The bankruptcy of a counterparty to just about any business or property transaction can be an unhappy event. Certainly it is not a picnic for the business entity or the businessman who is compelled to seek relief under the federal Bankruptcy Code; filing for bankruptcy should always be a last resort and undertaken for a bona fide purpose of rehabilitating the firm and maximizing the value of assets for the benefit of all parties, including specifically creditors. When the transaction is an oil and gas lease and the party filing a bankruptcy case is the lessee, the lessor will naturally have concern about its rights and the survival of the oil and gas lease without alteration. Fortunately, the courts that have addressed these issues have issued decisions that are sensible and protective of the lessor.
Business bankruptcy process features two modes of relief: liquidation, either under a Chapter 11 plan or in a liquidation proceeding under Chapter 7, or rehabilitation under a plan of reorganization in a case under Chapter 11. For purposes of the following discussion, it does not matter whether the debtor’s bankruptcy case is filed under either Chapter 11 or Chapter 7. There are differences—in Chapter 11, the debtor remains in possession and operation of its assets, while in Chapter 7 a trustee is appointed to take control of the debtor’s property and to liquidate it for the creditors—but a powerful tool of bankruptcy law is applicable in both types of cases: the ability to “reject” executory contracts and unexpired leases under section 365 of the Bankruptcy Code.
Accordingly, whether an oil and gas lease covering oil, gas, and other minerals in Texas is an executory contract or an unexpired lease for purposes of Bankruptcy Code § 365 is a question of significant interest. An "executory contract" is "a contract on which performance remains due to some extent on both sides." NLRB v. Bildisco & Bildisco, 465 U.S. 513, 522-23 n. 6 (1984). An "unexpired lease" is the rental of real or personal property for a set term. See, generally, Josiah M. Daniel, III, Lawyering on Behalf of the Nondebtor Party in Anticipation of, and During the Course of, an Executory Contract Counterparty's Chapter 11 Bankruptcy Case, 14 Hous. Bus. & Tax L.J.230 (2014).
The Code provides the debtor three options for each of its executory contracts and unexpired leases (with some technical issues not relevant here): (i) the debtor may assume it—in essence ratifying or reaffirming its obligations; the debtor may pick and choose which executory contracts to assume; and to assume it, the debtor must cure all defaults; (ii) the debtor may reject it—walking away from it with no further responsibility to perform and no further benefit to be obtained from it; and the non-debtor party is left with a general unsecured claim for its contract damages; and (iii) the debtor may assign it—regardless of contrary contractual provisions. An
Under a long line of precedents by Texas appellate courts, including its Supreme Court, an oil and gas lease in Texas is a grant of the right to explore, extract, sell, or own the oil, gas, and other minerals with respect to a specific tract of land or strata of the subsurface for a period of time and so long thereafter as oil and gas are produced. In Texas, the oil and gas lease, despite its “lease” nomenclature, creates a fee simple determinable, which is a real property interest. As a real property interest rather than a true leasehold interest, an oil and gas lease in Texas is not subject to Bankruptcy Code § 365.
Two judicial decisions clearly so state. In one decision, the U.S. District Court in Houston explained succinctly: “A mineral lease in Texas is a determinable fee. It is not a lease or other form of executory contract that a debtor may accept or reject.” Terry Oilfield Supply Co., Inc. v. American Security Bank, N.A., 195 B.R. 66, 70 (S.D. Tex. 1996).
In addition, the Court of Appeals for the Fifth Circuit has written:
While we interpret the Bankruptcy Code as a matter of federal law, state law determines whether these contracts constitute unexpired leases subject to Section 365. . . . In Texas, they do not. Instead, they convey interests in real property. . . . 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. . . . [T]he so-called [oil and gas] leaseholds at issue in this case actually constitute determinable fee interests.
River Production, Co., Inc. v. Webb (In re Topco, Inc.), 894 F.2d 727, 740 n.17 (5th Cir. 1990).
A Delaware bankruptcy court decision is consistent. Construing an overriding royalty interest document (i.e., a transfer of an interest in the oil and gas lease), the court wrote:
The Instrument in question is the "Conveyance of Overriding Royalty Interest." In standard oil and gas parlance, the term "overriding royalty" means a given percentage of gross production carved from the working interest in the land but, by agreement, not chargeable with any of the expenses of operation. . . . An overriding royalty interest is an interest carved out of, and constituting part of, the working interest created by an oil and gas lease. . . . It is a type of royalty. And, like any ordinary oil and gas royalty, it is an interest in real property regarded as a covenant running with the land between the assignor and the assignee, and is enforceable by the assignor against the assignee.
Foothills Texas, Inc. v. MTGLQ Investors, L.P. (In re Foothills Texas, Inc.), 476 B.R. 143 (Bankr. D. Del. 2012). The court held that the royalty conveyance is not an executory contract. Id. at 157.
In each of the three cases quoted above, the debtor is either the lessee of a Texas oil and gas lease or is the lessee and assignor of an interest in such lease.
Under Texas law, from the earliest days of the oil and gas industry, an oil and gas lease conveys a fee simple determinable estate in the oil and gas in place under the leased premises. For representative Texas precedents, see Anadarko Petroleum Corp. v. Thompson, 94 S.W.3d 550, 554 (Tex. 2002) and Cherokee Water Co. v. Forderhause, 641 S.W.2d 522, 525 (Tex. 1982). The lessee obtains a possessory interest in the minerals, leaving the lessor with a royalty interest and a reversionary interest, which may ripen into a possessory interest if the oil and gas lease terminates. See Coastal Oil & Gas Corp. v. Garza Energy Trust, 268 S.W.3d 1, 9 (Tex. 2008). The reported bankruptcy decisions respect the real property character of Texas oil and gas leases. That there are not more reported decisions coming out of bankruptcy cases that also state that Texas oil and gas leases are not subject to § 365 simply reflects how well known and unimpeachable this characterization is.
A Texas oil and gas lease is a grant by the lessor of a fee simple determinable under state law and is recognized as such, and is not characterized as an executory contract or an unexpired lease, under the bankruptcy law.