Ohio Appellate Court Holds That Oil and Gas Leases Mean What They Say, and Rejects Public Policy Arguments

October 1, 2014

On September 26, 2014, an Ohio appellate court struck down a trial court opinion invalidating an oil and gas lease on public policy grounds, in a ruling that reaffirms traditional principles of lease interpretation and rejects after-the-fact efforts to undo unambiguous leases using ill-defined equitable doctrines or implied contract terms. In Hupp v. Beck Energy Corp., the Seventh District Court of Appeals held that the trial court erred in granting summary judgment to plaintiffs-landowners and declaring the lease null and void, rejecting the trial court’s conclusion that the lease at issue was perpetual and that the defendant-lessee violated an implied duty to develop. Nos. 12 MO 6, 13 MO 2, 13 MO 3, and 13 MO 11 (Seventh Dist. Ct. App. September 26, 2014).

In the mid-to-late 2000s, defendant Beck Energy Corp. entered into oil and gas leases with various Ohio landowners using a preprinted form lease. The form leases contained the following key provisions:

2. This lease shall continue in force and the rights granted hereunder be quietly enjoyed by the Lessee for a term of ten years and as much longer thereafter as oil or gas or their constituents are produced or are capable of being produced on the premises in paying quantities, in the judgment of the Lessee, or as the premises shall be operated by the Lessee in search for oil or gas…

3. This ease [sic], however, shall become null and void and all rights of either party hereunder shall cease and terminate unless, within -12- months from the date hereof, a well shall be commenced on the premises , or unless the Lessee shall thereafter pay a delay rental of [Dollars] each year, payments made quarterly until the commencement of a well. A well shall be deemed commenced when preparations for drilling have commenced.

9. The consideration, land rentals or royalties paid and to be paid, as herein provided, are and will be accepted by the Lessor as adequate and full consideration for all the rights herein granted to the Lessee, and the further right of drilling or not drilling on the leased premises, whether to offset producing wells on adjacent or adjoining lands or otherwise.

17. In the event Lessor considers that Lessee has not complied with any of its obligations hereunder, either express or implied, Lessor shall notify Lessee in writing setting out specifically in what respects Lessee has breached this contract. Lessee shall then have 30 days after receipt of said notice within which to meet or commence to meet all or any part of the breaches alleged by Lessor…

19. … no implied covenant, agreement or obligation shall be read into this agreement or imposed by the parties …

At the time the lawsuit was commenced, the leases were still within the primary term, and Beck Energy had not commenced drilling operations but had regularly paid delay rentals to plaintiffs pursuant to the terms of the lease. Plaintiffs filed an early motion for summary judgment, asserting that they were entitled to a declaration that: (1) the leases at issue were void as against public policy because they were purportedly “perpetual leases,” (2) the leases expired because Beck Energy violated the implied covenant to develop, and (3) the leases expired because Beck Energy failed to commence drilling wells within 12 months of the leases’ effective dates.

The trial court granted summary judgment in favor of plaintiffs, finding that “the leases in question clearly, unequivocally, and seriously offend public policy in that they are perpetual leases that, by their terms and the payment of a nominal delayed rental may never have to be put into production.” Hupp v. Beck Energy Corp., No. 2011-345 (Monroe County Court Comm. Pl. July 12, 2012). Furthermore, the trial court found that the plaintiffs were “also entitled to Summary [sic] judgment because of the Defendant’s breach of the implied covenant to reasonably develop the land and by failing to drill any wells on any acreage that implied covenant has been violated.” Because the trial court found that the leases were void ab initio, the trial court further found that the Plaintiffs had no obligation to provide notice and opportunity to cure to Beck Energy, despite the express language of Paragraph 17 of the Leases (as set forth above). Finally, the trial court determined that forfeiture was the appropriate remedy.

On appeal, the Seventh District overturned the grant of summary judgment. As an initial matter, the court stated that “while perpetual leases are disfavored by the law,” they are not “per se illegal or void from their inception.” The court went on to hold that the Leases at issue were not even perpetual, and the trial court’s finding to the contrary “runs counter to years of established oil and gas jurisprudence in Ohio.” Relying on the express terms of the lease, the court concluded that the Leases had a ten-year primary term and a secondary term that would continue so long as the terms of the Leases were met. Relying on well-established Ohio law, the court found that the delay rentals under the leases could only preserve the lessee’s rights during the primary term, and could not function to extend the leases into the secondary term. Accordingly, the leases had a clear term and could not be extended into perpetuity by merely making a delay rental payment.

The Seventh District also held that the trial court misinterpreted various terms in the lease to support its erroneous conclusion that the lease was a no-term “perpetual lease.” For example, the court ruled that the phrase “capable of production” applied to wells, and not to the land more generally, as the trial court had mistakenly assumed. Additionally, the court ruled that, contrary to the trial court’s assertion, the phrase “in the judgment of Lessee” did not permit Beck Energy to determine arbitrarily whether a well is capable of producing in paying quantities, but rather imposed a good faith standard; i.e., it required Beck Energy to act in good faith in determining whether a well produced in paying quantities.

According to the Appellate Court, the trial court also erred when it found that the lease was subject to implied covenants during the primary term, in direct contradiction to the leases’ express language. In so ruling, the court relied on the clear disclaimer of implied covenants in paragraph 19 of the lease and the landowners’ agreement in paragraph 9 that the consideration was adequate and full consideration for the rights granted by the leases, including the “right of drilling or not drilling on the leased premises.” Furthermore, the Court of Appeals held that the trial court erred in determining that the language of the notice and cure provision in paragraph 17, which merely referenced implied or express covenants, imposed implied covenants on Beck Energy or created an ambiguity as to whether any such covenants would apply. The appellate court further concluded that, pursuant to the terms of the leases, Beck Energy was under no obligation to drill within 12 months of the effective date, so long as it paid delay rentals during the primary term.

Significantly, the appellate court granted Beck Energy’s motion to toll the terms of the leases effective October 1, 2012 (the time Beck Energy filed initially filed such a motion in the trial court), an equitable tolling that would continue until the Ohio Supreme Court accepts or declines jurisdiction. The appellate court reversed the trial court’s grant of summary judgment, expressly determined that the leases remained valid and remanded the matter for proceedings consistent with its rulings.

Because the Seventh District, based in Youngstown, has jurisdiction over a substantial portion of Ohio’s Utica Shale play (including Columbiana, Jefferson, Belmont and Monroe Counties), this decision is likely to be important and influential as Ohio’s oil and gas jurisprudence evolves in the shale gas era. Further, the Court of Appeals’ opinion provides a measure of certainty to oil and gas producers and royalty owners alike. In particular, the Seventh District Court’s opinion affirms previously well-established principles of oil and gas law specifically, and contract law more generally. As landowners continue to assert challenges to lease validity, the Hupp decision reaffirms that the intent of the original parties to a lease, as expressed in the terms of an unambiguous agreement, will trump amorphous policy concerns favoring exploration and production, even if landowners, with the benefit of hindsight, may be dissatisfied with the terms of the deal.