The Court of Appeals for the Third Circuit confirmed that the Pennsylvania Landlord and Tenant Act is inapplicable to an agreement by a landowner authorizing the “lessee” to extract oil and gas lying beneath the property's surface. Furthermore, the Court of Appeals affirmed the Bankruptcy Court’s refusal to allow the chapter 13 “lessor” to reject the lease. In re Mustafa Tayfur v. Swepi LP, Central Appalachian Petroleum, et al., No. 14-3478 (3d Cir. March 18, 2015).

Tayfur, the landowner of property in Butler County, Pennsylvania, executed a lease agreement permitting Central Appalachian Petroleum to extract oil and gas lying beneath his property’s surface (“Lease”). The Lease was dated in 2005 and was to run for at least 10 years.

In 2011, the lessor filed a chapter 13 petition and sought to reject the Lease. While the lessee made all payments as due under the Lease, drilling had not commenced. The lessor/debtor sought to reject the Lease, claiming he could relet the property to another driller for more money. The debtor/lessor claimed the right to terminate the Lease under the Landlord Tenant Act of Pennsylvania.

Under Pennsylvania law, “the surface estate, the mineral estate, and the right to surface support” constitute “discrete estates in land.” In re Powell, 482 B.R. 873, 876 (Bankr. M.D. Pa. 2012). “Because these estates are severable, different owners may hold title to separate and distinct estates in the same land.” Hetrick v. Apollo Gas Co., 608 A.2d 1074, 1077 (Pa.Super.Ct. 1992). Since the lessee was a purchaser of mineral rights rather than merely an occupant of Tayfur’s property, the provisions of the Landlord and Tenant Act defining the obligations of landlords and tenants are inapplicable to the Lease. See, Kepple v. Fairman Drilling Co., 551 A.2d 226, 230-231 (Pa.Super.Ct. 1988). The Bankruptcy Court, affirmed by the District Court, concluded that section 250.202 of the Pennsylvania Landlord Tenant Act did not give the Lease “the force and effect of a lease at will only.” Tayfur, 505 B.R. 673, at 677-678, 684 (Bankr. W.D. Pa. 2014), on appeal, 513 B.R. 282 (W.D. Pa. 2014).

Under Pennsylvania property law, oil and gas leases do not vest oil and gas interests until production, hence they are considered executory prior to production, and the contract is subject to rejection as either an executory contract or an unexpired lease. If production has not occurred prior to the bankruptcy filing of the debtor-lessor, then the lessee’s interest remains “inchoate.” T.W. Phillips Gas & Oil Co. v. Jedlicka, 42 A.3d 261, 267 (Pa. 2012). Section 362 of the Bankruptcy Code prevents this inchoate interest of the lessee from converting to freehold estate. § 362(a)(3). The result is that the debtor-lessor’s estate remains the owner of the oil and gas interest. If the agreement is deemed a real property lease (as opposed to a contract) (see, 11 U.S.C. § 365(m)), lessees retain rights under the lease even if the lease is rejected, such that the lessee can enforce its rights to exploration. 11 U.S.C. § 365(h)(1)(A)(ii). See, In re Mustafa Tayfur v. Swepi LP, Central Appalachian Petroleum, et al., No. 14-3478 (3 Cir. March 18, 2015; see also, In re Powell Development v. Anadarko Exp., 482 B.R. 873 (Bankr. M.D. Pa. 2012).

Because the lessee retains the rights to exploration, the debtor/lessor could not relet for more money, and hence did not meet the test necessary to reject the Lease – that rejection would be financially beneficial to the debtor’s estate.

Once the oil, gas or mineral interests vest, the contract is no longer executory – hence cannot be rejected under section 365.

NOTE: These decisions are based on Pennsylvania property law – which is different from other state laws regarding property rights in oil and gas.