In 2019, the Pennsylvania Superior Court issued a landmark decision in the SLT Holdings, LLC v. Mitch-Well Energy Inc, 217 A. 3d 1258 (Pa. Super. Ct. 2019) matter. The Superior Court affirmed the trial court’s decision in favor of the landowners and essentially held that the failure to operate and produce a gas well for sixteen (16) years constituted “abandonment” of the underlying oil and gas leases. This was a favorable and encouraging decision for Pennsylvania landowners because it recognized an alternative theory of lease expiration.
However, in an April 29, 2021 opinion, the Pennsylvania Supreme Court reversed this decision and muddied the lease expiration waters. Framing its decision as a procedural matter, the Supreme Court concluded that the trial court and the Superior Court “skipped a step” when rendering their decisions by mistakenly focusing on “abandonment” instead of certain contractual “cure” remedies available under the Subject Leases. But, in reaching this conclusion, the Pennsylvania Supreme Court appears to have conflated property law concepts with contractual remedies. Oil and gas drillers have made these same misguided arguments before and they may be emboldened by this recent decision. Pennsylvania landowners should beware.
Understanding the Case
The basic facts of the case are straightforward. This matter involved approximately 1,500 acres in two parcels in Warren County, Pennsylvania that were subject to identical oil and gas leases. A 350 acre parcel was known as “Lot 769” and the remaining 1,112 acre property was known as “Warrant 3010”. In 1985, Eleanor McLaughlin, the oil and gas owner, entered into the lease agreements for Lot 769 and Warrant 3010 which were in dispute in this case (the “Subject Leases”).
The Subject Leases had five (5) year primary terms and would remain in effect beyond the primary term as long as oil or gas were or could be produced in paying quantities, as determined exclusively by the lessee, or the lease was otherwise maintained in effect by its provisions.
The original lessee transferred its interests in the Subject Leases to Mitch-Well Energy (“Mitch-Well”). Mitch-Well drilled one well on Lot 769 and one well on Warrant 3010, producing oil in “paying quantities” until 1996, which was beyond the primary term. Thereafter, Mitch-Well did not produce oil or gas nor did it make any kind of payments under the Subject Leases for sixteen (16) years. The wells became overgrown, there were no motors to pump the oil and no electricity supply to the wells. In short, the wells had been ignored and had fallen into complete disrepair.
In 2013, the landowners filed a lawsuit against Mitch-Well seeking a determination that the Subject Leases were no longer operative. The landowners asserted claims for an injunction, declaratory judgment, an accounting, ejectment, conversion and interference with contract. The landowners moved for summary judgment on their claims for injunction, declaratory judgment and conversion, asking the trial court to find that the Subject Leases had terminated or had been abandoned. The trial court found in favor of the landowners and against the driller, Mitch-Well, concluding that the Subject Leases had been abandoned.
The case was appealed to the Pennsylvania Superior Court, which affirmed the trial court’s decision that the Subject Leases had been abandoned. We discussed the significance of this decision in our September 20, 2019 Bulletin and noted that it was peculiar that the Superior Court focused on “abandonment” as the reason that the Subject Leases were no longer in effect, instead of concluding that the Subject Leases expired due to non-production under the “automatic termination rule” READ MORE>>
The Pennsylvania Supreme Court Accepts the Case for Review
The Pennsylvania Supreme Court was not obligated to review this case. It could have allowed the Superior Court’s decision to stand. Somewhat surprisingly, the Pennsylvania Supreme Court decided to accept the following issue for review and consideration:
Did the Superior Court err in the grant of summary judgment against Petitioner of Counts I, II, and V of its amended complaint in equity of “drill or pay oil and gas lease” where a well on each parcel was drilled by [Appellant] and pursuant to each lease the wells were productive, and no testimony was taken as to [Appellant’s] good faith production decision pursuant to the Supreme Court decision in the case of T.W. Phillips Gas and Oil Co. v. Jedlicka, 42 A.3d 261 (Pa. 2012).
The Supreme Court also asked the parties to “. . . address Jacobs v. CNG Transmission Corp., 332 F. Supp. 2d 759 (W.D.Pa. 2004), Aye v. Philadelphia Co., 193 Pa. 451 [44 A. 555] (Pa. 1899), and the doctrine of abandonment”. The parties filed briefs and oral argument was held on October 22, 2020.
The Pennsylvania Supreme Reverses the Superior Court
The Pennsylvania Supreme Court reversed the Superior Court opinion that the Subject Leases had been “abandoned” and sent the case back down to the trial court for further proceedings. The Supreme Court concluded that both the trial court and the Superior Court had “skipped a step” by focusing on abandonment of the Subject Leases instead of examining the applicability of certain contractual remedies set forth in the Subject Leases.
