The Oil and Gas Addendum

The question of whether a sale of real estate includes the underlying gas rights remains a troubling issue for some Pennsylvania landowners. For example, let’s assume your family decides to buy a 135 acre farm in Tioga County from Mr. Jones. He had only owned the farm for three years and was ready to sell and move to warmer weather in Florida. The agreement of sale does not mention or reference the oil and gas rights and you assume that the sale includes both the surface and the underlying oil and gas. A deed is then prepared, signed at the closing and is subsequently recorded at the courthouse. The deed does not except or reserve the oil and gas rights. Several months later, you discover that The Franklin Family Trust leased the oil and rights to Big Oil Inc. You contact Big Oil Inc and inform them that the lease must be a mistake because you own the oil and gas rights. They disagree and tell you that the oil and gas rights were actually reserved in 2018 by the Franklin Family Trust when they sold the farm to Mr. Jones. You argue that no title search revealed any recorded instrument in the chain of title severing the oil and gas from the surface. How is it possible that someone else now owns the oil and gas? Big Oil Inc. then informs you that the original (and unrecorded) agreement of sale between the Franklin Family Trust and Mr. Jones in 2018 specifically excepted the “mineral rights” from the transfer but that the subsequent recorded deed erroneously omitted this exception. Can the oil and gas rights be severed by an unrecorded instrument in your chain of title? A recent case from the Pennsylvania Superior Court suggests that they can.

At issue in Walters v. McIlvee were several transactions and deeds concerning 220 acres of real estate in Harrison Township, Potter County, Pennsylvania (the “Subject Property”).  On May 12, 2003, the Walters entered into an agreement of sale with the McIlvees concerning the Subject Property (the “2003 Agreement”). The 2003 Agreement specifically excepted and reserved all “oil, gas and mineral rights” from the sale (the “Walters Reservation”). Despite the presence of the Walters Reservation in the 2003 Agreement, the deed recorded on July 10, 2003, did not except or reserve the oil, gas and mineral rights. This was apparently due to a scrivener’s error by the closing attorney. No one discovered this error until long after the deed was recorded.

In 2004, the McIlvees then conveyed approximately 130 acres of the Subject Property to the Howells (the “Howell Acreage”). The agreement of sale between the McIlvees and the Howells contained a handwritten notation which stated that “…[I]f all mineral rights are excluded, buyer has the option to declare the contract null and void or choose to purchase as is”. (the “McIlvee-Howell Agreement of Sale”). There was a second handwritten notation which then said “no mineral rights included in purchase, timber rights are included in purchase.” The subsequent deed which was recorded did not mention the oil and gas rights but also did not except or reserve the oil, gas and mineral rights from the transaction. Given the absence of an oil and gas exception and reservation clause in the deed, the Howells reasonably assumed that the oil and gas rights, as opposed to the “mineral” rights, did transfer to them as part of the conveyance.

In the summer of 2007, the McIlvees were contacted by Chesapeake Appalachia LLC (“CHK”) about a lease concerning the oil and gas underlying the Howell Acreage. The McIlvees informed CHK that they did not believe that they owned those oil and gas rights.  Nonetheless, the McIlvees and CHK entered into an oil and gas lease in September 2007 (the “McIlvee-CHK Lease”).

Several years later, the Walters discovered the scrivener’s error in the July 10, 2003 deed and also learned of the McIlvee-CHK Lease.  In 2013, the Walters brought suit against the McIlvees seeking reformation of the July 10, 2003 deed and unjust enrichment arising out of the improper McIlvee-CHK Lease. The Walters argued that the terms of the Walters Reservation should be enforceable despite their absence in the July 10, 2003 deed and the so-called doctrine of merger. During the trial court proceedings, Mr. McIlvee testified at his deposition that he informed the Howells of the unrecorded Walters Reservation and that the oil and gas rights would not be transferred in connection with the Howell Acreage because he simply did not own them. This oral testimony was corroborated by the hand-written notations on the McIlvee- Howell Agreement of Sale. The Howells disputed this evidence and claimed they had no notice of the unrecorded Walters Reservation.

Nonetheless, the trial court found the Walters’ evidence credible and compelling and entered an order reforming the July 10, 2003 deed to reflect the purported intent of the unrecorded Walters Reservation.  The trial court also ruled that the McIlvees had been unjustly enriched by entering into the McIlvee-CHK Lease and that all revenue and royalties generated by the lease belonged to the Walters. Finally, and perhaps most significant, the trial court opined that the Howells were not bona fide purchasers under Pennsylvania law and that they did not acquire any oil and gas rights in the Howell Acreage. The Howells appealed the trial court’s ruling to the Pennsylvania Superior Court.

On appeal, the Pennsylvania Superior Court had to wrestle with several competing, and in some ways, contradictory concepts, namely i) the doctrine of “merger”, ii) the equitable remedy of deed reformation and iii) bona fide purchaser status. In order to appreciate and understand the significance of the Walters v. McIlvee decision as it relates to oil and gas rights, a brief review of these concepts is warranted.

The doctrine of “merger” has been a part of Pennsylvania law for over 150 years. In essence, the doctrine provides that any prior agreements or discussions regarding the sale of real estate are subsumed into the recorded deed. Although the doctrine refers to “merger”, it is more accurate to say that the deed supersedes the prior discussions. As one court observed, “[T]he law presumes that delivery and acceptance of a deed consummates the prior agreement and precludes the parties from looking behind the conveyance….” See, Dobkin v. Landsberg, 273 Pa. 174 (1922).  The practical effect of the doctrine of merger is that promises or obligations set forth in the parties’ agreement of sale are generally unenforceable if they are not repeated and memorialized in the subsequent deed.

