In re Johnson

• Decision Date: 02 July 2014
• Docket Number: No. 13–40605.,13–40605.
• Parties: In re Jerry Ray JOHNSON, Darla Kay Johnson, Debtor(s).
• Court: U.S. Bankruptcy Court — Southern District of Illinois

513 B.R. 333

In re Jerry Ray JOHNSON, Darla Kay Johnson, Debtor(s).

No. 13–40605.

United States Bankruptcy Court,

S.D. Illinois.

Signed July 2, 2014.

Keith W. Kibler, Marion, IL, for Debtors.

OPINION

KENNETH J. MEYERS, Bankruptcy Judge.

A dispute has arisen between the chapter 7 trustee and the debtors over whether certain property belonging to the debtors is property of the bankruptcy estate that must be turned over to the trustee. The initial inquiry raised by the trustee's motion for turnover involves whether Jerry Johnson's “working interest” in an oil well, and the revenue received upon sale of extracted oil, is property of the bankruptcy estate or income to the debtors. A second inquiry focuses on whether property held in a trust belongs to the bankruptcy estate. A last inquiry addresses whether equitable considerations may govern the Court's determination as to the other two issues before it.

Oil and Gas Working Interest

The trustee seeks turnover of all indicia of debtor Jerry Johnson's 11/32nds “working interest” in an oil well, and of all the revenue received by Jerry Johnson from that oil well since the commencement of the chapter 7 case on May 30, 2013. According to the trustee, the “working interest” is an interest in real estate and the extracted oil and the funds produced from the extracted oil are proceeds of that real estate interest. The debtors dispute the trustee's analysis that Jerry Johnson's “working interest” is realty. They concede that the “working interest” is personal property,¹ yet contend that it is a contractual right to payment that must be treated as income and, therefore, is protected from the trustee's reach.

The following facts are not in dispute. On March 5, 1980, Raymond W. Clayton entered into an Agreement pursuant to which he became the lessee and operator under an oil and gas lease of indefinite duration (Clayton Lease). On September 3, 1982, Raymond Clayton d/b/a Clayton Enterprises entered into an Agreement and Receipt calling, among other things, for Raymond Clayton, as Operator, to drill a well for oil and gas exploration and for Jerry Johnson, as an Interest Holder, to pay Raymond Clayton a sum of money to complete the well if it appeared productive. Under this Agreement and Receipt, at ¶ 6, Raymond Clayton, as operator, expressly “reserve[d] the right to operate and manage the said premises herein in behalf of all INTEREST HOLDERS.” On November 27, 1982, Raymond W. Clayton d/b/a Clayton Enterprises assigned a 5/16 “workinginterest” in the Clayton Lease to Jerry Johnson. On August 14, 1985, Cecil D. Karnes and Bobbie A. Karnes assigned a 1/32 “working interest” in the same oil and gas lease to Jerry Johnson. There is no indication from the documents of record that Jerry Johnson is a lessee or operator under an oil and gas lease. Rather, the documents reflect that he became an “Assignee” under each “Assignment Oil and Gas Lease.”

On June 7, 2012, the debtors filed a chapter 13 case in this District which was dismissed on February 4, 2013, without a confirmed plan. The debtors contend that during the course of the chapter 13 case, they were allowed to keep the income derived from Jerry Johnson's working interest in the oil and gas lease.

On May 30, 2013, the debtors filed the instant chapter 7 case. On their schedule of personal property, Schedule B, the debtors listed Jerry Johnson's oil interest as follows:

Approximately 34% ( 11/32nds) of working oil well

Operated by Bi–Petro ²

Receives $924.45/month income ³

The debtors have provided no evidence to show that the income at issue is earnings from services performed by either of them after the commencement of the bankruptcy case.

While the Bankruptcy Code, 11 U.S.C. § 541(a), sets the parameters of what property is included in the bankruptcy estate, the nature of an interest in property is defined by state law. E.g., In re Chenoweth, 132 B.R. 161, 164 (Bankr.S.D.Ill.1991)aff'd,143 B.R. 527 (S.D.Ill.1992)aff'd,3 F.3d 1111 (7th Cir.1993). This Court has previously held that, in Illinois, oil and gas interests have a hybrid character involving both real and personal property components. In re Fullop, 125 B.R. 536, 539 (Bankr.S.D.Ill.1990)aff'd,133 B.R. 627 (S.D.Ill.1991)aff'd as modified, Matter of Fullop, 6 F.3d 422 (7th Cir.1993). In Fullop, this Bankruptcy Court found:

As a general rule in Illinois, oil and gas in place constitutes land or real estate and belongs to the owner of the land so long as it remains under the land. Miller v. Ridgley, 2 Ill.2d 223, 117 N.E.2d 759 (1954); see 26 I.L.P. Mining, Oil, and Gas, § 12 (1956). An Illinois oil and gas lease, while not granting title to the oil itself, grants to the lessee the right to enter upon the surface of the land and to reduce the oil and gas to the lessee's possession. Ohio Oil Co. v. Daughetee, 240 Ill. 361, 88 N.E. 818 (1909). Because such a lease concerns the right to oil prior to extraction, Illinois courts classify an oil and gas leasehold as a freehold or real estate interest subject to real estate law. In re Hanson Oil Co., Inc., 97 B.R. 468 (Bankr.S.D.Ill.1989).

