Today’s blog article, which looks at offshore leases in the United States, is the fourth in a Weil Bankruptcy Blog series, “Drilling Down,” a series that will look at issues at the intersection of the oil and gas industry and bankruptcy law.  In Part One we provided an overview of the oil and gas industry, in Part Two we discussed specific oil and gas property interests and their treatment in bankruptcy, and in Part Three we discussed the ability to assume or reject oil and gas interests as leases in bankruptcy.

Smoke on the Water—The Hazy Law of Oil and Gas Leases on the Outer Continental Shelf

“For the love of God please GIVE ME THE ANSWER!”  — Billy Madison

Up until now, the Drilling Down series has focused on the most common type of oil and gas relationship in the United States – the privately-held onshore oil and gas lease between the private mineral interest holder and the E&P company holding a working interest.  While this type of relationship may be the most prevalent in this country, it is far from the norm worldwide.  Indeed, the United States is the only country in the world with widespread private ownership of minerals, as mineral interests everywhere else are the considered property of the State (or Sovereign).

The United States is not entirely without this mineral ownership dynamic, however.  Where the United States owns federal lands, the underlying mineral rights in those lands also belong to the federal government, which profits by leasing the right to explore and drill for the minerals on federal lands to private developers.  This includes the 1.7 billion acres of submerged lands, subsoil, and seabed known as the Outer Continental Shelf (the “OCS”), the offshore area typically located between three and 200 nautical miles from a State’s coastline.

The Outer Continental Shelf Lands Act Governs OCS Leases

The federal legislation that grants exclusive jurisdiction to the OCS and its riches in favor of the United States government is the Outer Continental Shelf Lands Act (“OCSLA”), which tasks the Bureau of Ocean Energy Management (“BOEM”) with managing offshore oil and gas leases.  Signed into law in 1953, the OCSLA brought under federal jurisdiction an area that in 2013 produced approximately 477 million barrels of crude oil, roughly one-fifth of our nation’s annual production.

As discussed in earlier articles, the appropriate property law characterization of onshore mineral leases is determined by applying the law of the individual State from which the resource is produced.  The resulting classification of a particular oil and gas property interest has a significant impact on its treatment in bankruptcy law, which looks to applicable non-bankruptcy law to define property interests.  On the OCS, applicable non-bankruptcy law shifts from state law to federal law, and specifically the OCSLA.  However, while the assumption might be that this shift would lend itself to a certain uniformity not seen in oil and gas laws onshore, there unfortunately may be no more unsettled intersection between bankruptcy law and oil and gas law than where the OCSLA meets the Bankruptcy Code.

The OCSLA is by no means intended to be an all-encompassing statutory scheme.  Inevitably, this exposes “gaps” in the law that the Act was not designed to address.  To manage these shortcomings, the OCSLA includes a comprehensive choice-of-law scheme that incorporates the law of the adjacent State as “surrogate” federal law:

To the extent that they are applicable and not inconsistent with this Act or with other Federal laws . . . the civil and criminal laws of each adjacent State now in effect or hereafter adopted, amended, or repealed are hereby declared to be the law of the United States for [the OCS] . . .

Thus, non-conflicting laws of adjacent states fill in the gaps in the OCSLA pursuant to this“mandatory” choice of law provision.

Within the realm of bankruptcy law, the “gap filler” provision leads to more uncertainty, not less, because whether OCS leases and associated production interests carved out of these larger interests are defined by federal law or the law of an adjacent state is required to understanding their proper treatment in bankruptcy.  Predictably, thanks to a dearth of statutory guidelines and precedential case law, the question of whether federal law or the law of the adjacent state defines an OCS property interest remains unsettled.

NGP v. ATP Offered a Clear Opportunity to Set OCS Precedent 

Most OCS leases are located off the coasts of Louisiana and Texas – states that have case law addressing whether oil and gas leases are true leases or freehold conveyances of vested real property interests; and whether the instruments conveying those interests are executory contracts.  But, under the OCSLA’s choice of law provision, that established case law is only applicable to OCS leases if (i) the OCSLA or other federal law does not address the issue and (ii) the case law is not inconsistent with the OCSLA and other federal law.  A few courts have skirted around how to characterize the property rights in OCS leases, and specifically whether those interests are defined in the OCSLA or must come from the gap-filling case law of adjacent States, but there has been no definitive answer on the issue.

