the legal and business risks of developing an oil and gas ... · leasehold interest without...

The Legal and Business Risksof Developing an Oil and Gas

Leasehold InterestWithout Obtaining Lien Subordination

Agreements

Kimberly Luff WakimJustin C. Harding

Thorp Reed & ArmstrongPittsburgh, Pennsylvania

Synopsis§ 2.01. Introduction .......................................................................... 38§ 2.02. Types of Liens. ...................................................................... 39

[1] — Mortgages. .................................................................. 40[2] — Deeds of Trust. ............................................................ 41[3] — Tax Liens. .................................................................... 42[4] — Judgments. .................................................................. 43[5] — Mechanics/Materialmen’s Liens ................................. 43[6] — UCC Financing Statements. ....................................... 45

§ 2.03. Establishment of Priority Status. ....................................... 47[1] — Actual Notice. ............................................................. 48[2] — Record Notice. ............................................................ 49[3] — Recording Statutes. ..................................................... 49

[a] — Race Recording Statutes. ................................ 49 [b] — Notice Recording Statutes. ............................. 51 [c] — Race-Notice Recording Statutes. .................... 52

[4] — Other Priority Statutes. .............................................. 53§ 2.04. Prior Liens. ........................................................................... 54

[1] — What Interests Have Been Collateralized? ................. 54[2] — When Can a Mortgagor Act Without the Consent

of the Mortgagee? ....................................................... 57 [a] — Generally Permissible Mortgagor Activities. . 58 [b] — Oil and Gas Leasing. ....................................... 59 [c] — Title Theory and Lien Theory of Mortgages

and Effects Upon Waste. ................................ 60§ 2.05. Oil and Gas Operations. ..................................................... 62

[1] — Land Valuation. ........................................................... 62[2] — Damage(s) to the Surface Estate. ................................ 67

§ 2.06. Ramifications of Foreclosure. ............................................. 68[1] — Joinder of Lessee in Majority of States. ..................... 68[2] — No Joinder of Lessee in Minority of States. ............... 70

Cite as 19 E. Min. L. Inst. ch. 2 (1999)

Chapter 2

EASTERN MINERAL LAW INSTITUTE

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§ 2.07. Title Curative for Prior Liens ............................................ 70[1] — Satisfaction on the Record of Lien Obligations

Previously Fulfilled. .................................................... 70[2] — The Subordination Agreement. ................................... 71[3] — The Non-Disturbance Agreement. .............................. 75

§ 2.08. Business Curative of Prior Liens. ...................................... 77[1] — Purchase Lienholder’s Position. ................................. 77

[a] — Subrogation. .................................................... 77 [b] — Redemption. .................................................... 79

[2] — Use of Lease Royalties. ............................................. 80 [3] — Mandatory Notification by Lessor to Lessee

of Lien Debt Service or Default. ............................... 81§ 2.09. Summary and Conclusion. .................................................. 81

§ 2.01. Introduction.

Imagine you are the best friend and attorney of Blackbeard –no, not the pirate, but a descendant of the very Blackbeardthat used to terrorize the eastern seaboard. Blackbeard hasgrown tired of life in Texas, and has decided to take a TomSawyer-like voyage on the Mississippi and its tributaries insearch of a better life. In Kentucky, Blackbeard finds what heis seeking, a scenic and peaceful parcel of land where he canavoid all the people who flee in terror after hearing his name.Blackbeard purchases the land and sets out to build his dreamhouse. He obtains a loan from FreeMoney Bank, grantsFreeMoney Bank a mortgage on his land to secure the loanand hires a number of contractors to build his dream home.One of the last things in Blackbeard’s home building processis the drilling of a water well. Blackbeard drills deep, becausehis land is well above the water table. However, instead offinding water, Blackbeard finds oil and gas. OilCo is veryexcited upon hearing the news, and convinces Blackbeard toenter into an oil and gas lease with OilCo.

Blackbeard is overjoyed at the prospect of all the extra royaltyincome from the oil and gas lease, and adds a new wing tohis home. The new wing is funded by a loan from SecondBank, which loan is secured by a mortgage on Blackbeard’sland, and more contractors come in to build. While things

§ 2.01

LIEN SUBORDINATION AGREEMENTS

39

appear to be rosy, Blackbeard is often inattentive to his billsand fails to pay his taxes, both mortgages, and both sets ofcontractors who built his home and the new wing. Blackbeardand OilCo now have all kinds of problems, including the factthat FreeMoney Bank is displeased that they were notconsulted prior to Blackbeard’s entering into the oil and gaslease with OilCo.

This example highlights many of the issues that an oil and gas lessorand lessee may face. Assuming proper recordation of their interests in theappropriate recording offices, it appears that FreeMoney Bank and thefirst group of contractors (via mechanics’ liens) have priority over theOilCo oil and gas lease, which if properly recorded, should have priorityover the mortgage of Second Bank and possibly (depending on state law)the second set of contractors that filed mechanics’ liens againstBlackbeard’s land. As a general rule, a properly conducted foreclosureproceeding with respect to a lien that is recorded prior to an oil and gaslease will divest the rights of the lessee under the oil and gas lease and allother interests in the real estate that are subordinate to the lien that isbeing foreclosed upon.1

This chapter discusses what Blackbeard and OilCo should have done,or still can do, in order to preserve OilCo’s oil and gas lease. In order toproperly analyze issues pertaining to the subordination of legal rights andinterests to an oil and gas lease, a review of implicated rights and interestsare necessary.

§ 2.02. Types of Liens.A lien has been defined as “a claim, encumbrance, or charge on

property for payment of some debt, obligation or duty.”2 A lien can becreated in one of two manners: through statute or through contract.3

1 See 4 Eugene Kuntz, The Law of Oil and Gas § 52.3 (1990); State ex rel. Comm’rs of

Land Office v. Reynolds, 206 P.2d 184 (Okla. 1949).2 Black’s Law Dictionary 922 (6th ed. 1990)(citing Sullins v. Sullins, 396 P.2d 886,

888 (Wash. 1964)).

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[1] — Mortgages.A mortgage has been defined as “. . . an interest in land created by a

written instrument providing security for the performance of a duty or thepayment of a debt.”4 A mortgage is a form of a lien.5 A mortgage does notgenerally transfer title to the property, but rather it provides the mortgageewith the ability to obtain title to the property if certain conditions havebeen satisfied.6 A mortgage must be evidenced by a writing, indicate whomthe relevant parties are and that the parties desire the writing to secure adebt, and describe the property subject to the mortgage.7 Generally,mortgages become binding, as to the public, when they are filed in theappropriate recording offices.8

The effects of a mortgage generally depend on whether the land is ina state that has adopted the lien theory or title theory of mortgages. Thelien theory of mortgages provides that a mortgage only serves as a lien onthe property, and that the mortgagor owns both the actual title to the land,and the right to use the land.9 The title theory of mortgages was born outof old English law that stated that in a mortgage, the mortgagee obtainstitle, or legal ownership of the property.10 In American law, the differences

3 See 53 C.J.S. Liens § 4(a)(1987); “Courts cannot create a lien neither provided for bylaw nor created by contract, and a lien may not be imposed merely from a sense of justice

in a particular case.” Id.4 Black’s Law Dictionary 1009 (6th ed. 1990).5 See Great Falls Bank v. Pardo, 622 A.2d 1353 (N.J. Super. Ct. Ch. Div. 1993).6 See Oldham v. Noble, 66 N.E.2d 614 (Ind. App. 1946). However, under the minorityviewpoint, the mortgagee is regarded as the legal owner of the land, with the mortgagorpossessing the right to use the property. See Cooperstein v. Bogas, 58 N.E.2d 131 (Miss.

Ct. App. 1944); City Lumber Co. of Bridgeport v. Murphy, 179 A. 339 (Conn. 1935).7 See 59 C.J.S. Mortgages §§ 92-102 (1998).8 For example, in Ohio a mortgage “. . . shall be recorded in the office of the countyrecorder in which the mortgaged premises are situated and shall take effect at the timethey are delivered to the recorder for record.” Ohio Rev. Code. Ann. § 5301.23 (Anderson

1989).9 See 4 Richard R. Powell and Patrick J. Rohan, Powell on Real Property § 37.03

(1998).10 See id. The primary characteristic of a title theory mortgage was that, according toEnglish common law, the mortgagee could evict the mortgagor at any time, even prior to

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between the two theories have almost completely evaporated11 and mostcourts reach the same results despite a state’s position on mortgages.12

Finally, while title or lien mortgaging generally has very little relevance,oil and gas law is one of the few areas where the type of a mortgage mayhave some relevance.13

[2] — Deeds of Trust.A deed of trust is “. . . an instrument in use in some states, taking the

place and serving the uses of a mortgage, by which legal title to realproperty is placed in one or more trustees, to secure the repayment of asum of money or the performance of other conditions.”14 However, deedsof trust and mortgages are generally interpreted in an identical manner.15

