Question: The borrower pledged oil and gas rights related to the collateral property to the lender. The borrower has notified the servicer that it would like to sell these oil and gas rights. Can the lender approve the lease or sale of oil and gas rights and, if so, what issues must the servicer consider?
Answer: Yes, the lender can approve the lease or sale of oil and gas or other mineral rights pledged as collateral provided that the transaction (i) complies with REMIC requirements, (ii) is an acceptable loan modification under the applicable Pooling and Servicing Agreement, and (iii) is otherwise an acceptable loan modification from a credit and servicing standard perspective.
From a REMIC perspective, the sale or lease of oil and gas or other mineral rights should be analyzed as a release of collateral for the borrower’s loan. The simplest way for the servicer to confirm REMIC compliance with respect to the borrower’s request is to establish that the loan will be deemed to be “principally secured” by an “interest in real property” following the release of any collateral. This analysis will require the servicer to confirm the value of the loan collateral following the release. See Tom Biafore and Steve Edwards, “MODERN DAY ALCHEMY—MODIFYING QUALIFIED MORTGAGES IN REMICS” in the 2017-18 edition of the Servicer Survival Guide for a discussion of REMIC issues associated with the release of loan collateral.
If the servicer can confirm REMIC compliance and that the borrower's request is permissible under the Pooling and Servicing Agreement, the credit issues to consider are similar to those reviewed in a partial release transaction. In addition to analyzing the effect of the transaction on the value of the property, requirements for deposit and disbursement of any funds received and other standard credit items, the servicer will consider additional issues related specifically to the nature of an oil and gas sale or lease. Activities related to the exploration and development of oil and gas, particularly drilling and extraction activities, could cause leaks of chemicals, drilling fluids, or other contaminants into the soil, nearby rivers and groundwater, or otherwise cause environmental damage. Because of the risks inherent to oil and gas extraction operations, safety standards are high and are strictly regulated in most jurisdictions. As a condition to permitting a borrower to enter into an oil and gas lease or sale, we recommend that the lender require broad indemnification from the borrower and a guarantor with substantial net worth with respect to any liabilities, including personal injury, property damage, or environmental damage, that may arise in connection with the operations and exploration or development activity on the real property. As a result of the increased risk, additional reserves or collateral to cover any losses or costs should also be considered.
In considering any request for approval of a transfer of oil and gas rights, the servicer must carefully review the documents to confirm the parties’ responsibilities and the conditions for exploration, drilling, and operations. While often the transaction will be noted as a lease transaction, exclusive ownership rights are typically transferred with the right to explore, drill, or operate for oil and gas. The owner of the oil and gas rights can generally access and use the surface property in a manner that is reasonable and necessary to recover the oil and gas. In practice, the borrower can impose additional restrictions on the use of the surface property, such as prohibitions on certain kinds of structures, limitations for access to the surface property, and requirements regarding the placement of drilling operations and wells. In deciding whether to consent to an oil and gas lease or sale, the servicer may wish to consider the current use of the surface property and any ability the lender may have to require a borrower to restrict exploration or development activities or structures that would impede the current use or impair the value of the surface property. In addition, lease/transfer documents will typically contain express restrictions that could affect the borrower’s use of its property and the lender’s interest that should be carefully evaluated. Often, the document provisions expressly limit the use of the surface property or impose transfer restrictions. Even if the use of the surface property is not expressly restricted by the lease/transfer documents, the oil and gas owner’s access and rights regarding the surface property may be an issue for the borrower and lender, particularly if the oil and gas exploration and production operations are expected to be disruptive.