Last year, it appeared that the litigation in NGP Capital Resources v. ATP (and other, similar adversary proceedings in the ATP bankruptcy) might finally force a bankruptcy court to settle the choice of law questions associated with OCS leases, as well as whether those leases could be subject to the assumption and rejection provisions of section 365 of the Bankruptcy Code.  If the OCS leases at issue could be rejected under section 365, overriding royalty interest (“ORRI”) holders like NGP would only hold unsecured claims in the amount of rejection damages.  Tens of millions of dollars were at stake.

Unfortunately, as we’ll discuss below, the clear answers practitioners hoped for never came.  Nonetheless, the proceedings did bring these infrequently-litigated issues to the forefront.  On one side of the line, plaintiff NGP argued that the gap-filling provision in the OCSLA required the application of the law of the adjacent state – Louisiana – under which an OCS lease would (probably) be a real property conveyance that was not subject to section 365 of the Bankruptcy Code.  On the other side, both ATP and the Department of Justice (acting on behalf of the United States) took the position that OCS leases are defined by federal law and regulations as both unexpired leases and executory contracts, making them subject to rejection under section 365.  They further argued that to the extent Louisiana law is inconsistent with that position, Louisiana law cannot be used as a “gap filler.”

Is the OCS Lease as an Unexpired Lease?

The United States’ primary argument for characterization of the OCS leases as unexpired leasehold interests subject to section 365 would be considered a straightforward, common sense position – if only the oil and gas industry didn’t suffer from a widespread misuse of the word “lease.”  Essentially, the government argues that because the OCSLA uses the term “lease” to characterize the property interests granted by the United States, OCS leases are – by their plain language – leases.  The DOJ pointed to two additional facts to further support this position: (i) the OCSLA enabling statute grants lessees only the right to “explore, develop, and produce the oil and gas contained within the lease area” and (ii) the OSCLA requires the lessee to submit rental payments and royalties pursuant to the terms of the leases.  However, if you’ve been following this blog series, you know by now that those facts are not only common to virtually every oil and gas “lease” in this country, they are also entirely inconsequential as to whether the interest being characterized is a lease capable of being affected by section 365 or a vested real property conveyance.

The United States’ second argument is that other federal law, namely the Bankruptcy Code, specifically defines a “lease” as “any rental agreement to use property.”  To support the notion that an OCS lease is a rental agreement, the DOJ cited to Union Oil Co. v. Morton, a Ninth Circuit case that predates the Bankruptcy Code, which held that an OCS lease “does not convey title in the land, nor does it convey an unencumbered estate in oil and gas.”

The full implications of the Union Oil holding in this context, however, are not clear for two reasons.  First, the very next sentence in the holding recognizes that an OCS lease conveys some type of enforceable property interest (though the nature of that interest is not defined).  Second, and more importantly, the Supreme Court has specifically held that federal courts cannot create federal common law to override state law under the OCSLA, holding “Congress made clear provision for filling the ‘gaps’ in federal law; it did not intend that federal courts fill in those ‘gaps’ themselves by creating new federal common law.” This position has led some scholars to question whether the term “federal law” in the OCSLA choice of law provision in fact only refers to federal statutory law.

What does seem clear is that absent the support of federal common law, nothing in the statutory language of the OCSLA provides a substantive property law characterization of the OCS leases.  In other words, beyond the Act’s consistent use of the word “lease,” nothing in the OCSLA or other federal law explicitly addresses whether the property rights conveyed pursuant to an OCS lease are real or personal in nature.  Indeed, even the DOJ has been inconsistent with its position on the matter.

Is an OCS Lease as an Executory Contract?

As discussed, in the ATP-NGP litigation, the United States takes the position that OCS Leases are not only unexpired leases subject to section 365 of the Bankruptcy Code, but that the instrument conveying an OCS lease is also an executory contract subject to section 365.  Specifically, the DOJ asserts that because an OCS lessee must continue to make royalty and rental payments, and because the United States “must make the OCS lands available for development and supervise all development on the OCS,” there are obligations for performance remaining on both sides.  The United States argues these outstanding obligations by both parties meet the Countryman definition of executory contracts.  However, courts (including the ATP court) have thus far not addressed whether these obligations would meet the Countryman definition.

If Gap-Filling State Law Considers the Mineral Interests Real Property Interests, Is that Position Inconsistent with OSCLA?