[3] — Tax Liens.A tax lien is a form of a statutory lien, “. . . existing in favor of the

state or municipality, upon the lands of a person charged with taxes, bindingthe same either for the taxes assessed upon the specific tract of land or (in

a default. See id. Under lien theory analysis, a mortgagor cannot be evicted unless a

default has occurred. See id.11 Unless otherwise indicated, the discussion in this chapter assumes that the applicable

state law is a lien theory of mortgages jurisdiction.12 See id. Over half the states have completely adopted the lien theory either by statute

or via caselaw. See id.13 Under a title theory jurisdiction, some authorities have held that the creation of anoil and gas lease after the land has been mortgaged results in an automatic finding of

waste. For further discussion, see §§ 2.03[2](b) and (c).14 Black’s Law Dictionary 414 (6th ed. 1990)(citing In re Title Guar. Trust Co., 113

S.W.2d 1053, 1057 (Mo. Ct. App. 1938)).15 “A mortgage is the conveyance of an estate, or pledge of property, as security for thepayment of money, or the performance of some other act, and conditioned to becomevoid upon such payment or performance; a deed of trust in the nature of a mortgage, is aconveyance in trust by way of security, subject to a condition of defeasance, or redeemableat any time before the sale of the property. A deed conveying land to a trustee as merecollateral security for the payment of a debt when due, and with power to the trustee tosell the land and pay the debt, in case of default on the part of the debtor, is a deed of trustin the nature of a mortgage.” Sandusky v. Faris, 38 S.E. 563, 573 (W. Va. 1901)(quotingHoffman, Burneston & Co. v. Mackall, 5 Ohio St. 124, 130-31 (1855)).

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some jurisdictions) for all the taxes due the individual, and which may beforeclosed by non-payment, by judgment of a court or sale of the land.”16

Tax liens are a mechanism to collect unpaid taxes.17 Tax liens can becreated at both the federal and state/local level. The establishment of stateor local tax liens and the perfection of the same depend upon the relevantstate statute. For example, state law will provide the manner in which alien is perfected as to the public.18

The priority of federal tax liens is also governed by state law.19 Thestate statutes creating federal tax liens tend to be uniform throughout thenation, especially throughout the eastern portion of the United States.20

A federal tax lien is made of public record when it is filed with theappropriate recording office.21

16 Black’s Law Dictionary 1459 (6th ed. 1990).17 See 53 C.J.S. Liens § 9(a)(1987).18 For example, one Pennsylvania statute provides that taxes, penalties and interestassessed against a taxpayer shall be a lien after they have been docketed by the prothonotaryof the county where the taxpayer’s franchises or property are situated. See 72 Pa. Cons.

Stat. Ann. § 3402-508(B)(West 1994).19 The Internal Revenue Code indicates that “. . . liens for an unpaid federal tax shallnot be valid as against mortgagees, pledgees, judgment creditors, purchasers and holdersof other security interest until notice of the tax lien has been filed in an office designatedby the law of the state in which the property subject to the lien is situated, or, in theabsence of a valid state designation, in the federal district court for the place where the

property is situated.” I.R.C. § 6323 (West 1998).20 A majority of the states have adopted the Uniform Federal Tax Lien RegistrationAct. See Black’s Law Dictionary 1462 (6th ed. 1990). Eastern states that have adoptedthe Uniform Federal Tax Lien Registration Act, or its successor, the Uniform FederalLien Registration Act, include Alabama, Connecticut, Delaware, Florida, Georgia, Illinois,Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Mississippi, NewHampshire, New York, Pennsylvania, North Carolina, South Carolina, Virginia and WestVirginia. See Uniform Federal Tax Lien Registration Act, 7A U.L.A. 376 (1985 & Supp.

1997); Uniform Federal Lien Registration Act, 7A U.L.A. 359 (1985 & Supp. 1997).21 The Uniform Federal Lien Registration Act, as passed in West Virginia, states: “Noticesof liens upon real property for obligations payable to the United States and certificatesand notices affecting the liens shall be filed in the office of the clerk of the countycommission of the county in which the real property subject to the liens is situated.” W.

Va. Code. § 38-10A-2 (Michie 1996-97).

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[4] — Judgments.Judgments are another type of lien that may exist against real estate.

A judgment lien is “[a]n encumbrance that arises by law when a judgmentfor the recovery of money is docketed and that attaches to the debtor’sreal estate located in the county where the judgment is docketed.”22 Justas with other types of liens, judgment liens must be recorded in theappropriate recording office, as designated by state law.23

[5] — Mechanics/Materialmen’s Liens.Mechanics’ liens are another form of statutory lien.24 The term

mechanic’s lien usually encompasses both liens for mechanics and formaterialmen.25 A mechanic’s lien arises when a materialman, contractoror other similar person provides work, services or materials on or for apiece of property.

Mechanics’ liens are only available to parties specifically designatedby statute. Statutes that designate persons that can use the statute havedescriptions that range from “any person who performs labor or furnishesmaterials”26 to descriptions of specific parties, such as contractors,subcontractors, materialmen, laborers, professional engineers, landsurveyors and architects.27 Mechanics’ liens only attach to the propertywhere the work was performed.28 Just as with other forms of liens,mechanics’ liens must be filed in the appropriate recording office.29

22 Black’s Law Dictionary 845 (6th ed. 1990).23 For example, in Virginia, a confessed judgment is entered on the “. . . judgement(sic) lien docket of the clerk’s office of the county or city in which the land of the defendant

lies.” Va. Code Ann. § 8.01-434 (Michie 1992).24 See 56 C.J.S. Mechanic’s Liens § 2(b)(1992). Some states’ mechanic’s liens are derived

from the state constitution. See id.25 See id. In its most refined form, the term “mechanic’s lien” represents labor contributed

to a project, whereas “materialmen’s lien” represents supplies. See id.26 Ky. Rev. Stat. Ann. § 376.010(1)(Michie 1998).27 See Ind. Code §§ 32-8-3-1, 32-8-25-1 (Michie 1995).28 “Every improvement and the estate or title of the owner in the property shall be

subject to a lien. . .” 49 Pa. Stat. Ann. § 1301 (West 1965).29 For example, see N.Y. Lien § 10 (McKinney 1993 & Supp. 1998).

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Deciphering when mechanics’ liens attach or become binding uponthe public is often a difficult task.30 Mechanics’ liens can and do relateback to a time prior to when the lien itself is physically filed.31 The term“relates back” or “relation back” refers to a “[p]rinciple that an act donetoday is considered to have been done at an earlier time.”32 For example,state statutes provide a broad range of relation back dates for mechanics’liens, including back to the time of the making of the contract, uponcommencement of work, and upon notice to the owner that work hascommenced.33

The necessity of looking to the relevant state statutes is especiallyimportant in the context of oil and gas. Many state statutes provide forspecific mechanics’ liens against oil and gas interests. These oil and gas-specific provisions specifically list what properties are covered by oil andgas mechanics’ liens. These statutes are often designed to cover situationswhere an oil and gas lessee has contracted for work for oil and gas purposesand will often specifically list what may be liened. Examples of potentialproperties that may be liened include the property that was leased, the leaseitself, any oil and gas equipment, extracted oil and gas, and may even includeproceeds from oil and gas that has already been sold.34

The contractors who built Blackbeard’s house may file mechanics’ liensagainst Blackbeard’s land. However, such liens would not affectBlackbeard’s personal property. On the other hand, if OilCo uses contractorsto erect the gas well, an oil and gas specific mechanic’s lien law could verywell allow those contractors to levy upon the oil and gas lease, the gaswell, and oil and gas that OilCo has extracted. Therefore, prior to enteringinto an oil and gas lease one should examine lien records for both the ownerof the land (for general mechanics’ liens) and prior to acquiring an existing

30 With respect to this, or any other mechanic’s lien concept, it is always necessary toexamine each individual state provision to determine what and how a mechanic’s lien

operates.31 See 56 C.J.S. Mechanic’s Liens §§ 204-10 (1992).32 See id.33 See id.34 See Briggs v. McAdams Pipe & Supply Co., 359 P.2d 572 (Okla. 1961). See also

Ohio Rev. Code Ann. § 1311.021 (Anderson 1993).

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oil and gas lease one should examine lien records for mechanics’ liensagainst the person leasing the property (such as a sublessor).

[6] — U.C.C. Financing Statements.The Uniform Commercial Code specifically deals with security interests

in oil and gas, once extracted. In most jurisdictions, oil and gas in the groundare considered realty and therefore financing relationships regarding oiland gas in the ground and oil and gas leases are not governed by the UniformCommercial Code.35 However, once oil and gas has been extracted fromthe ground, it becomes personal property and Article IX of the UniformCommercial Code becomes the primary authority governing securityinterests in such oil and gas.36 Notwithstanding these seemingly simpleconcepts, the law of each state must be carefully examined to ascertain thatparticular states’ classification of a particular interest as being realty andgoverned by the applicable real estate laws, or personal property andgoverned by Article IX of the Uniform Commercial Code. Generally, acreditor obtaining a security interest in oil and gas interests is well advisedto file a mortgage in the real estate records as well as financing statementsin accordance with Article IX of the Uniform Commercial Code.

