The Oil and Gas Addendum

Landowners are often alarmed and angered when they receive word that the oil/gas lease they executed several years ago, after months of intense and personal negotiations, has been assigned to an unknown, unfamiliar gas operator. This anxiety is amplified when the landowner’s phone calls or letters go unanswered, the royalty checks are late or are not made at all and the once well-maintained well pad site is now overgrown and in a state of disrepair. Can the landowner seek redress against the original gas operator? A federal court in Pittsburgh recently addressed this issue and suggested that the assignment of an oil/gas lease may not relieve the original gas operator from liability. This decision could impact thousands of leases throughout the Commonwealth of Pennsylvania. Given the potential impact of this decision, landowners and gas operators alike should carefully review the assignment clauses in their leases and re-evaluate liability risks in light of the federal court’s opinion in Rice v. Chesapeake Energy Corp., et al., 2012 WL 3144318 (W.D. Pa., August 1, 2012).

The Rice case was originally filed on March 5, 2012 in the Court of Common Pleas of Greene County by the landowners, James and Veronica Rice (“State Court Action”). The State Court Action arose out of the oil/gas lease the Rices signed with Dale Property Services Penn, LP (“DPS Penn”) on November 24, 2009 (the “Lease”). Since DPS Penn had subsequently assigned the Lease to Chesapeake Energy Corp. (“Chesapeake”), the Rices also named Chesapeake as a defendant in the State Court Action. The Rices’ Complaint alleged various claims against both DPS Penn and Chesapeake, including trespass, unauthorized access roads, crop damage and failure to pay the well pad drilling fees.

On March 25, 2012, Chesapeake sought to “remove” the State Court Action to the federal court sitting in Pittsburgh, Pennsylvania. Generally, a defendant such as Chesapeake may “remove” an action to federal court only if there is complete “diversity of citizenship” between the parties – i.e., each plaintiff and defendant must be from different states. Although both the Rices and DPS Penn were Pennsylvania citizens, Chesapeake and DPS Penn argued that because DPS Penn had assigned the Lease to Chesapeake, there could be no liability against DPS Penn and, as such, DPS Penn’s citizenship could be ignored and the case should proceed in federal court. The Rices opposed removal on the grounds that, under Pennsylvania law, the mere assignment of the Lease did not automatically extinguish DPS Penn’s liability and, therefore, the claims against DPS Penn remained viable. The federal court agreed with the Rices and sent the State Court Action back to Greene County.

The Rice decision illustrates the complex and unique nature of oil/gas leases. DPS Penn argued that the Lease should be treated solely as a property conveyance. If viewed solely as a conveyance, the promises and covenants set forth in the Lease “run with the land” and can only be enforced against the party in possession of the property at the time of the alleged breach. Pennsylvania law has long observed that “privity of estate” must exist in order to enforce lease or deed covenants. See, Conti v. Duve, 15 A.2d 494, 495 (Pa.Super. 1940) (liability of lessee “grows out of privity of estate [and] ceases when the privity ceases. If he has assigned before the time of performance, his liability would have ceased with his title, and liability would have attached to his assignee…”); See also, Goldberg v. Nicola, 178 A. 809, 813 (Pa. 1935) (“the covenantor of … an easement or a benefit attached to land is not liable after parting with his title …”). Under this analytical framework, DPS Penn maintained that since the Lease was assigned to Chesapeake, “privity of estate” was lacking and, therefore, the covenants could only be enforced against Chesapeake.

The Rices contended, however, that under Pennsylvania law, when it comes to the effect of an assignment, oil and gas leases are treated the same as any other contract. According to the Rices, oil/gas leases contain both “land use and contractual attributes” and that absent consent and release by the lessor, a lessee retains liability even after an assignment. Since the Rices never formally released DPS Penn from the original lease covenants, the Rices contended that the Lease covenants could still be enforced against DPS Penn despite the purported assignment. As support for their position, the Rices relied on a Pennsylvania Supreme Court decision from 1889. In Washington Natural Gas Co. v. Johnson, 16 A. 799, 801 (Pa. 1889), the Supreme Court observed “[t]hat [lessee] continued liable notwithstanding their assignment to [assignee] is very clear. The covenant was their own, and their privity of contract with their lessors continued notwithstanding their assignment of the lease.” Importantly, the Washington Natural Gas court did not require “privity of estate” and enforced the covenants against the original lessee:

“…although their assignment had divested them of the lease, it could not relieve them from their contract.”

See, Washington Natural Gas, 16 A. at 801. The Rices maintained that, despite being over 120 years old, the Washington Natural Gas decision had never been overturned or reversed and remained the law of Pennsylvania. As such, the Rices argued that, contrary to DPS Penn’s assertion, “privity of estate” is not required and the claims against DPS Penn could move forward.

In remanding the State Court Action back to Greene County, the federal court was compelled to follow the rule set forth in Washington Natural Gas. The court observed that the “advanced age of the [Pennsylvania Supreme Court’s] doctrinal rules does not, in and of itself, make them inapplicable.” Rice, 2012 WL 314318 at 5. Since the Washington Natural Gas rule does not require “privity of estate”, the lease covenants could still be enforced against DPS Penn despite the assignment to Chesapeake. The Rice court observed that remand to Greene County was appropriate even through “it is entirely possible, that in state court, [DPS Penn’s] theories to defeat the claims asserted against it will ultimately prevail.” Id. In light of this ruling, the litigation against DPS Penn and Chesapeake will now proceed in Greene County as opposed to federal court.

Although the Rice court did not rule on the actual merits of the Rices’ claims against DPS Penn, the decision is nonetheless significant because it recognizes those claims as being viable against the original lessee. What can we take away from the Rice decision? Unless the lessor specifically “releases” the original lessee, the mere assignment of the lease to another gas operator may not automatically extinguish the liability of the original lessee. Landowners who may have claims for unpaid rentals, incorrect royalties or surface damage should carefully review the assignment clauses in their respective leases. In the event of an assignment, such claims may be advanced against the original lessee.