance of a determinable fee interest, a type of ownership right.[6] Other states, including Oklahoma, Illinois and Louisiana, have followed Texas’s approach.[7]

In contrast, under Michigan law, oil and gas leases are considered “rental agreements to use real property,” and are therefore leases in bankruptcy subject to § 365.[8] One Michigan court has acknowledged that treating these agreements as unexpired leases makes sense given that the purpose of § 365 is “to deal with transactions that are not fully executed when the petition is filed.”[9] Under this reasoning, oil and gas leases that have outstanding obligations as of the bankruptcy filing would fall within § 365’s scope. Ohio and Wisconsin also treat oil and gas leases in this manner.[10]

Other courts have looked to congressional intent regarding the application of § 365 and have come to different conclusions. For example, in In re Clark, the U.S. Bankruptcy Court for the Northern District of Oklahoma reviewed § 365’s legislative history and determined that Congress intended the statute to apply to “traditional” leases, such as shopping centers and other “nonresidential structures,” rather than to an oil and gas “lease,” which in Oklahoma creates an interest in realty.[11]

Is It an Executory Contract?

If an oil and gas conveyance is not considered to be an “unexpired lease,” it still may be assumed or rejected pursuant to § 365 if it is found to be an executory contract. Federal bankruptcy law determines whether a contract is executory, and many courts rely on the Countryman definition of executoriness, defining an executory contract as one where “the obligations of both the bankrupt and the other party are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.”[12]

Although the application of federal law to the question of executoriness would seem to indicate a uniform result, a state law element still exists, as state law determines when the property interest in an oil and gas lease vests. Thus, courts may come to different conclusions about the executoriness of oil and gas conveyances based, once again, on differences in state law.[13]

Conclusion

The question of whether an oil and gas “lease” may be assumed or rejected, though facially dependent on bankruptcy law, actually turns a great deal on the intricacies of state property law as well as the express language of the instrument at issue. For this reason, it is always wise to consult the law of the relevant state, both when drafting and executing such conveyances, and when determining their status in bankruptcy.