Various oil and gas interests are generally perfected/liened, as the casemay be, in the following manner:

1. Mineral interests, including royalty and overriding royaltyinterests, leasehold interests, farmout agreements andproduction payment contracts are generally deemed to relateto minerals in the ground and covered by real estate law.37

2. Extracted minerals, including oil and gas produced at thewellhead, in storage or in transit are personal property (goods)that are subject to Article IX of the Uniform CommercialCode.38

35 Both relationships are considered by the Code to be interests in real property andhence, outside the Code’s scope. See 1B Alvin C. Harrell, “Oil and Gas Lending” in

Secured Transactions § 14.01[3](Peter F. Coogan et al eds., 1998).36 See id. at §§ 14.02[2], 14.13.37 See id. at §§ 14.02[2].38 See id. at §§ 14.02[2].

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3. Accounts and proceeds arising from the sale of oil andgas and contractual rights relating to oil and gas afterextraction, including operating agreements, production, salesand processing contracts are generally treated as “accounts”or “general intangibles” under Article IX of the UniformCommercial Code. However, in some states, contractual rightsrelating to production oil and gas may be treated as realproperty.39

There is a significant amount of conflict among the states as to whetherthe financing of an oil and gas lease is best characterized as an interest inreal property or a chattel mortgage (and hence, subject to the UniformCommercial Code.) Although the basic intent of the Uniform CommercialCode has been to exclude all interests in real property–including leases ofreal property–from the coverage of the code,40 some states haveestablished, either through caselaw or non-uniform Uniform CommercialCode provisions, a preference to label mortgages on oil and gas leases astransactions subject to Article IX of the Uniform Commercial Code. Thestates that have reached this conclusion have done so based upon theirlaw that provides that a landowner does not own the oil and gas beneaththe ground (and hence no real property is involved).41 However, whilethere is a great deal of caselaw discussing whether leases, or any otherinterest in oil and gas, should be considered personal or real property,very little caselaw discusses whether a mortgage on a lease is an interestin personal property.42

39 See id. at §§ 14.02[2].40 See U.C.C. §§ 9-103 to 105 (1994).41 This is known as the “nonownership theory.” The ownership theory states that oil andgas property owners do own the oil and gas beneath the ground. Not all nonownershipjurisdictions argue that leases are personal property, and that mortgages on these leasesare chattel mortgages. See 1B Alvin C. Harrell, “Oil and Gas Lending” in Secured

Transactions § 14.14[5](Peter F. Coogan et al eds., 1998).42 See generally 1 Howard R. Williams and Charles J. Meyers, Oil and Gas Law § 212-

15 (1991).

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Many states are quite clear in that mortgages on oil and gas interestsmust filed in the appropriate recording offices where real estate recordsare to be filed.43 Other states, such as New York, quite clearly set forthlaw that pronounces both leases and mortgages on leases as subject to thelaws of personal property. New York statutory law indicates that “Oilwells and all fixtures connected therewith situated on lands leased for oilpurposes and oil interests, and rights held under and by virtue of anylease or contract or other right or license to operate for or producepetroleum oil, shall be deemed personal property for all purposes excepttaxation.”44 Ohio courts have, at different points in time, adopted boththe real and personalty distinctions, despite statutory language indicatingthat oil leases should be filed with the realty records.45

Prior to obtaining an oil and gas lease, a lessee should examine alldocuments in the various recording offices, for both real estate and personalproperty, to ascertain whether the lessee will possess a valid leaseholdinterest in oil and gas, and if so, whether there are existing liens that, as apractical matter, prohibit development of the oil and gas.

§ 2.03. Establishment of Priority Status.The term priority, as applied to all forms of liens, refers to the order

in which the liens are ranked.46 A ranking of rights in a particular piece ofproperty will depend on two factors: (1) whether the existence of a legalright has been made known (a) by filing with the appropriate recordingoffice and/or (b) by actual notice to the party interested in obtaining an

43 For example, in Texas this concept is imbedded so deeply it becomes difficult tofind a clear statement of this policy. See 1B Alvin C. Harrell, “Oil and Gas Lending” in

Secured Transactions § 14.14[5][a] (Peter F. Coogan et al eds., 1998).44 See N.Y. Gen. Constr. Law. § 39 (McKinney 1951).45 See Ohio Rev. Code Ann. § 5301.09 (Anderson 1989).46 Priority has been defined as “The relative ranking of competing claims to the sameproperty. When two persons have similar rights in respect to the same subject-matter,but one is entitled to exercise his right to the exclusion of the other, he is said to havepriority. The order in which claims may be satisfied out of the sale of real property or

other assets.” Black’s Law Dictionary 1193-94 (6th ed. 1990).

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interest in the property,47 and (2) how a particular state establishes priorityfor the implicated rights.48

[1] — Actual Notice.Actual notice focuses on whether a person has been provided with

facts that either did or should have made that person aware of a prior lien.For example, one West Virginia court stated: “Notice is actual when thepurchaser knows of the existence of the adverse claim, or, perhaps, whenhe is conscious of having the means of knowledge, and yet does not usethem; and it is immaterial whether his knowledge results from directinformation, or is gathered from facts and circumstances.”49

Actual notice may be express or implied. If the one, it isestablished by direct evidence; if the other, by proof ofcircumstances from which it is inferable as a fact. Constructivenotice is, on the other hand, always a presumption of law.Express notice embraces, not only knowledge, but also thatwhich is communicated by direct information, either writtenor oral, from those who are cognizant of the factcommunicated. Wade, Notice, § 6. Implied notice, which isequally actual notice, arises where the party to be charged isshown to have had knowledge of such facts and circumstancesas would lead him by the exercise of due diligence, to aknowledge of the particular fact. . . .50

The concept of actual notice, whether express or implied, appliesequally to both deeds and liens. For example, courts have found that whena mortgage included a provision stating that there was a prior mortgage,and that the prior mortgage was a first mortgage, that contract recitalprovides actual notice sufficient to give priority to the earlier mortgage –even if that mortgage has not yet been recorded.51 Finally, just as actual

47 This is commonly referred to as actual notice or record notice. See §§ 2.02[1][2].48 In their most basic forms, the methods are categorized as pure race, notice and race-

notice priority statutes. See § 2.02[3].49 Clark v. Lambert, 47 S.E. 312, 318 (W. Va. 1904).50 City of Baltimore v. Whittington, 27 A. 984, 985 (Md. 1893).51 See 2 Words and Phrases Actual Notice 434 (1955)(citing Angus v. Mariner, 278 P.

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notice can apply to a granting of a lien, it can also apply to the release ofa lien.52 Returning to the example of Blackbeard, if FreeMoney Bankhad not properly recorded its mortgage and Second Bank was informed,either orally by Blackbeard or in the loan documents executed byBlackbeard, of the mortgage of FreeMoney Bank, then equity may requirethat Second Bank’s mortgage be junior to the mortgage of FreeMoneyBank as well as all other interests of record.

[2] — Record Notice.The concept of record notice focuses on when an instrument is

recorded with the appropriate recording office. “Record notice is suchnotice as is presumed to be imparted by recording with the properauthorities a properly drawn and properly acknowledged instrument. Therecord of any instrument entitled to be recorded will give constructivenotice to the persons bound to search for it.”53

[3] — Recording Statutes.Record notice and actual notice are the determinative factors in ranking

competing liens. There are three types of recording statutes used today:(a) race, (b) notice, and (c) race-notice, to prioritize liens.54

[a] — Race Recording Statutes.A race statute, also called a pure race statute, prioritizes rights based

solely on which party recorded first.55 Actual notice is wholly irrelevant

996, 997 (Mont. 1929)). See also Farmers Trust Co. v. Bomberger, 523 A.2d 790, 797

(Pa. Super. Ct. 1987).52 In Randell v. Fellers, 252 N.W. 787 (Iowa 1934), the court found that a purchaser ofmortgaged property would have actual notice of the ineffective release of a prior mortgagewhen the purchaser knew of information that would have caused a reasonably prudent

person to inquire further so that such inquiry would have discovered the truth.53 66 C.J.S. Notice § 18 (1950).54 See 14 Richard R. Powell and Patrick J. Rohan, Powell on Real Property § 82.02[1][a]

(1998).55 See id. at § 82.02[1][c][i].

