Banking and Finance Law Report : Banking & Finance Lawyer & Attorney : Porter Wright Morris & Arthur Law Firm : Bankruptcy, Commercial Lending

The debtor objected to the lease claiming that “(i) there are alleged environmental issues associated with hydraulic fracking; (ii) even without any environmental concerns, the massive machinery and noise would impair the use and enjoyment of the homestead and devalue the Debtors' property (iii) the Debtors' interest in the oil and gas is ‘unsevered’ from the Real Estate; and (iv) in the alternative, [the debtor] is entitled to her Homestead Exemption” from the signing bonus.

The court quickly dispensed with the first two issues finding that the debtor’s claims to environmental issues were “unspecific and unsupported,” and similarly that the debtor had offered “no support for the proposition that the alleged impairment in use and enjoyment and/or diminution in value of the Real Estate is sufficient reason to prohibit the Trustee from maximizing the value of the bankruptcy estate.”

As to the debtor’s third and fourth grounds for objection, the debtor argued that, because the oil and gas rights had not been severed from the debtor’s residential property, such oil and gas rights were subject to her homestead exemption.  Relying on the case of In re Thexton, 39 B.R. 367 (Bankr. Kan. 1984) (applying Kansas law), the debtor argued that the homestead exemption prevented the trustee from entering into the lease.  The court, however, explained that, while under Kansas law, a homestead exemption would apply all future royalty payments under an oil and gas lease, “the homestead exemptions in Kansas and Ohio are in no way similar.” 

Relying heavily on the decision in  In re Loveday, No. 10-64110, 2012 WL 1565479 (Bankr. N.D. Ohio May 2, 2012) (for a discussion of Loveday, see our previous blog post HERE), the court held that, despite a split among Ohio state courts, the better view of the ownership of unextracted oil and gas “recognizes the migratory nature of oil and gas, and requires actual possession to establish ownership of the resource, and the right held by the landowners is the right to reduce the oil and gas to possession or to sever this right for economic consideration” (referred to as the “nonownership theory”).  Thus, under the nonownership theory:

[B]ecause the oil and gas rights cannot be valued until they are either removed from real estate or there is, at minimum, an offer to purchase the right to remove the oil and gas, the Homestead Exemption cannot apply to such rights.  The Homestead Exemption exempts certain property of a debtor—up to a specified dollar amount—from execution by a creditor.  If the oil and gas rights cannot be valued, how can a creditor know if the rights constitute an asset?  How can a creditor execute on unvalued oil and gas rights?  If a value cannot be placed on the property right, how can one know if the specified dollar exemption applies? Indeed, until oil and gas rights are valued by removal of the oil and/or gas or an agreement to remove, it is impossible to ascertain whether such alleged rights have any value.

….

Moreover, the Homestead Exemption does not apply to oil and gas once these resources are severed from the realty because, at that time, such oil and gas become personal property and cannot be part of the homestead.

Furthermore, the court noted that the only real question is whether the signing bonus is subject to the homestead exemption.  The court explained that “[t]he Signing Bonus is separate and apart from the unsevered oil and gas rights,” and held that the signing bonus constitutes personal property.  Because it is personal property, a simple judgment lien would not attach to the signing bonus and in a related fashion, neither would Ohio’s homestead exemption.  Accordingly, the trustee was authorized to enter into the lease.

The Cassetto decision, case like Loveday, serves to highlight the far reaching implications of the determination of whether unextracted oil and gas is owned by the landowner or not.  Different states have answered this question in different ways, and, while Ohio courts are split on the issue, the clear trend among the state’s bankruptcy courts is to recognize the nonownership theory of oil and gas rights, which requires extraction of oil and gas to establish ownership.

Even if a title insurer could be persuaded to remove the aforementioned exceptions, many mineral interests were granted in the first half of the 20th century, which is farther back than the average title search extends. These topics are discussed in-depth in a two-part post published previously on the Oil & Gas Law Report blog.  Read part one and part two. 

Today's topic focuses on what the above changes mean for lenders. The existence of a severed mineral interest or an oil and gas lease is of consequence to lenders because those interests have the potential to significantly decrease the value of the mortgaged property. A severed subsurface mineral interest is the dominant estate when compared to the surface, and impliedly includes the right to use as much of the surface area as is reasonably necessary to enjoy the subsurface rights. Subsurface leases (most often oil and gas leases) will often expressly convey similar rights to the lessee, and could contain terms and conditions rather unfriendly to the surface owner. In practice, this means that the owner of valid subsurface rights on a particular parcel could theoretically build roads, install pipelines or construct a drilling pad on the mortgaged property. Although often the potential for royalties might offset some of this devaluation or risk, the ultimate surface rights claimed by the owner of the mineral estate do have the potential to significantly decrease the value of the mortgaged property. 

How this type of operation could devalue a property should be fairly obvious.  And some leases prohibit the landowner from building on, digging in and even landscaping over a certain portion of the land.  The discovery that such a prohibition exists over a critical portion of the property could severely limit the uses that can be made of the property as well as the number of potential buyers and, in turn, the value of the collateral.

Given the state of affairs in the realm of title insurance, what can lenders do to protect themselves short of refusing to extend credit in resource-rich regions?  Most obviously, lenders can no longer rely on standard title insurance to protect against devaluations in mortgaged land caused by unknown mineral interests, or even to reveal the existence of those interests. Ideally a lender would find a way to persuade a title company to remove the standard mineral exceptions mentioned above; but, unfortunately, that result is exceedingly unlikely and may well be impossible under today's underwriting standards.

Assuming there is no title insurance to be had, lenders should obtain as much information as possible about the mineral interests applicable to the collateral property.  This information can help lenders assess their risk levels with respect to any given property.  For example, lenders should search for a title insurer who will include mineral interests in the title search, even if it refuses to insure against those interests.  And the lender should request that the title search extend back at least 100 years rather than the standard 40 or 60 years.  But both of these additional services will be accompanied by additional fees.

Another option is to retain a company specializing in searches designed to turn up severed interests and oil and gas leases.  However, this option is typically recommended for large-scale projects so it may not be a viable option for lenders who do not issue a large volume of mortgages.  Finally, lenders can search oil well records with the Ohio Department of Natural Resources and/or conduct physical due diligence (i.e., a site walk) to determine whether there are any active wells on the property.

All these options are less than satisfying, and lenders will need to get creative to protect themselves from the hidden perils of undisclosed mineral interests.