One Size Does Not Fit All Leases—it's Time to Amend Bankruptcy Code Section 365

• Publication year: 2022

One Size Does Not Fit All Leases—It's Time to Amend Bankruptcy Code Section 365

Rachel Hudson

ONE SIZE DOES NOT FIT ALL LEASES—IT'S TIME TO AMEND BANKRUPTCY CODE SECTION 365

Abstract

For far too long, Bankruptcy Code Section 365 has caused confusion among parties to oil and gas leases when one party files for bankruptcy. This section of the Bankruptcy Code is intended to provide relief to debtors who are party to an unexpired lease or an executory contract, allowing a debtor-in-possession or trustee to make the decision to either assume or reject the agreement. While this concept is straightforward for standard lease agreements and contracts, courts have struggled to determine whether oil and gas leases actually fall into the category of a "lease" per se, an executory contract, or neither.

Many courts have held that oil and gas agreements are not actually leases, despite their title, because they convey an interest in real property that exceeds that of a leasehold interest. Some courts, however, have chosen to categorize such agreements as unexpired leases, or even executory contracts. This variation in court decisions is problematic because determining what category to place an oil and gas agreement is of paramount importance in determining whether the debtor has the right to reject the agreement in a bankruptcy proceeding. Additionally, such variation has had the effect of producing shocking results during bankruptcy proceedings, leaving parties to current oil and gas agreements unsure of their contractual and property rights in the event that a counterparty experiences financial distress.

To alleviate the uncertainty caused by the current caselaw, this Comment proposes an amendment to Bankruptcy Code Section 365 that provides a framework for consistency in evaluating oil and gas leases moving forward and protections for the property rights of the contracting parties.

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Table of Contents

Introduction.............................................................................................318

I. Background ...................................................................................319

A. Texas......................................................................................... 324
B. Louisiana.................................................................................. 325
C. Oklahoma ................................................................................. 326
D. Utah .......................................................................................... 330
E. Ohio .......................................................................................... 331
F. Michigan ................................................................................... 332
G. Pennsylvania ............................................................................. 333

II. Analysis..........................................................................................336

A. Effect on Parties to the Agreement ........................................... 339

III. The Problem Will Persist............................................................342
IV. Is There a Solution?......................................................................345
V. Proposed Amendment....................................................................350

Conclusion.................................................................................................352

Introduction

Historically, Bankruptcy Code (the "Code") Section 365 has benefited debtors seeking relief of obligations under unexpired leases and executory contracts. However, despite this generally positive treatment of debtor interests, the issue of whether Section 365 should apply to relieve (debtor) parties to oil and gas leases remains a point of debate among the courts. Code section 365 allows the trustee to assume or reject an executory contract or unexpired lease of a debtor.¹ More specifically, this section of the Code aims, not only to relieve debtors from their existing obligations under leases and contracts,² but also to prevent third parties from ceasing business dealings with debtors.³ In furtherance of these goals, Section 365 gives debtors the option to either assume the contracts and/or leases that benefit their estate, or reject those that do not serve such interests.⁴

Agreements between landowners and producers of oil and gas are often memorialized in "leases." A plain reading of the word "lease" in such agreements may cause one to assume that these agreements fall within the

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purview of Section 365, thereby allowing a trustee or debtor in possession to assume or reject an agreement in the case of a bankruptcy filing. Yet, some courts argue that, with respect to oil and gas leases, the term "lease" is misnomer because such leases are categorically different from the typical leases governed by landlord-tenant law.⁵ This distinction hinges on the argument that the type of interest conveyed in an oil and gas lease is often more substantial than that of a typical lease agreement. Thus, the use of this terminology has led to disparate results when courts attempt to address how the agreements should be treated during a bankruptcy proceeding. Because it is often unclear what interest in real property has been conveyed to the "lessee," courts are left to grapple with state property law when determining whether an oil and gas lease may be assumed or rejected under the purview of Section 365.⁶

The recent decline in oil and gas production,⁷ paired with the economic downturn caused by the COVID-19 pandemic, will likely elicit an increase in bankruptcy litigation over oil and gas leases,⁸ thus demanding a uniform standard for addressing the treatment of such leases under Section. Therefore, this Comment will explore the various positions taken by courts among the several states, exploit the problematic nature of a lack of consistency in those court rulings, and propose a solution that provides clarity to parties entering oil and gas leases in the future. Because the current Code does not provide courts with guidance on the treatment of oil and gas agreements, parties entering into oil and gas leases are often ill-equipped to plan for the possibility of insolvency by another contracting party. Consequently, the current Code should be amended to incorporate such guidance.

I. BACKGROUND

In a bankruptcy proceeding, contract and property questions generally arise under state law and, therefore, must be evaluated pursuant to relevant state law unless a countervailing federal interest exists.⁹ When evaluating Code Section 365 in the context of standard landlord-tenant agreements, the language and application of the statute is clear. With a few exceptions, and "subject to the

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court's approval," the trustee in these standard agreements "may assume or reject any executory contract or unexpired lease of the debtor."¹⁰ When adhering to the common use of the word "lease" to guide our understanding of this statute, there are certain scenarios in which there the term has an obvious meaning. For example, a party to a standard lease agreement is unlikely to argue that a building lease for a term of years conveys any interest other than a leasehold interest in real property. However, because the interest conveyed in an oil and gas agreement differs from that of a landlord-tenant agreement, this understanding of the term "lease" fails to adequately capture the nature of such agreements.¹¹ A lessee in the example above has the right to occupy the building for a term of years, and at the end of the lease, he must either vacate the premises or renew the lease for another term. However, oil and gas leases are often structured in such a way that the "lessee"—who is typically an oil and gas producer—has the right to occupy and use the land until the oil reserve becomes depleted. This open-ended type of conveyance begs the question: is the conveyance actually a leasehold or something more?

Assuming that an oil and gas lease might be something other than a "lease," we must also determine whether such a "lease" might, instead, constitute an executory contract pursuant to the language of the statute.¹² When making this determination, the first question is: what is an executory contract? Unfortunately, the Code does not provide a definition. However, in an effort to ascertain its meaning from other sources, courts have looked to the "Countryman Definition" of executory contracts, which sets forth two distinct limitations for their scope.¹³ First, contracts in which the obligations of both parties are materially underperformed at the time of the bankruptcy filing are executory contracts.¹⁴ Second, contracts in which either party has fully performed do not constitute executory contracts, regardless of whether the nonperforming party is the bankrupt party¹⁵ or the non-bankrupt party.¹⁶ Additionally, while Section

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365 does not expressly state what definition courts should apply, legislative history suggests that Congress supports a definition consistent with the Countryman meaning, and notes that executory contracts do not typically consist of agreements in which the only obligation remaining for one party is payment to the other party.¹⁷

Because an oil and gas lease may be interpreted as conveying something other than a leasehold interest, the term "lease" within Section 365 must be interpreted in a way that makes sense within the legislative intent of the Code as a whole. A primary objective of the Code is to provide an "honest but unfortunate debtor" with a fresh start.¹⁸ This purpose raises the question of whether the treatment of oil and gas leases as executory contracts or unexpired leases—subject to rejection pursuant to the debtor's "business judgment"—is at odds with the idea of an "honest" debtor.¹⁹ When courts decline to recognize that oil and gas leases convey anything more than a leasehold interest, they often defer to...