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to prioritization in a pure race jurisdiction.56 Very few states use a purerace ranking system.57

An example of a race statute is found in Bourne v. Lay & Co.58 InBourne, the Supreme Court of North Carolina was presented with a situationwherein the owners of a piece of property granted a 10-year lease to Layand Company, but the lease was not recorded.59 The owners of the landthen sold the property to the plaintiffs, and the sale was duly recorded.60

The plaintiffs were informed of the outstanding lease in favor of Lay andCompany.61 After the sale and recordation of the sale, the lease was thenrecorded.62 The buyers/plaintiffs then attempted to raise the rent owed byLay and Company.63 Lay and Company refused to pay the higher rent, andthe buyers/plaintiffs instituted an action to determine if they were boundby the lease.64

The North Carolina Supreme Court looked to its past decisions andmade several conclusions. First, the court held that “[a] lease of more thanthree years must, to be enforceable, be in writing, and to protect it againstcreditors or subsequent purchasers for value, the lease must be recorded.”65

The court next found that “[a]s between two purchasers for value of thesame interest in land, the one whose deed is first registered acquires title.”66

Finally, the court found that “[a]ctual knowledge, however full and formal,of a grantee in a registered deed of a prior unregistered deed or lease will

56 See id.57 See id. The only two states with pure race statutes for all forms of collateral areLouisiana and North Carolina. See La. Rev. Stat. Ann. § 9:2721 (West 1998); N.C. Gen.Stat. § 47-18(a)(1984). A small number of other states have pure race statutes with respectto mortgages and deeds of trust. See 14 Richard R. Powell and Patrick J. Rohan, Powell

on Real Property § 82.02[1][c][i]n.8. (1998).58 See Bourne v. Lay & Co., 140 S.E.2d 769 (N.C. 1965).59 See id.60 See id.61 See id.62 See id.63 See id.64 See id.65 Id. at 771.66 Id.

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not defeat his title as a purchaser for value in the absence of fraud or matterscreating estoppel.”67 The court then concluded that because no contractualprovision stated that the mortgage was “subject to” the lease, the plaintiffswere therefore not bound by the terms of the lease, despite the plaintiffsknowing full well that the lease existed.68

This case demonstrates what record notice actually represents. Recordnotice is achieved by recording, or filing in the case of the UniformCommercial Code, the relevant documents. As the North Carolina casepointed out, once the document is recorded, then subsequent recordingsare ranked behind, and have less priority, than that earlier recordation,because recording automatically is presumed to inform the world of whatis contained in the recorded document. The inverse is also true in that if aparty fails to record, then record notice has not been established.

Applying a pure race statute to Blackbeard’s situation, the ranking wouldbe relatively simple. Assuming all parties properly recorded their interests,Blackbeard’s land would be subject to the first lien of FreeMoney Bank,followed by the mechanics’ liens filed by the first group of contractors(ignoring any statutory provision that would provide that the mechanics’liens of the first group of contractors would prime the lien created byFreeMoney Bank’s mortgage), followed by the OilCo oil and gas lease, thelien created by the mortgage of Second Bank and the mechanics’ liens ofthe second group of contractors (again ignoring any state statutory provisionthat would provide that the mechanics’ liens of the second group ofcontractors would prime the liens created by FreeMoney Bank’s mortgageand Second Bank’s mortgage and the interest of OilCo as the lessee underthe oil and gas lease).

[b] — Notice Recording Statutes.A notice statute prioritizes interests in land based upon a time line of

the actual knowledge of each party.69 While a notice recording statute does

67 Id.68 See id. at 771-72.69 For example, the Massachusetts notice recording statute states: “A conveyance of anestate in fee simple, fee tail or for life, or a lease for more than seven years from themaking thereof, or an assignment of rents or profits from an estate or lease, shall not be

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not contain any race element in the words of the statute “. . . the recordingof one’s own interest is deemed to be notice to any purchaser who wouldseek to acquire the same interest at a later date.”70 Approximately 50percent of the states now have a notice recording statute for interests inland.71

Applying a notice statute to Blackbeard’s situation, the ranking woulddepend solely upon what notice each party had. If FreeMoney Bank hadnot recorded its mortgage at the time when Second Bank recorded itsmortgage and Second Bank did not have actual knowledge of or couldnot have reasonably discovered FreeMoney Bank’s mortgage, then SecondBank’s mortgage should be ranked ahead of FreeMoney in a prioritizationranking. However, if FreeMoney Bank’s mortgage was properly recorded,then Second Bank would be charged with constructive notice ofFreeMoney Bank’s mortgage, even if Second Bank failed to check theappropriate recording office for such instruments. Thus, recording andrace recording statute concepts are still critical in a notice recording statuteprioritization state. On the other hand, if FreeMoney Bank had not recordedits mortgage, but Second Bank nevertheless knew of FreeMoney Bank’smortgage, then FreeMoney Bank’s mortgage should be ranked ahead ofSecond Bank’s mortgage in a notice recording prioritization state.

[c] — Race-Notice Recording Statutes.A race-notice statute combines the elements of both a pure race

recording statute and a notice recording statute.72

Thus, unlike a pure notice statute, for a subsequent purchaserto have priority she must achieve a dual status: she must not

valid as against any person, except the grantor or lessor, his heirs and devisees and persons

having actual notice of it. . . .” Mass Gen. Laws Ann. ch. 183, § 4 (West 1991).70 See 14 Richard R. Powell and Patrick J. Rohan, Powell on Real Property

§ 82.02[1][c][ii] (1998).71 See Id at § 82.02[1][c][ii] (citing 4 American Law of Property § 17.5 (A.J. Casner

ed. 1952)).72 See 14 Richard R. Powell and Patrick J. Rohan, Powell on Real Property §

82.02[1][c][iii] (1998).

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only must take without notice of the prior interest, but alsoshe must put her interest on the record before the holder ofthe prior interest is able to do so. It is also unlike a race statutesince the subsequent purchaser must be without notice of theprior interest. This means that even if the prior interest is notrecorded, the subsequent purchaser might not prevail if shehad either actual or inquiry notice of it.73

As is obvious from the title, a race-notice jurisdiction places twoburdens on the second-in-time party: “a subsequent purchaser in a noticestate bears but one burden, that of taking his deed without knowledge ofthe prior conveyance; but he gains only partial security, that against thepast. In a notice-race jurisdiction, where he must both take innocentlyand record first, he bears two burdens, but he gains security not onlyagainst past conveyances but against divestment in favor of a still latergrantee.”74

[4] — Other Priority Statutes.While pure race, notice and race-notice recording statutes traditionally

only cover deeds and mortgages, many states have similar statutes forliens that are conceptually identical. For example, in West Virginia, thepriority of a mechanic’s lien is “. . . subordinate to any other lien createdby a deed of trust or otherwise which is duly recorded or otherwiseperfected to constitute constructive notice. . . .”75 Similarly, UniformCommercial Code provisions may be similarly characterized into one ofthe three categories. For example, unperfected security interests are

73 Id.74 Id. (citing Francis S. Philbrick, “Limits of Record Search and Therefore of Notice”

(pts. 1-3), 93 U. Pa. L. Rev. 125, 159 (1944-45)).75 W. Va. Code. § 38-2-17 (1998).76 U.C.C. § 9-301 (1994).

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subordinate to “. . . a person who becomes a lien creditor before the securityinterest is perfected.”76

§ 2.04. Prior Liens.[1] — What Interests Have Been Collateralized.It has long been held that a person holding a parcel of land can sell

the land however, and to whomever, that person may choose. For example,assume Blackbeard owns Goldacre. Goldacre is a piece of Kentuckyfarmland consisting of a parcel of land five miles long by five miles wide.Blackbeard has grown tired of farming in Kentucky, and wants to sellGoldacre and return to Texas. Blackbeard has five sons and he sells eachson a five mile by one-mile strip of land from Goldacre.

No one would ever question Blackbeard’s partition and sale of hisproperty in this manner. The creation of multiple estates in one parcel ofland may be achieved vertically as well as horizontally. For example,assume that before Blackbeard could sell his land to his sons, the InternalRevenue Service (I.R.S.) found Blackbeard, and took all of his land, withthe exception of a piece of land measuring one hundred feet by two hundredfeet, because Blackbeard failed to report any income for many years. Thisparcel of land is too small to subdivide into five useful parcels, one foreach of his sons. However Blackbeard, being the savvy entrepreneur thathe is, knows that he has somehow managed to retain the most valuablepart of the land, that which has the single largest group of mineral depositsin Kentucky, consisting of coal, oil and gas, gold, titanium and uranium.Blackbeard sells each son the mineral rights to one of these minerals, andretains the surface rights to this small parcel of land.77

This story about Blackbeard has several key elements. First, just as aperson can subdivide and sell, retain or mortgage surface rights, so toocan a person subdivide and sell, retain or mortgage subsurface rights.Second, each estate, whether surface or subsurface, is a separate anddistinct estate. For example, if the I.R.S. entered the scene after Blackbeardmade either group of conveyances (surface and/or subsurface), the I.R.S.

77 This chapter will not address what language is necessary to properly convey mineralrights in general, or oil and gas specifically. For a detailed analysis of the appropriatelanguage for a grant of mineral rights, see 1A Walter L. Summers, The Law of Oil and

Gas §§ 131 et seq. (1954 & Supp. 1997).

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would be limited to proceeding against the estate, if any, retained byBlackbeard. This simple example demonstrates the concept of severingthe mineral estate from the surface estate.