Once oil reaches the surface and is reduced to possession, it is considered personalty and its sale and disposition is governed by personal property law. Palumbo v. Harry M. Quinn, Inc., 323 Ill.App. 404, 55 N.E.2d 825 (1944); see Nation Oil Co. v. R.C. Davoust Co., 51 Ill.App.2d 225, 201 N.E.2d 260 (1964): oil pumped out of the ground and stored in tanks is personal property. Thus, while an oil and gas lease itself conveys a real property interest, transactions concerning oil after extraction involve personal property interests subject to rules of personal property law.

Id.

The parties to this dispute agree that Jerry Johnson was assigned a 5/16 “working interest” and later a 1/32 “working interest” in the oil and gas lease operated by Raymond Clayton as lessee under the 1980 conveyance. The nature of that interest, and whether it is property of the bankruptcy estate, however, remains in contest. Neither party has clarified for the Court, by reference to the documents of record, what property interest was conveyed to Jerry Johnson by virtue of the assignments. The phrase “working interest” can be amorphous, taking its shape from the context in which it arises. When the phrase describes a lessee's interest as the operator under an oil and gas lease, the term “working interest” includes rights to enter upon the land, to drill the well, to place storage tanks and to pump oil.⁴ These rights to enter upon and use the land for oil exploration and production constitute the real estate component of an oil and gas freehold interest. Matter of Fullop, 6 F.3d at 425. In contrast, the term has a narrower meaning when a lessee/operator assigns a fractional “working interest” under an oil and gas lease, as is the case here. “The phrase ‘working interest’ in an assignment of a fractional working interest under an oil and gas lease has the accepted meaning in the oil industry as the assigning of the fractional portion of the oil and gas produced from the premises, after the royalty for the share paid to the lessor is first deducted.” Monica C.M. Leahy, Assignment of Lease; Transfer, 26 Illinois Law and PracticeMining, Oil & Gas § 64 (Thomson Reuters May 2014) (citations omitted) ( database available on Westlaw ).

The Court finds that a freehold interest in real estate was not assigned to Jerry Johnson because none of the documents of record reveal that Mr. Johnson was granted the rights “to enter upon the surface of the land and to reduce the oil and gas to [his] possession,” In re Fullop, 125 B.R. at 539, that is the sine qua non of a freehold estate in oil and gas.⁵ Raymond Clayton expressly reserved the rights to operate and manage the premises for himself in the Agreement and Receipt and the trustee has pointed to nothing in the documents of record to show otherwise. Based on the accepted usage of the phrase as well, the Court concludes that Jerry Johnson's “working interest” does not include a real estate component. Having determined that Jerry Johnson does not have a freehold interest by virtue of the conveyances to him, the Court need not revisit the question posed by the trustee of whether the extracted oil and the profits from its sale constitute a proceed or product of the real estate interest.⁶

The Court turns next to the nature of the debtor's personal property interest in the oil and gas assignment. In this regard, Illinois law is conclusive that an oil and gas lease of indefinite duration—as is the case here—does not confer title of the oil and gas upon the lessee while the oil and gas remain in the ground. Title does not transfer from the lessor to the lessee until the oil and gas are found and in the possession of the lessee. As explained in a well known encyclopedia of Illinois law,

an oil and gas lease granting the right to enter and occupy premises for the purpose of searching for oil and gas and reducing any oil and gas found to possession confers on the lessee a freehold estate or interest in the real estate if it is of indefinite duration. However, such a lease does not work a severance of the oil and gas from the surface rights, nor does it grant or convey to the lessee any interest in the oil and gas in the ground, as title to it remains in the lessor until oil and gas is found and reduced to the lessee's possession.

26 Illinois Law and PracticeMining, Oil & Gas § 59, at 740–41 (West Group 2002) (footnotes omitted). As a result, the debtors are correct that Jerry Johnson has a personal property interest in a commodity—oil and gas—that arises upon its removal from the ground when it is reduced to the lessee's possession.

But that is not the end of the matter. Oil and gas leases, and assignments of fractional interests in oil and gas leases, are contracts. See, e.g., Bi–County Properties v. Wampler, 61 Ill.App.3d 799, 18 Ill.Dec. 847, 378 N.E.2d 311, 314 (1978); ...