The parties on both sides of the NGP-ATP litigation and related adversary proceedings arguing these section 365 issues agreed that OCSLA applied generally to govern the OCS Leases, but the sides differed in their interpretation of whether the OCSLA’s “gap filling” provision was applicable under the circumstances.  ATP and the DOJ take the position that any state law that prevents the disposition of OCS leases in bankruptcy as unexpired leases or executory contracts is inconsistent with the OCSLA.  Specifically, both ATP and the U.S. Government argue that to the extent that mineral interests are considered vested real property interests under Louisiana or Texas law, such law is inconsistent with the characterization of such interests under the OCSLA and are thus inapplicable.

Assuming that Louisiana law does not consider mineral interests to be unexpired leases or executory contracts (as the ATP court did), the question of whether Louisiana law is inconsistent with federal law would seem to be one of the most important, outcome determinative issues in the litigation.  And yet, the plaintiffs in the NGP-ATP litigation, as well as plaintiffs in similar litigations initiated by other interest holders in the ATP case, only minimally addressed the “inconsistency” issue in their briefs before making their primary arguments under (the more established) Louisiana law.  As a way to sidestep the issue, the plaintiffs argued that the ORRIs, production payments, and net profits interests they received from ATP were not prohibited under OCSLA or other federal law, and that the property law characterization of those interests is not addressed by the OCSLA.  Under their theory, the OCSLA could not be considered inconsistent with Louisiana law, because the OCSLA and other federal laws do not address the characterization of these types of derivative property interests.

The DOJ countered this position head-on.  It argued that if ATP’s mineral interests under the OCSLA were not vested real property rights, then ORRIs and similar derivative interests carved out of ATP’s interests could also not be vested real property rights.  It was, the DOJ argued, a “venerable principle” of property law that one “may not convey more than he owns.”  In other words, the DOJ argued that since ATP holds only leasehold interests or simple contractual payment rights in the OCS leases, it could not have conveyed anything other than that type of property right to derivative holders.  Conversely, if Louisiana law treated the ORRIs and other derivative interests as real property interests, then not only would the ORRI holders have real property rights in the production from the OCS leases, but ATP by definition must have real property rights in the OCS leases.  The DOJ believed the arguments all ended in the same result – irreconcilable inconsistencies between Louisiana law and federal law.

As discussed above, the plaintiffs in the NGP-ATP litigation (and related litigations considering the same issues) largely chose not to address the DOJ’s position that Louisiana state law is inconsistent with the OCSLA directly.  Plaintiffs primarily addressed these choice of law considerations insofar as they summarily argued that “surrogate” state law applied under the OCSLA’s “gap filler” provision.  In the end, the decision not to spend significant energy addressing the alleged “inconsistencies” between state and federal law was effectively validated in the summary judgment opinion of the court.

The Court’s Ruling in the NGP-ATP Litigation Leaves Questions Unanswered

The ATP court has provided one significant memorandum opinion thus far in the NGP-ATP litigation.  That opinion, decided on a summary judgment standard, was expected to address the unexpired leases/executory contracts question as part of what it referred to as the “first phase” of a bifurcated adversary proceeding.  Unfortunately, the court elected to not tackle the OCSLA issues in a substantial way, preferring instead to focus the majority of the opinion on recharacterization issues.

After a brief discussion regarding the choice of law arguments of ATP and the DOJ in the background section of the opinion, the court elected to summarily apply Louisiana law. The only portion of the holding that approached this contentious issue stated, “[u]nless Louisiana law is inconsistent with federal law on the issues in this adversary proceeding, Louisiana law is applicable to this dispute.”  There was no additional analysis offered, and it appears that the court assumed there was no inconsistency between Louisiana law and federal law.  Exactly how the court reached this conclusion and how future litigants will choose to utilize this precedent, however, remains decidedly uncertain.

Conclusion

OCS leases represent a growing portion of the oil and gas production in the United States, but unfortunately, how they should be characterized remains largely unaddressed.  Given the opportunity to address the issue head-on, both the plaintiffs and the ATP court deflected on the subject, leaving bankruptcy practitioners with another hazy oil and gas issue to sort out in the future.  Until such time as these questions are addressed head-on, those in the restructuring field can expect to fight the same battles the next time a significant offshore E&P company files for chapter 11 protection.