Legally, it is quite clear that the surface owner of the land owns theminerals beneath his land.78 It is equally clear that “the surface of theearth and the minerals under the surface may be severed by a deed, orreservation in a deed, and when so severed, they constitute two differentestates.”79 The mineral estates should be considered as real propertyinterests, just as any other parcel of land.80 As might be expected, if aperson did not have title to a mineral estate, that person cannot validlyconvey an interest in the mineral estate.81

When land is divided into mineral interests and surface interests, it isimportant to remember that three estates in land are created: “the surfaceestate, the mineral estate, and the right to subjacent (surface) support.”82

Additionally, it is also important to note that the severance of an oil andgas estate is treated by the law just as the law would treat a severance ofany other type of mineral estate.83

Liens operate similarly with respect to mineral and surface rights.For example, courts around the country have regularly found that whensurface and mineral rights have been severed, a tax sale on one estatedoes not transfer the interest in the other estate.84 The Appellate Court ofIllinois considered a situation where the plaintiffs had inherited a severedmineral estate, but the defendant claimed the plaintiffs’ mineral rightspursuant to a tax deed issued when a prior surface owner didn’t payassessed taxes.85 The court stated:

78 See Stevens Mineral Co. v. State, 418 N.W.2d 130, 133 (Mich. Ct. App. 1987).79 Ives v. Real-Venture, Inc., 388 S.E.2d 573, 577 (N.C. App. 1990)(citations omitted).80 See Frey v. Amoco Prod. Co., 603 So. 2d 166, 171 (La. 1992).81 See Ives, 388 S.E.2d at 576-68.82 Hetrick v. Apollo Gas Co., 608 A.2d 1074, 1077 (Pa. Super. Ct. 1992).83 See id.84 See State v. Wilbe Lumber Co., 64 So. 2d 327 (Miss. 1953); State v. Estep, 175 S.E.

350 (W. Va. 1934).85 See Jackson v. Reed, 448 N.E.2d 226, 227 (Ill. App. Ct. 1983).

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The plaintiff’s insist . . . that the 1944 tax deed was insufficientto pass title to the mineral interests to the defendants or theirpredecessors in title. They correctly note that the 1915 and1920 conveyances effectuated a severance of the mineralestate from the surface estate by the reservation of the mineralinterests to the grantors, thus requiring the minerals to beassessed and taxed separately from the surface.86

The severance analysis used by the Illinois court has widely beenused by courts when confronting oil and gas property claims. For example,in examining a similar situation, the Superior Court of Pennsylvania heldthat a lien for unpaid taxes attached only to the estate assessed, and thatestate, and no more, passes at a public sale even though the authoritiesassume to convey land against which there has been no valid assessment.87

This severance analysis has not been limited merely to tax sales. Forexample, with respect to mortgages, it has been commonly held that amortgagor can only convey or create a mortgage in the interest actuallyowned by the mortgagor.88 Therefore, if a mortgagor has no interest inthe oil and gas, or had such an interest and conveyed that interest awayprior to granting a mortgage on the mortgagor’s property, then themortgagor has no interest in the oil and gas to which a mortgage mayattach.

However, just as a severance prevents a lien or mortgage fromattaching to a mineral estate, a non-severance implicitly means that amortgage or lien does attach to the unsevered mineral estate. “Aconveyance of land carries with it all incidents of ownership, including

86 Id. at 228.87 See Babcock Lumber Co. v. Faust, 39 A.2d 298, 302 (Pa. Super. Ct. 1944).88 “Generally, one who has no ownership interest in property has no right to mortgage itwithout the owner’s consent.” Jennings Realty Corp. v. First Nat’l Bank of North Vernon,485 N.E.2d 149, 152 (Ind. Ct. App. 1985). The Indiana court was able to strengthen itsanalysis by using an Indiana statute which stated that a person cannot create or satisfy alien or mortgage by using a third person’s property unless that third person authorizes

such action. See id. at 152-53.89 Rosewood Resources, Inc. v. Jonesboro State Bank, 535 So. 2d 1083, 1084-85 (La.

Ct. App. 1988)(citations omitted).

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mineral rights, except such rights as may be expressly reserved. By thesame reasoning a mortgage of land includes such mineral rights as arenot expressly excepted.”89 The Supreme Court of Illinois was presentedwith a situation where a piece of property was mortgaged pursuant to amortgage instrument that did not exclude the mineral interest.90 The courtrecognized that generally “a landowner is entitled to the surface and allthat is below it, and where he makes a deed that contains no reservationor exception and does not limit the estate conveyed, he conveys everythingunder the surface as well as the surface itself.”91 Applying this concept,the court concluded that since the mortgage did not expressly excludeany oil or gas interests, the mortgage did in fact contain all of the mineralrights.92

These examples make especially clear that collateralization hingesupon whether (i) there has been a prior severance of the mineral interests,and (ii) whether any language in the mortgage expressly relates to themineral interests. If there has been no prior severance or reservation ofthe oil and gas interests, then, as a general rule, the current estate, and anylien on that estate, should include the oil and gas interests beneath thesurface. Remember, one may only collateralize that portion of an estatein which one has an interest.

[2] — When Can a Mortgagor Act Without the Consent ofthe Mortgagee?

The term waste has been defined as an “[a]ction or inaction by apossessor of land causing unreasonable injury to the holders of other estatesin the same land.”93 Waste can occur between a mortgagor and mortgageebecause “. . . destruction or injury to the land itself is an injury to themortgagee, since it diminishes the value of the pledge.”94 Therefore,whether a mortgagor can lease or use the land will usually depend upon

90 See Updike v. Smith, 39 N.E.2d 325, 327 (Ill. 1942).91 Id.92 See id. at 328.93 Black’s Law Dictionary 1589 (6th ed. 1990).94 44A Words and Phrases Waste 659 (1962).

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whether the mortgagor is committing “waste.” In other words, whetherBlackbeard violated his mortgage with FreeMoney Bank by entering intoan oil and gas lease with OilCo depends on what constitutes “waste.”

[a] — Generally Permissible Mortgagor Activities.The law of waste is jumbled and logically inconsistent with respect

to actions such as whether a mortgagor can lease land, farm, cut downtimber or mine. While some acts are universally allowed, others may createdifficulties under a mortgage due to the doctrine of waste.

As a general rule, in the absence of a provision to the contrary, amortgagor in possession of mortgaged property has the right to make,amend or cancel leases of the mortgaged property, subject, however, tothe mortgagee’s rights and not the prejudice of the mortgagee’s title.95

Therefore, a normal landlord-tenant lease should generally be found tobe a permissible mortgagor activity under the doctrine of waste.

Other actions, such as cutting down timber, are somewhat moresusceptible to being branded as waste.96 With respect to timber, the generalrule is that if a person knows of an outstanding mortgage on the property,the property may not be timbered without the prior consent of themortgagee.97 However, when the timber is more accurately characterizedas a crop, then the weight of authority would allow the mortgagor toharvest the timber crop.98

The taking and using of mineral interests, such as coal, are generallyfound to be “waste.”99 However, with respect to mortgages, some

95 See 59 C.J.S. Mortgages § 297(b)(1998).96 See 44A Words and Phrases Waste §§ 677-78 (1962) “The cutting of timber ondemised premises, beyond what is necessary for the uses and improvement of such

premises, is ‘waste.’” Id. at 677 (citing Mooers v. Wait, 3 Wend. 104, 107 (N.Y. 1829)).97 See Shirling v. Hester, 40 S.E.2d 743 (Ga. 1946).98 See 59 C.J.S. Mortgages § 180 (1998). “Absent a contrary provision in the mortgage,the mortgagor is entitled to the rents, profits and crops of the mortgaged property aslong as he lawfully remains in possession of the premises.” Lake County Trust Co. v.

Two Bar B, Inc., 606 N.E.2d 258, 263 (Ill. App. Ct. 1992).99 “Generally, opening of new mines on land and taking of minerals therefrom bytenant in possession constitutes ‘waste.’” 44A Words and Phrases Waste 671-74

(1962)(citing to Schuykill Trust Co. v. Schuykill Min. Co., 57 A.2d 833 (Pa. 1948).

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authorities imply that a finding of waste does not automatically occurupon the opening of a coal mine. For example, it has been stated that “Amortgagor who has a right to, and remains in possession of, the mortgagedpremises has the right to work a mine or quarry and to take and enjoy theincome derived from the sale of the products, unless it unreasonablyimpairs the security of the mortgage.”100

[b] — Oil and Gas Leasing.The law of waste with respect to oil and gas is generally consistent.101

Courts across the country have generally found that removal of oil andgas does constitute waste.102 Generally, property that has been mortgagedmay not be developed by the landowner or the landowner’s lessee withoutthe consent of the mortgagee.103 Absent such consent, at least with respectto wells opened subsequent to the mortgage,104 development and removalof oil and gas is generally considered to be voluntary waste.105

10059 C.J.S. Mortgages § 284 (1998).101Some variation may occur when state law is a lien theory of mortgages jurisdictionand the mortgage document in question does not either specifically define mineral leasesas waste or otherwise defines waste broadly enough so as to include the operation of an

oil and gas lease.102See 44A Words and Phrases Waste 671-74 (1962).103See 2 Howard R. Williams and Charles J. Meyers, Oil and Gas Law § 518 (1991).104There is authority, under the “Open Mine Doctrine,” for the proposition that as to amortgagee, the operation of oil and gas wells by the landowner/lessee that were open atthe time of the execution of the mortgage is not waste. See Federal Land Bank of NewOrleans v. Mulhern, 157 So. 370 (La. 1934); Cronan v. Castle Gas Co., 512 A.2d 1 (Pa.

