In re AURORA OIL

• Decision Date: 14 September 2010
• Docket Number: Bankruptcy No. DT 09-08254.,Adversary No. 09-80518.
• Citation: 439 B.R. 674
• Parties: In re AURORA OIL & GAS CORPORATION, Debtor. Frontier Energy, LLC, Plaintiff, v. Aurora Energy, Ltd., Defendant.
• Court: U.S. Bankruptcy Court — Western District of Michigan

439 B.R. 674

In re AURORA OIL & GAS CORPORATION, Debtor.Frontier Energy, LLC, Plaintiff,

v.Aurora Energy, Ltd., Defendant.

Bankruptcy No. DT 09-08254.

Adversary No. 09-80518.

United States Bankruptcy Court,W.D. Michigan.

Aug. 13, 2010.

Order Denying Reconsideration Sept. 14, 2010.

COPYRIGHT MATERIAL OMITTED.

D. Andrew Portinga, Miller Johnson, Grand Rapids, MI, Marc N. Swanson, Timothy A. Fusco, Miller Canfield Paddock and Stone PLC, Detroit, MI, for Plaintiff.

Charles N. Ash, Jr., David R. Whitfield, Stephen B. Grow, Warner Norcross & Judd, LLP, Grand Rapids, MI, Scott A. Storey, Webb A. Smith, Foster, Swift, Collins & Smith PC, Lansing, MI, for Defendant.

OPINION AND ORDER REGARDING APPLICABILITY OF 11 U.S.C. § 365 TO OIL AND GAS LEASES

SCOTT W. DALES, Bankruptcy Judge.

[1] Plaintiff Frontier Energy, LLC (“Frontier” or “Plaintiff”) and Defendant Aurora Energy, Ltd. (“Aurora” or “Defendant”) ¹ are parties to two oil and gas leases referred to in this adversary proceeding as the Hudson Agreement and the Corwith Agreement (collectively the “Agreements”). Long before Aurora filed a voluntary petition for relief with this court, the parties were embroiled in litigation over their respective rights under the Agreements, principally those regarding royalty payments that Frontier claims Aurora owes. When Aurora filed for relief in this court, the dispute became more complicated by the applicability of 11 U.S.C. § 365 (“ Section 365”). The issue initially arose in connection with the confirmation hearing on Aurora's reorganization plan, but the parties agreed to resolve the controversy through this adversary proceeding. Frontier has since filed a motion for partial summary judgment to resolve issues related to the Agreements and Section 365 (the “Motion,” DN 124). ² Frontier contends that the Agreements qualify as unexpired leases or, at least, executory contracts as a matter of Michigan law, within the purview of Section 365. Aurora, in contrast, argues that, as a matter of economic reality and Michigan law, the Agreements are neither leases nor executory contracts. Instead, each represents an executed sale of oil and gas, conveying an interest in the oil and gas and the real estate akin to a determinable fee.

Should the court determine that the Agreements are either unexpired leases or executory contracts, Aurora will have to assume or reject them. If Aurora elects to assume one or both of the Agreements, it will have to cure all defaults. If instead, Aurora rejects the Agreements, then Frontier's resulting claim will share a limited fund, pro rata, with other unsecured creditors.

There are no factual disputes affecting this issue, and the decision depends entirely on the court's legal analysis. If Michigan treats a lessee's interest in an oil and gas lease as an interest in real estate (rather than personalty), and if the lessee's interest is not a freehold interest, then the Agreements qualify as “leases” within the meaning of Section 365.

After carefully considering the parties' oral and written arguments, including the amicus curiae brief of Michigan's Department of Natural Resources and Environment, the court will grant Frontier's Motion.

ANALYSIS

[2] In order to prevail on this Motion, Frontier must establish that the Agreements are either “unexpired leases” or “executory contracts” within the meaning of Section 365. ³

1. “Unexpired Lease” Analysis

[3] [4] The meaning of the term “lease” is a question of federal law, informed to a considerable extent by state law principles the court is bound to respect. Terrell v. Albaugh (In re Terrell), 892 F.2d 469, 471-72 (6th Cir.1989). ⁴

Though Section 365 does not give much guidance on the meaning of these key terms, it expressly provides that “leases of real property shall include any rental agreement to use real property.” 11 U.S.C. § 365(m); see also In re Gasoil, Inc., 59 B.R. 804, 807 (Bankr.N.D.Ohio 1986).

[5] [6] [7] [8] Michigan law plainly provides that the right to grant oil and gas leases originates with the holder of the land in fee simple. Winter v. Mackie, 376 Mich. 11, 135 N.W.2d 364 (1965). Similarly, Michigan regards the rights conveyed under oil and gas leases as interests in real estate. Jaenicke v. Davidson, 290 Mich. 298, 287 N.W. 472, 474 (1939). Although the ultimate object of the transaction between Aurora and Frontier is the extraction of oil and gas, an oil and gas lease does not grant an interest in the oil and gas qua personalty, only the right to extract it from the land. Indeed, only after the oil or gas is severed from the realty does it become personal property under Michigan law. ANR Pipeline Co. v. 60 Acres of Land, 418 F.Supp.2d 933, 940 (W.D.Mich.2006). The Michigan Court of Appeals explained that the interest of an oil and gas lessee is regarded as a profit á prendre, an interest in the real estate, but not an interest in the oil and gas itself, at least not until the oil and gas are extracted. VanAlstine v. Swanson, 164 Mich.App. 396, 417 N.W.2d 516, 520 (1987) ( profit á prendre “transfers no present interest in the minerals in place.”).