The High Court explained that “abandonment” is an “equitable doctrine” and that equity is available only if there is no adequate remedy “at law”. The Pennsylvania Supreme Court further observed that “[a]bsent from the analysis of the trial court or the Superior Court is any inquiry as to whether [SLT] demonstrated that their adequate remedy under a breach of contract action is inadequate.”
In particular, the Supreme Court focused on Paragraph 12 in the Subject Leases which provided as follows:
12) Default and Election of Remedies – In the event of a default, Lessor agrees to notify Lessee in writing as to the nature of the default and Lessee shall have thirty (30) days … to cure such default. Lessor agrees that its exclusive remedy shall be to terminate this lease in the event a court … determines that the default has not been cured ….
Reflecting on this specific paragraph, the High Court opined that “Appellees never explain why their bargained for remedy of termination under Paragraph 12 of the lease is unavailable or inadequate.” SLT Holdings, 249 A.3d at 896. Essentially, the Supreme Court concluded that there was a remedy “at law” built into the Subject Leases by virtue of Paragraph 12 and that the trial court and the Superior Court improperly found that the Subject Leases were “abandoned” without first addressing the availability of this “at law” contractual remedy.
The authors submit that the rationale and reasoning adopted by the Pennsylvania Supreme Court was, and is, flawed. As detailed below, the problem with this reasoning is that lease termination is more of a question of property law rather than one of contract.
Evaluating the Impact of the Decision and the Court’s Reasoning
There is an attractive simplicity to the SLT Holdings decision. The Supreme Court reasoned that the Subject Leases provided a specific remedy and procedure in the event of a contractual breach and that the trial court and the Superior Court incorrectly bypassed that remedy in favor of a finding that the Subject Leases were “abandoned”. On its face, the Supreme Court’s opinion suggests that “abandonment” is a remedy of last resort. But, this conclusion rests on the Court’s assumption that the Subject Leases did, in fact, contain a specific remedy and procedure (i.e., Paragraph 12) that should have been followed. The authors respectfully submit that this reasoning is inconsistent with long-settled Pennsylvania oil and gas law.
The Supreme Court focused its analysis on the conclusion that Paragraph 12 was implicated. Under Paragraph 12, if the lessee defaulted on a contractual obligation, the lessor was required to provide written notice and the lessee had thirty (30) days to cure the default. In the event that a court determined that a default was not timely cured, Paragraph 12 stated that “Lessor agrees that its exclusive remedy shall be to terminate this lease.” To these authors, there was no contractual “default” and therefore Paragraph 12 should have had no bearing on the resolution of the landowner’s claims.
There is a distinction between a driller’s default of an affirmative contractual obligation under an oil and gas lease and the expiration of the leasehold interest due to non-production. For instance, if a driller produces and sells oil or gas and fails to pay the royalty, that is a “default” of the contractual obligation to pay a royalty. That would trigger Paragraph 12, because the driller was contractually required to pay the royalty if it produced oil or gas. But, that is different from this situation, where the driller appears to have simply walked away from the lease altogether. A review of the unique nature of oil and gas leases is important here, and it is something that the Supreme Court largely did not address in its SLT Holdings decision.
When an oil and gas lease is executed, the lessee’s initial title is “inchoate” for exploration and development of oil and gas. T.W. Phillips Gas and Oil Co. v. Jedlicka, 42 A.3d 261, 267 (Pa. 2012). But, if oil or gas is found, the lessee’s rights transition to a fee simple determinable. Id. “A fee simple determinable is an estate in fee that automatically reverts to the grantor upon the occurrence of a special event.” Jacobs v. CNG Transmission, 332 F.Supp.2d 759, 773 (W.D.Pa. 2004). As such, it is important to note that while an oil and gas lease is a contract, the interest created by the contract (i.e., fee simple determinable) is governed by property law. See, Jedlicka , 42 A.3d at 267 (“[a]n oil and gas lease reflects a conveyance of property rights within a highly technical and well-developed industry….”).
The “special event” or “limitation event” that automatically terminates the fee simple determinable estate is non-production. See, Jacobs, 332 F. Supp. 2d at 777-78. So, if at the end of the primary term there is no production, then the leasehold interest automatically terminates. This is known as the “automatic termination rule” and has been a part of Pennsylvania oil and gas law for nearly a century.