Super. Ct. 1986).105“The mortgagor of gas, oil or mining lands may extract the oil or gas and remove theminerals, and convert them into money, if the gas or oil wells or mine operated were dugor opened at the time the mortgage was placed upon the premises; but if they were not,then the lands cannot be so worked, for it is waste as against the mortgagee to permit it,even though the land was purchased as mineral land.” Montague v. Brassell, 443 S.W.2d

703, 705-06 (Tex. Civ. App. 1969)(citing 2 Thornton, Oil & Gas § 746 (5th ed. 1932)).106See Federal Land Bank of New Orleans v. Mulhern, 157 So. 370, 371 (La. 1934).

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Many courts have used similar analyses in deciding that a mortgagorcould not extract oil and gas from the property. The Supreme Court ofLouisiana examined a typical mortgagor mortgagee scenario and foundthat the mortgagor did in fact commit waste by operating an oil well.106

In reaching its conclusion, the court first found:

A lease granted by the owner for the development of theproperty for oil and gas is, in a sense, a conveyance of themineral rights, an alienation of a part of his interest in theland, a dismemberment of the realty. The gas in place in theground being a part or element of the realty, it follows that itconstitutes part of the land, and it, like the surface of the realty,was pledged by the mortgagors to the mortgagee as securityfor the debt. By giving the mortgage, the mortgagors grantedto the mortgagee a right, a species of pledge, over not onlythe surface of the land, but over all its constituent elements,including the gas in place and unsevered.107

By leasing the land for oil and gas development, the court stated thatas a result, “. . . the fee was impaired, the value of the royalty wasdiminished to the extent of the value of the gas reduced to possession,and the mortgagee’s security weakened. . . . The withdrawal of gas fromthe lands not only deteriorated them, but was a waste of them. . . .”108

Therefore, without the consent of the mortgagee, development of theland for the purpose of removing oil and gas will generally constitutewaste which may be enjoinable by the mortgagee or for which themortgagee may recover damages.109 Such “waste” may also result in anacceleration of the mortgage debt.”110

[c] — Title Theory and Lien Theory of Mortgagesand Effects Upon Waste.

107Id. at 373.108Id.109See 2 Howard R. Williams and Charles J. Meyers, Oil and Gas Law §518 (1991).110See id.

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While it is generally considered to be waste to create an oil and gaslease after a mortgage has been created, some states, to some extent, willallow oil and gas leases to be created. The potential ability to create an oiland gas lease depends, in part, upon whether the state in question views amortgage under the title theory or the lien theory. In a title theory ofmortgages jurisdiction, where title to or possession of the land is in themortgagee, removal of oil and gas by the mortgagor will constitute aninjury to the security of the mortgagee.111 In a lienor hybrid-theoryjurisdiction, injury to the security of the mortgagee does not occur untilthe mortgagee’s security has been impaired, which is usually stated to bewhen the value of the property becomes less than the balance of the debt.112

Under a title theory jurisdiction, it is quite clear that the creation ofan oil or gas lease results in waste.113 The lien hybrid-theory jurisdictionsdo not argue that the creation of an oil and gas lease is automaticallywaste to a mortgagee. Instead, they generally argue that waste does notoccur until the value of the land, after removal of oil and gas, falls belowthe balance due on the debt.114 This doctrine has been criticized because

111See Richard W. Hemingway, The Law of Oil and Gas § 5.6 (3d ed. 1991).112See id. For example, if the loan balance is $50,000, and the property value is $100,000,the property owner can extract oil and gas until the value of the property falls below

$50,000.113See supra § 2.03[2][b].114This doctrine was largely created out of the case of Carroll v. Edmundson, 41 S.W.2d64 (Tex. Comm’n App. 1931). Carroll dealt with the removal of an elevator from propertyunder a lien mortgage jurisdiction. In reaching its conclusion, the court states: “It followsin the case at bar the measure of Carroll’s damage for the wrongful removal of the elevatorin question is not the market value of the elevator itself, but the injury done to Carroll’smortgage by such removal, and if the property as left was of sufficient value to secure the

debt, then Carroll has suffered no injury.” Id. at 65.115See Richard W. Hemingway, The Law of Oil and Gas § 5.6 (1991). For example, ifthe property in question was worth $100,000, a bank might only lend $80,000 toward thepurchase of the property. A lending cushion therefore provides the bank with leeway

should market conditions change.116For example, if an oil and gas lease decreases the value of property from $100,000 to$50,000, and a mortgage of $80,000 exists, then waste would occur if the balance due onthe loan is not decreased to $40,000. I.e., the loan balance should decrease proportionately.

Since the land value decreased by 50 percent, so too should the loan balance.

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117See Richard W. Hemingway, The Law of Oil and Gas § 5.6 (3d ed. 1991).118See Federal Land Bank of New Orleans v. Mulhern, 157 So. 370 (La. 1934). “Thewithdrawal of oil and gas not only deteriorated them, but was a waste of them as the term

‘waste’ was meant in the act of mortgage.” Id. at 373.119See Thompson v. Paasche, 950 F.2d 306, 308-309 (6th Cir. 1991).120See id. at 309.121See id. at 309-310.122See id. at 310.

a lender generally will not lend 100 percent of the value of their collateralproperty, but will require that a cushion of value, a lending cushion, existin their collateral property to support the loan.115 If a court is using thelending cushion analysis, waste occurs when the ratio of the value of thecollateral property to the balance due on the debt is diminished.116

Applying the foregoing concepts to Blackbeard’s oil and gas leasewith OilCo, Blackbeard’s oil and gas lease with OilCo will constitutewaste if the property is located in a title theory of mortgages jurisdiction.However, in a lien theory of mortgages jurisdiction, three answers emergeto this question. First, the removal of oil and gas pursuant to the OilColease will constitute waste if Kentucky law is such that such productionconstitutes waste. Second, waste will have occurred if FreeMoney Bank’smortgage is impaired; that is, the value of the collateral property becomesless than the balance due on Blackbeard’s debt to FreeMoney Bank asdetermined under Carroll v. Edmundson117 or the lending cushion analysis.Third, if the mortgage given by Blackbeard to FreeMoney Bank provides(expressly or implied) that the removal of oil and gas is waste, then suchremoval is waste.118 Therefore, particular care must be paid to both statelaw and the instrument(s) creating mortgage(s).

§ 2.05. Oil and Gas Operations.[1] — Land Valuation.Oil and gas operations can affect the value of property in several

different ways. For example, the mere existence of an oil and gas leasemay cause a diminution in the value of property. In Thompson v. Paasche,

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a developer of land sold off several lots of land, retaining the mineralinterests, so he claimed, to ensure that no oil or gas lease would destroythe scenic beauty of the area.119 Simultaneously with these representations,the developer was negotiating an oil and gas lease.120 The oil and gaslease was executed and recorded subsequent to the plaintiff’s deeds ofsale.121 The plaintiff land purchasers eventually discovered the lease andcommenced suit against the land developer.122

After the court affirmed the fraud claim, the court turned to the issueof damages.123 On the issue of damages, the court agreed with theplaintiff’s witness, who testified that the fact that the mineral lease appearedin the title chain caused a reduction in the market value of the property.124

The plaintiffs suffered damages, inasmuch as the market value of theirland was reduced.125

This case is similar to the concept of waste. For example, waste occurswhen the value of the property is diminished in such a way as to causepermanent loss to the owner of the property.126 This case points out thatland value can be diminished at a point prior to the actual removal of oilor gas.

Concepts such as the creation of an oil or gas lease, or, in thealternative, the discovery or non-discovery of oil and gas, can eitherdiminish or enhance the value of property. Conceptually, the “why” behindwhy the creation of a lease can diminish the value of land isstraightforward. If a person reserves a mineral interest, or if a parcel ofland is subject to an existing oil and gas lease, the buyer of the land receives

123See id. at 311-313. A second claim, based in Racketeer Influenced Corrupt

Organizations (RICO), was ruled to be insufficiently proven by the plaintiffs. Id.124See id. at 313.125See id. at 313.126See 2 Howard R. Williams and Charles J. Meyers, Oil and Gas Law § 518 (1991);

Federal Land Bank of New Orleans v. Mulhern, 157 So. 370, 373 (La. 1934).127Speculative value, or a speculative transaction, has been formally defined assomething “. . . outside the range of ordinary buying and selling, and involving elementsof risk and uncertainty dependant on fluctuations in the market more or less remote intime, upon engagements extraordinary in nature, upon commitments of exceptionalnature, . . . or upon ventures otherwise partaking of business hazards promising large

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something less than the entire bundle of rights associated with the land,which is less valuable than the entire bundle of rights.

