The Oil and Gas Addendum

The fine print in an oil and gas lease can have some serious repercussions for an unwary landowner. One of the fine print clauses that often gets overlooked and ignored during lease negotiations is the warranty clause. Here’s how that clause often comes into play. Let’s assume that your family has owned a 150 acre farm in Butler County since the early 1900s. Although no well was ever drilled on the farm, your grandfather always told you that the family “owned everything…. including the oil and gas rights.” In 2013, your grandfather signs an oil and gas lease with a prominent driller and receives $2,000 per acre as the “signing bonus.” In 2016, your grandfather passes away. As the executor of his estate, you are puzzled when you receive a letter from the driller demanding that $280,000 of the signing bonus be repaid. You call the driller and the landman informs you that your grandfather breached the “warranty” set forth in the lease and now the driller wants its money back. You press further and the landman explains that your grandfather only owned 10 acres of oil and gas rights, not the 150 acres as he thought. You are shocked, frustrated and concerned. The estate simply does not have $280,000 to repay the driller. Can the driller actually pursue such a claim years after the lease is signed and the bonus has been paid? The short and alarming answer is yes.

The consequence of breaching a warranty clause in an oil and gas lease was recently addressed by the Pennsylvania Superior Court in Pennsylvania General Energy Company v. Hershey (908 WDA 2016, February 13, 2017). In Hershey, the landowner signed an oil and gas lease on November 1, 2014 covering 243 acres in Potter County (the 2014 Lease). Paragraph 8 of the 2014 Lease contained a warranty clause:

8. Title and Interests – Lessor hereby generally specially warrants and agrees to defend title to the Leased Premises. Lessor covenants that Lessee shall have quiet enjoyment hereunder. Should any person having title to the Leased Premises fail to execute this Lease, the Lease shall nevertheless be binding upon all persons who do executed it as Lessor.

In February 2015, the driller, Pennsylvania General Energy Company (PGE), tendered the agreed upon signing bonus of $243,520. Shortly thereafter, the landowner cashed the signing bonus check. One month later, PGE received a title opinion noting that the landowner only owned 5.09 acres of oil and gas rights. PGE demanded a return of $238,551 of the signing bonus. When the landowner refused to return or repay the bonus, PGE brought suit under the warranty clause.

In its suit, PGE asserted that the landowner had breached the “special warranty” set forth in Paragraph 8 of the 2014 Lease. A “special warranty” is a covenant made by the lessor to defend the lessee against encumbrances or clouds on the oil and gas title created by the lessor during his ownership of the estate. The protection offered by this warranty is therefore limited to those title defects caused or created by the lessor himself. In contrast, a “general warranty” obligates the lessor to defend the oil and gas title against any and all claims, including those that are based on prior owners and conveyances. The protection afforded by the general warranty is much broader and is without regard to the origin or cause of the defect. The landowner is, in effect, on the hook for any encumbrance or cloud that exists on the oil and gas title.

A lessee who has been given a warranty in an oil and gas lease, whether general or special, may sue for a breach only if there has been an actual or constructive eviction. In the context of an oil and gas lease, the mere existence of a cloud on the title can operate as a constructive eviction. See, Derrickheim Co. v. Brown, 451 A.2d 477 (Pa. Super. 1982) (noting that tax sale defect constituted a cloud on the oil and gas title which operated as constructive eviction of lessee); see also, Ralston v. Thacker, 932 S.W.2d 384 (Ky. Ctr. of Appeals 1996) (observing that prior oil/gas lease “constituted the assertion of an adverse superior or paramount claim of title constructively evicting” the lessee). If the encumbrance or cloud is superior or paramount to the lessee’s oil and gas title under the lease, the lessor has failed to convey “good and marketable title” and is subject to liability under the lease’s warranty clause.

In Hershey, PGE argued that because the landowner previously conveyed the oil and gas rights underlying 237.98 acres to the Sherwood family in 1989, he essentially created and caused the title defect. Since the title defect (i.e., no present ownership to the 237.98 acres) was caused by the landowner and occurred during his purported ownership of the oil and gas estate, the special warranty set forth in Paragraph 8 was implicated. The landowner breached this warranty when PGE was constructively evicted and he failed to repay and return the signing bonus. The trial court agreed with PGE and entered judgment in PGE’s favor for $238,551.

On appeal, the landowner tried to avoid liability under Paragraph 8 by asserting that the 2014 Lease never became operative. Specifically, the landowner argued that because PGE did not “complete a record title search” before tendering the signing bonus as contemplated by the order of payment, the 2014 Lease never became binding or enforceable. In the landowner’s view, the contract “was never formed and the [2014 Lease] never became operative before PGE made a voluntary payment to [Landowner] for which [PGE] has no legal basis to seek reimbursement.” The Superior Court rejected the landowner’s strained argument and held that the 2014 Lease became binding and enforceable upon execution. The Hershey panel opined that the timing mechanism set forth in the order of payment (i.e., requiring PGE to tender payment “within 60 business days of receipt of the agreement”) did not create a condition precedent to the formation of a valid agreement. As such, the landowner’s effort to avoid the effect of Paragraph 8 was unavailing.

The Hershey decision serves as a stark reminder of how warranty clauses can come back to haunt a landowner. Ideally, when negotiating an oil and gas lease, a landowner should resist and oppose the insertion of any warranty language. Unless the landowner is willing to conduct his or her own title search to verify the oil and gas title, the inclusion of a blanket warranty clause can be risky. If the lessee demands a warranty, the landowner should only give a “special warranty” and should also try to mitigate or cap the exposure risk by limiting the recoverable damages.