Conversely, the remedy of reformation is often invoked by parties when there is a clear “mistake” as the material terms or provisions set forth in a recorded deed.  The evidentiary showing necessary to reform a deed is high: the “proof of the mistake must be established by evidence that is clear, precise, convincing and of most satisfactory character”. See, In Re Duncan’s Estate, 426 Pa. 283 (1967). The parties’ intention to the contrary must be “clear and manifest” in order to rebut the legal presumption of merger. In other words, in order to avoid the doctrine of merger and reform a deed, the proponent must generally demonstrate the existence of a clear scrivener’s error- the deed was simply prepared incorrectly and failed to follow or incorporate the parties’ agreement of sale.

Finally, it is well-established that a subsequent purchaser of real estate is entitled to rely on the prior instruments in the recorded chain of title. This protection was codified in 1925 by the enactment of 21 P.S. 351. This statute basically says that if an interest in real estate is not recorded, then such an interest or claim is invalid as to a subsequent purchaser who does not have notice of the interest or claim. As one court observed, “[t]he Pennsylvania recording statute….protects subsequent purchasers by giving a subsequent bona fide purchaser for value without notice of a prior transaction priority over the equitable estate of the first owner…”.  See, Long John Silver’s Inc. v. Fiore , 386 A.2d 569 ( Pa. Super. 1978).  Pennsylvania law, however, recognizes that a purchaser who as actual or constructive notice of the competing interest is not entitled to bona fide purchaser status. See, Overly v. Hixon, 82 A.2d 573 (Pa. Super. 1951)(“Either actual or constructive notice is sufficient to prevent the subsequent purchaser from acquiring the status of a bona fide purchaser”). Constructive notice is not limited to instruments of record and can include unrecorded agreements of sale that are brought to the purchaser’s attention.

In Walters, the Pennsylvania Superior Court had to harmonize all three concepts in connection with the appeal filed by the Howells. The panel opined that, based on the factual record before the trial court, the Howells had actual knowledge of the unrecorded Walter’s Reservation. The court concluded that the handwritten notations on the agreement of sale demonstrated that the parties did discuss the oil and gas rights. That evidence, along with the testimony from Mr. McIlvee, negated the bona fide purchaser presumption:

“…..the evidence of record supports the trial court’s finding that the handwritten language contained in the agreement of sale, taken together with McIlvee’s credible testimony in this regard, evidences that the Howells had notice of [the Walter’s Reservation] prior to their transaction with the McIlvees…….Accordingly, we must affirm the trial court’s verdict that the Howells were not bona fide purchasers….”

It is important to note that the Howells disputed and denied that they had actual or constructive notice of the Walters Reservation or that the oil and gas rights were even discussed with the McIlvees. In support of this position, the Howells further argued that the handwritten notations themselves referred only to “mineral rights”, which under Pennsylvania law, generally does not include oil and gas. In short, the Howells argued that the factual record was unclear and, as such, did not meet the heightened standard to overcome the bona fide purchaser presumption.

The court’s ruling on bona fide purchaser status was, and is, significant: the Howells did not acquire or obtain any oil and gas rights in the Howell Acreage. This result is troubling given the absence of any recorded oil and gas reservation in the chain of title. If the Howells’ version is accurate and they did not have knowledge of the unrecorded Walters Reservation, then the decision is even more alarming. The purpose of recording deeds and other instruments of title is to provide certainty and clarity to the buyer when he or she is evaluating the ownership status of a potential purchase. If the buyer cannot rely upon the recorded chain of title as being conclusive and complete, the entire process will break down.  For example, does Walters now impose an obligation on buyers to research, investigate and contact every prior owner in a particular chain of title to make sure no unrecorded instruments exist? And what level of investigation is required? Can a buyer lose bona fide purchaser status simply because the seller verbally tells the buyer that he recalls someone once told him that the oil and gas rights were severed from the surface seventy years ago? These important questions remain unanswered after Walters.

The Walters panel also rejected the Howells’ argument that the parties’ use of the term “minerals” in the handwritten notations on the McIlvee-Howell Agreement of Sale did not include the oil and gas rights. The Howells argued that under the so-called Dunham Rule, the terms “minerals” typically do not include the oil and gas rights unless there is “clear and convincing” evidence to the contrary. See, Butler v. Charles Powers Estate, 65 A.3d 885 ( Pa. 2013) (“…..the rule in Pennsylvania is that natural gas and oil simply are not minerals because they are not of a metallic nature as the common person would understand minerals”).  Since “minerals” does not mean “oil and gas”, the Howells argued that the notations only demonstrated an intent and understanding to except and reserve the minerals and that the oil and gas would transfer along with the surface.  In rejecting the Howells argument, the Superior Court almost exclusively relied upon the fact that oil and gas development was prevalent in Potter County and that there was little or no coal development. The author submits that it is debatable whether such attenuated evidence meets the “clear and convincing” standard required to rebut the Dunham Rule. Nonetheless, buyers and sellers alike should remain mindful of the Dunham Rule and how it can dramatically shape the nature and scope of a transaction.