The Michigan Supreme Court's opinion in Energetics Ltd. v. Whitmill, 442 Mich. 38, 497 N.W.2d 497 (1993), is not to the contrary. In this relatively recent pronouncement, the Supreme Court observed that an oil and gas lease “is a transfer of an interest in oil and gas,” but for this proposition the court cited Jaenicke, a case that clearly characterized oil and gas rights as interests in real estate until extracted. Energetics, Ltd., 497 N.W.2d at 502 ( citing Jaenicke); Jaenicke, 287 N.W. at 474 (oil and gas rights under oil and gas lease are “part of the realty until severed therefrom.”). The Energetics court explained the operation of oil and gas leases in Michigan:

The typical lease grants the lessee the exclusive right to enter the land to explore, drill, and produce oil and gas. 1 Williams & Meyers, Oil & Gas, § 202.1, p 21. The lessor retains a reversionary interest in the mineral estate. See 3A Summers, Oil and Gas, § 601, p 310; Lampman, Oil and Gas Royalty, 42 Mich. St B J 27 (March, 1963). At termination of such a lease, the oil and gas rights revert to “the grantors of the lease, their heirs or assigns.” Jupiter Oil Co. v. Snow, 819 S.W.2d 466, 468 (Tex.1991); Kaiser v. Love, 163 Tex. 558, 560, 358 S.W.2d 586 (1962). It is evident that the transfer of an interest in oil and gas occurs both when a lease takes effect and when the leasehold interest reverts to the interest owner upon termination of the lease.

Energetics, Ltd., 497 N.W.2d at 502 (footnotes omitted). Significantly, the Supreme Court characterized the reversionary interest as a “leasehold” interest that reverts to the “interest owner,” even though it cited Texas law which generally treats a lessee's interest as a fee.

Similarly, when confronted with the question of whether the rights of a lessee under a Michigan oil and gas lease qualify as a fee interest subject to a wife's claim of dower, the court concluded that such interests did not qualify as fee interests. The Supreme Court reasoned that a lessee under an oil and gas lease is “but a lessee for a determinable term and [is] not seised of an estate of inheritance” within the meaning of Michigan's dower statute. Redman v. Shaw, 300 Mich. 314, 1 N.W.2d 555, 556-57 (1942). The high court's discussion of “seisen” as a condition of a freehold tenure, and its conclusion that an oil and gas lessee is not “seised” of any interest, ⁵ persuades the court that Michigan treats a lessee's interest as a leasehold or profit á prendre, but not a freehold estate. In this significant respect, Michigan departs from the law of Texas and several other oil and gas states that apparently regard a lessee's interest under an oil and gas lease as a freehold or fee.

[9] At oral argument, Aurora argued, based on the U.S. Supreme Court's recent decision in Hamilton v. Lanning, --- U.S. ----, ----, 130 S.Ct. 2464, 2471, 177 L.Ed.2d 23 (2010), that “[w]hen terms used in a statute are undefined, we give them their ordinary meaning.” See Transcript of Oral Argument Held July 28, 2010 at pp. 35-36 & 49 (DN 187). Although Section 365(m) does attempt to define the term “lease,” the definition is somewhat circular, as Judge Wedoff has noted, because the term “rental agreement” is generally understood to mean “lease.” In re Resource Technology Corp., 254 B.R. 215, 225 (Bankr.N.D.Ill.2000). Because, as the parties agree, the term “lease” as used in Section 365 is not fully defined, the court should consider its ordinary meaning. Lanning, 130 S.Ct. at 2471; American Tobacco Co. v. Patterson, 456 U.S. 63, 68, 102 S.Ct. 1534, 71 L.Ed.2d 748 (1982).

[10] Judge Wedoff observed that a lease is commonly understood to mean:

[1] an agreement by the owner of property (the lessor) to allow exclusive possession of that property by another person (the lessee), [2] for a defined period of time, [3] in exchange for payment (“rent”) by the lessee, [4] with the property reverting to the lessor at the end of the lessee's period of possession.

Resource Technology Corp., 254 B.R. at 225-26 (citing Black's Law Dictionary 889 (6th ed. 1990)). The Agreements between Frontier and Aurora, though obviously touching the arcane area of oil and gas law, fall within this common understanding.

First, the Agreements recite, and no one appears to disagree, that prior to the execution of the Agreements Frontier was the owner of the subsurface mineral estate, and both Agreements plainly grant Aurora exclusive possession and control.

Second, the Agreements grant Aurora exclusive use for a defined period of time-the initial term and thereafter so long as oil and gas are produced in “paying quantities.” The fact that the duration may be difficult to ascertain does not disqualify Aurora's interest as a leasehold because “oil and gas cannot be produced forever ...” Redman, 1 N.W.2d at 557. The term of...