Similarly, the discovery or non-discovery of oil and gas can affectthe value of property. The buyer/lessee of property has no guarantee thatthere will/will not be commercial quantities of oil and gas on a particularproperty. Value of this type of land is commonly referred to as being“speculative.”127 It is this concept of speculative value that courts examinewhen attempting to value oil and gas land. For example, in a trespasscontext, commentators have stated that an oil and gas trespasser destroysthe speculative value of land in another when he demonstrates theimprobability of securing commercial production from it.128 Thisdestruction of speculative value may result from the wrongful drilling ofa dry hole or non-commercial well on the land, or from the making of awrongful geophysical survey which reveals (or is believed to reveal) thatdrilling operations are not reasonably prudent.129

Several prominent cases have examined oil and gas land’s speculativevalue. One such case was Humble Oil & Refining Co. v. Kishi.130 In Kishi,an oil and gas lease was granted to Humble Oil by the two mineral rightsholders.131 After the three-year lease term had expired, Humble Oil entered

returns if fortunate, and involving considerable losses if disastrous, or in other respectsoutside the common conduct of trade.” 39A Words and Phrases Speculative Transaction479 (1953)(citing Rosenblum v. Springfield Produce Brokerage Co., 137 N.E. 357 (Mass.

1922)).128See 1 Howard R. Williams and Charles J. Meyers, Oil and Gas Law § 229 (1991).129See id.130 Humble Oil & Refining Co. v. Kishi, 276 S.W. 190 (Tex. Comm’n App. 1925)

judgment set aside on other grounds 291 S.W. 538 (Tex. Comm’n App. 1927).131See id. at 190. The owners held three-quarters and one-quarter mineral rights. Id.132See id. Humble acted under a good faith belief that it still had the right to enter the

land. Id.133See id. at 191.134See id. But see Martel v. Hall Oil Co., 253 P. 862 (Wyo. 1927)(finding, under similarfacts, that the plaintiff could not recover because the trespass only discovered the truth –

that there were no minerals there to be mined).135 American Surety Co. v. Marsh, 293 P. 1041 (Okla. 1930).

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onto the property to conduct exploratory drilling.132 Humble Oil failedto find any oil on the property, and the mineral rights holders sued, claimingthat the speculative value of the land had been destroyed.133 In Kishi, thelandowners were entitled to recover for the harm done to the land’sspeculative value.134 Other cases and commentators have relied on theKishi decision. For example, in American Surety Co. v. Marsh,135 thecourt found that a loss of speculative value existed as to the plaintiff whenafter a defendant lost a property title suit claim to the plaintiff, the defendantthen drilled a dry hole on an adjacent piece of property.136

In oil and gas law, not only does the actual discovery or non-discoveryof oil and gas affect land value, but so too does the granting or non-granting of the right to look for oil and gas.137 In criticizing decisionssuch as Shell Petroleum Corp. v. Puckett138 and Mustang Production Co.v. Texaco,139 that found that no harm had occurred through the discoveryof geologically important information, commentators have stated:

To the extent that an individual is allowed to conductgeophysical exploration without the consent of the lessee,the lessee’s bargaining power is affected. It is the reductionof this uncertainty that has avalue . . . . The court’s error wasin classifying geophysical exploration as an activity that doesnot affect the lessee. As the information gained by the

136See Marsh, 293 P. 1041. However, the court so ruled because the plaintiff proved theloss of a specific lease opportunity. Id. The court indicated that in the absence of suchspecifically proven damages, the plaintiff would not have prevailed. Id. For more discussionon this topic, see 1 Howard R. Williams and Charles J. Meyers, Oil and Gas Law § 229

(1991).137See N. Suzanne Lomenick, Comment, “The Oil and Gas Lessee’s Right to GeophysicalExploration: Incidental or Exclusive?” 20 Tulsa L.J. 97 (1984). The right to search for oil

and gas deposits usually takes the form of sample holes or seismographic testing.138 Shell Petroleum Corp. v. Puckett, 29 S.W.2d 809 (Tex. Civ. App. 1930).139Mustang Production Co. v. Texaco, 549 F. Supp. 424 (D. Kan. 1982).140N. Suzanne Lomenick, Comment, “The Oil and Gas Lessee’s Right to Geophysical

Exploration: Incidental or Exclusive?” 20 Tulsa L.J. 97, 106-07 (1984).141See Phillips Petroleum Co. v. Cowden, 241 F.2d 586, 590 (5th Cir. 1957).

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exploration becomes more widespread and available, fewerindividuals will be interested in purchasing the right toconduct their own exploration. The right to geophysicalexploration would then decrease in value each time it isexercised.140

The Fifth Circuit applied some of these concepts when it examinedan instance where the mineral rights and surface rights had been severed,and the surface owner conducted geological testing.141 In examiningwhether the surface rights holder had harmed the value of the mineralinterest, the court stated:

[A]n unexplored mineral right has only a speculative valuefar in excess of or considerably less than the real value of theproperty it represents. It is both public knowledge in generaland it appears from this record that the right to explore forminerals has a considerable monetary value. . . . Since mineralrights are in the first instance almost always purchased asspeculations and are often resold as such a number of times itwould be a peculiar rule that would permit the owner of anentirely different estate, the surface, to reduce or to sell theright to reduce to a certainty, and thereby change the wholebasis of the valuation of information about the propertybelonging to another. . . .142

Finally, the value of oil and gas land may be affected in foreseeable,and not so foreseeable manners. For example, one court noted that changesin the oil and gas price per barrel market can either increase or decreasethe market value of oil and gas real property.143 Similarly, the merepresence of activities such as oil and gas leasing, or the presence of a

142Id.143See Lynch v. State Bd. of Equalization, 210 Cal. Rptr. 335, 343 (Cal. Ct. App. 1985).144See N. Suzanne Lomenick, Comment, “The Oil and Gas Lessee’s Right to GeophysicalExploration: Incidental or Exclusive?” 20 Tulsa L.J. 97 nn.33,60 (1984)(citing Hull, “Oiland Gas Leasee v. Seismograph License,” 21 Okla. B. J. 1503, 1504 (1950)). It is alsonoted that litigation could potentially arise over the destruction of speculative values of

land due to such activities. Id.

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seismographic party, can cause land values to increase, or may cause landto become effectively condemned.144

Valuation topics such as these can have profound effects upon thenegotiating of subordination and/or non-disturbance agreements with priorlienholders in general. Obviously, if it can be shown that oil and gas incommercial quantities does exist on collateralized property, then thelienholder may be able to foreclose on more valuable property than wasoriginally believed. If so, then the lienholder may wish to foreclose,terminate the oil and gas lease, and sell the property at a higher price. Onthe other hand, the lienholder may feel additionally secure due to thehigher value of his collateral, and allow development of the oil and gas tocontinue. Similarly, the non-discovery of oil and gas may cause the valueof the prior lienholder’s collateral to decline, if in fact the mineral interestswere included in the original valuation of the collateral, which, in allprobability they were not.

[2] — Damage(s) to the Surface Estate.While an oil and gas lease interest may provide for surface usage

rights, if the lease or interest fails to create an express surface easement,then the law will imply one. In such a case, the surface easements impliedare those that will permit the lessee or mineral owner to enjoy the interestconveyed.145 The lessee or mineral owner may make such use of thesurface land as is reasonably necessary for exploration, development andproduction of the minerals.146 Examples of reasonable use include cutting

145See 1 Howard R. Williams and Charles J. Meyers, Oil and Gas Law § 218 (1991).

For state caselaw, see id. at § 218 n.8.146See id.147See Gulf Refining Co. v. Davis, 80 So. 2d 467 (Miss. 1955).148See Stradely v. Magnolia Petroleum Co., 155 S.W.2d 649 (Tex. Civ. App. 1941).149See Fowler v. Delaplain, 87 N.E. 260 (Ohio 1909).150See Gulf Oil Corp. v. Walton, 317 S.W.2d 260 (Tex. Civ. App. 1958).151See Voisin v. Berry Bros., Inc., 387 So. 2d 633 (La. App. 1980).152See Brown v. Lundell, 344 S.W.2d 863 (Tex. 1961).153See Wilson v. Schermerhorn Oil Co., 245 P.2d 845 (N.M. 1952).