This rule provides that the property interest acquired by the driller upon execution of an oil and gas lease will automatically terminate if the driller fails or ceases to produce hydrocarbons any time after expiration of the primary term. See, Brown v. Haight, 255 A.2d 508 (Pa. 1969) (“[T]herefore, in 1947 when oil and gas were not produced in paying quantities, the grantee’s fee interest terminated automatically and the property reverted to the grantor”); Cassell v. Crothers, 44 A. 446 (Pa. 1899) (“[W]here oil was no longer being produced in paying quantities, the lease was liable to be terminated”); Hite v. Falcon Partners, 13 A.3d 942 (Pa. Super. 2011) (“…when that primary term ended and Falcon failed to commence production, the agreement expired.”); Heasley v. KSM Energy, 52 A.3d 341 (Pa. Super. 2012) (“[W]hen production ceased, the lease became an at-will tenancy, subject to termination by the lessor at any time”). The hallmark of the “automatic termination rule” is that it is automatic: cessation of production, unless excused by a savings mechanism in the parties’ lease, terminates the driller’s property interest by operation of law.
Here, the Subject Leases were well beyond its primary term. The Subject Leases provided that it would remain in effect as long as oil or gas were or could be produced in paying quantities. It was undisputed that Mitch-Well had not produced oil or gas from the Subject Leases in sixteen (16) years. Mitch-Well’s failure to produce oil or gas was not a breach of the Subject Leases per so. Instead, it was, and is, the determinable event that automatically terminated the fee simple property interest created when the Subject Leases were executed.
Oil and gas leases with “default” provisions are somewhat common and drillers oppose lease termination claims by arguing that contractual “default” provisions control and govern resolution of such claims. The implication of this faulty reasoning is apparent: the drillers then argue that they should have the ability to “cure” the purported “default” by resuming or restarting production. In other words, they want a second chance. However, the “automatic termination rule” is not subject cure and the leasehold estate automatically terminates when there is non-production. The SLT Holdings decision appears to sanction and encourage this troubling and misplaced argument.
Under Paragraph 12 of the Subject Leases, if there is a “default”, the landowner must provide the driller with “notice” and the ability to “cure” the “default”. This means that a “default” is something that necessarily can be cured or fixed by some action on the part of the driller. This cannot apply to the driller’s failure to produce oil and gas or to otherwise reverse or override the automatic termination rule.
The driller’s “fee simple determinable” estate automatically terminates when the habendum is not satisfied. Those leasehold rights automatically revert back to the landowner. To argue that non-production does not terminate a lease absent an opportunity to “cure” completely ignores the basic nature of a driller’s leasehold title. This results in obvious absurdities because any “cure” would be prospective. The driller here could not go back in time and produce oil or gas during this sixteen (16) year period when there was no production. So, a “cure” would not even resolve or address the issue. This confirms that a failure to satisfy the “habendum” is not an issue that is subject to “cure”. If the driller satisfies the “habendum”, it retains developmental and exploration rights granted by the lease. If the driller does not satisfy the “habendum”, the developmental and exploratory rights expire and terminate.
In order to persuasively argue that non-compliance with the “habendum” clause of a lease is a “default” of lease obligations, one must concede that the “habendum” sets forth mandatory contractual obligations. If oil and gas leases mandated production or payments in lieu of production (like shut-in payments), a “habendum” clause would serve no purpose in setting the duration of the lease. There would be no “special event” that would terminate a fee simple determinable. Instead, the only way for an oil and gas lease to end would be the voluntary surrender by the lessee. This conclusion does not make sense and would re-work the nature of oil and gas development across the Commonwealth because it would affirmatively obligate drillers to produce and sell hydrocarbons under every lease. That is not reasonable.
Focusing on the text of the Subject Leases, their “habendum” clause imposes no obligation to produce oil or gas or to make payments. The driller has the right to perform these actions to maintain its lease in effect if it chooses. The text of the Subject Leases does not require that the driller perform these actions.
Although Paragraph 12 was an inviting basis to determine that the trial court and the Superior Court had overlooked contractual remedies, these authors respectfully submit that the Pennsylvania Supreme Court’s logic is flawed. Paragraph 12 was simply inapplicable. The failure to produce oil or gas under the Subject Leases was not a “default” by the driller – it was a determinable event that automatically terminated the leasehold interest. Unfortunately, the Pennsylvania Supreme Court failed to appreciate the distinction between traditional contractual “cure” remedies and the unique property interest created by an oil and gas lease.
Landowners across Pennsylvania should be wary of drillers who suggest that the “default” clause in an oil and gas lease applies to a claim of lease expiration based on non-production. Non-production itself is not a contractual “default” that can be cured by unilaterally resuming production or tendering retroactive royalties.