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down trees,147 the right to use water on the surface,148 housing ofemployees on the surface,149 and the construction of roads.150

A mineral interest owner cannot go beyond reasonable uses of thesurface estate and cause destruction to the surface estate. If the mineralowner does harm the surface estate, traditional legal principles such asnuisance or negligence may lead to liability. There is no lack of caselawexplaining how a lessee has inappropriately damaged the surface estate.Cases include the negligent destruction of oysters,151 negligent failure toprevent seepage from a salt water disposal tank,152 negligently allowingpuddles of oil to form on the surface,153 and the poisoning of cattle byleaving a can of pipe lubricant open.154 Finally, there is a dispute ofauthority as to whether a typical oil and gas lease implies a duty to restorethe condition of the surface.155

§ 2.06. Ramifications of Foreclosure.Generally speaking, the foreclosure of a mortgage, or the execution

upon a lien, if properly conducted, will cut off all junior interests in theproperty, including the interests of a lessee under an oil and gas lease thatis junior to the lien that is being foreclosed/executed upon.156 However,interests arising prior to the mortgage or lien being foreclosed upon thathave not been subordinated to such instrument are generally not affected

154See Weaver v. Reed, 303 S.W.2d 808 (Tex. Civ. App. 1957).155Commentators do not favor this implied covenant, largely because it is well knownthat oil and gas operations cause damage to the surface estate. See 1 Howard R. Williams

and Charles J. Meyers, Oil and Gas Law § 218.12 (1991).156See 4 Richard R. Powell and Patrick J. Rohan, Powell on Real Property § 37.36[6](1998); 4 Eugene Kuntz, The Law of Oil and Gas § 52.3 (1990); State ex rel. Comm’rs of

Land Office v. Reynolds, 206 P.2d 184 (Okla. 1949).157See 4 Richard R. Powell and Patrick J. Rohan, Powell on Real Property § 37.36[6]

(1998).158Dundee Naval Stores Co. v. McDowell, 61 So. 108 (Fla. 1913); Brush v. Fowler, 36Ill. 53 (1864). Deeds of trust and other liens reach the same result. See Dover MobileEstates v. Fiber Form Products, Inc., 270 Cal. Rptr. 183 (Cal. Ct. App. 1990); Agribank,FCB v. Rodel Farms, Inc., 623 N.E.2d 1016 (Ill. App. Ct. 1993)(discussing liensgenerally); Abella v. Knight Oil Tools, 945 S.W.2d 847 (Tex. App. 1997)(mechanic’s

lien terminates junior lease interest).

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by a foreclosure proceeding.157 Therefore, assuming that FreeMoney Bankhas a first mortgage on Blackbeard’s property, if FreeMoney Bankforecloses on its mortgage, and the foreclosure proceeding is properlyconducted under Kentucky law, then the oil and gas lease of OilCo willbe cut off; that is, OilCo’s leasehold interest will be divested.

[1] — Joinder of Lessee in Majority of States.In a majority of states, the question of whether a foreclosure action

and sale terminates a subsequent lease depends on the joinder of the lesseeas a party to the foreclosure action.158 Under the majority view, asubsequent lease is terminated only if the lessee is joined as a defendantin the foreclosure action.159 Under the majority view, any person whoseinterest is claimed to be subject to and subordinate to the lien beingforeclosed should be joined as a defendant in the foreclosure action.160

The defendants should include the owner of record, tenants, holders ofreversionary or remainder interests, holders of dower or courtesy rights,judgment creditors and junior lienors.161

A failure to join a necessary party in a foreclosure action generallymeans that the foreclosure is ineffective as to the omitted party.162 Thusif FreeMoney Bank forecloses, and OilCo is a necessary party, butFreeBank fails to name OilCo as a defendant, OilCo’s leasehold interest

159See id. See also East New York Sav. Bank v. Austin Mall Assocs., 638 N.Y.S.2d

730, 730-31 (N.Y. App. Div. 1996).160See 4 Richard R. Powell and Patrick J. Rohan, Powell on Real Property § 37.36[6](1998); Polish Nat’l Alliance of Brooklyn, U.S.A. v. White Eagle Hall Co., 470 N.Y.S.2d

642, 646-67 (N.Y. App. Div. 1983).161See id.162See id. at 648.163Id. at 647(citations omitted).164See 4 Richard R. Powell and Patrick J. Rohan, Powell on Real Property § 37.37[12]

(1998).

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will not be cut off. Joinder of necessary parties is not only desirable so asto convey clear title, but also “[n]otice to interested persons provides themwith the opportunity to redeem prior to sale, to bid at the sale (whichconceivably might increase the sale price), and to protect their interestsin a possible surplus.”163

The omission of a junior interest does not necessarily cause apermanent scar on the title of foreclosed property. While an omitted partyis allowed to proceed as though no foreclosure had taken place, the partywho purchases at the foreclosure sale is generally deemed to stand in thesame position as the party that foreclosed.164 Not only may the purchaserredeem the rights of the junior interest,165 the purchaser may alsoreforeclose and cut off any rights the junior lienor may have.166

[2] — No Joinder of Lessee in Minority of States.In a minority of states, joinder of the lessee as a party to the foreclosure

action is irrelevant.167 Under the minority view, the leasehold interestacquired subsequent to a mortgage or other lien are extinguished by aproperly conducted foreclosure proceeding, notwithstanding the fact thatthe lessee is not a party to the action.168 A careful review must beundertaken of each state’s foreclosure statutes because some states,although not requiring that a lessee be joined as a party, require that alessee be provided with notice of a foreclosure sale in order to cut off thelessee’s leasehold interest.169

§ 2.07. Title Curative for Prior Liens.

165Redemption of the junior lien involves paying the balance due on the junior lien. Bypaying the junior lien, the purchaser prevents the junior lienor from filing a foreclosure

action.166See 4 Richard R. Powell and Patrick J. Rohan, Powell on Real Property § 37.37[13]

(1998).167See id. at § 37.37[8].168See 55 Am. Jur. 2d Mortgages § 653 (1996).169For example, Pa. R. Civ. P. 3129 requires, among other things, that thirty days priorwritten notice of a foreclosure sale be served upon every person who has any recordinterest in the property being foreclosed upon (e.g. a lessee), whose interest may be

affected by the sale.

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[1] — Satisfaction on the Record of Lien ObligationsPreviously Fulfilled.

One goal of the lessee under an oil and gas lease should be to obtainas high a priority as possible in the chain of title for its leasehold interest.Toward that goal, the lessee should first obtain a title examination for theproperty that is to be the subject of the lease and determine whether thereare encumbrances of record (e.g. a very old mortgage) that should havebeen, but were not, satisfied. If so, the lessee should attempt to satisfysuch obligations on the record. For example, if when Blackbeard purchasedhis property there was an existing mortgage of record that had been paid,but not satisfied, then OilCo should work with Blackbeard to obtain andrecord a satisfaction piece for this prior mortgage. Other methods forclearing prior liens that may be seen by the lessee as being “title defects”are the use of statutes that work to eliminate such “title defects” and theinitiation of quiet title actions.170

[2] — The Subordination Agreement.In its simplest form, a subordination agreement “attempt[s] to create

a contractual system of superiority and inferiority between two or more

170See Joseph Shade, “Petroleum Land Titles; Title Examination & Title Opinions,”

46 Baylor L. Rev. 1007, 1058-59 (1994).171Ethan M. Cohen, “Subordination Agreements” § 4.4, Illinois Institute for ContinuingLegal Education, Advanced Commercial Finance and Creditor’s Rights in Illinois (July

1993)(available on Westlaw at ACFCR Il-CLE 4-1 (Main Handbook)).172See id. at § 4.8. “Lien subordination should be sharply distinguished from debtsubordination. In a pure lien subordination, the junior secured creditor does not promiseto forego payment on the junior claim. It may receive cash from the common debtorwithout violating any rights of the senior secured party. If the collateral were to disappear,the senior and junior secured parties would be equal general creditors of the debtor. . . .A further difference between debt subordination and lien subordination is that lien

subordination presupposes that both the senior and junior do, in fact, have liens.” Id.173Oakes v. Michigan Oil Co., 476 So. 2d 618 (Ala. 1985)(citing 59 C.J.S. Mortgages

§ 229 (currently found at 59 C.J.S. Mortgages § 213 (1998)).174See Oakes, 476 So. 2d at 621.175The subordination clause in an oil and lease should provide, at a minimum, that (1)the lessor consents to the subordination to the oil and gas lease of any lien affecting the

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classes of debt.”171 Liens may also be subordinated.172 “The legal orderof priority as between mortgages and other liens or claims may be fixed,reserved, or modified by an agreement of the parties or by a waiver orrelease on the part of the prior lienholder.”173 In light of the ability of aprior lienholder to cut off the rights of a junior interest or lien in property,the subordination of liens can be of critical importance in developing, orleasing land, for oil and gas recovery. As with any contract, a subordinationagreement must contain the requisite elements of a contract.174 Althoughit is advisable to include a subordination clause in an oil and gas lease, forthe protection of the lessee vis-a-vis the lessor,175 as a general rule, theconsent of the lessor is not required to effect a change in the order ofpriority as between a lessee, mortgagee or other lienholder.176

The most important provision of a subordination agreement is thatthe foreclosure of the lien will not affect the validity of the oil and gaslease. The legal priorities of the leasehold interest and the lien beingsubordinated must be such that the leasehold interest is the superior interest.When attempting to draft a subordination agreement, care should be takenas to whether a mortgage or some other type of lien is being subordinated.Representative language that may be included in a subordinationagreement with respect to the subordination of a prior mortgage is asfollows:

NOW THEREFORE, in consideration of One Dollar in handpaid, the receipt of which is hereby acknowledged, theundersigned hereby excepts and releases the interest of the

leasehold interest and (2) upon the request of the lessee, to assign, to the prior lienholderto be subordinated, a portion, if not all, of any royalty, rental or other payments accruingto the lessor under the oil and gas lease. 4 Howard R. Williams & Charles J. Meyers, Oiland Gas Law § 697.3 (1991). Representative language for a subordination clause is asfollows: “If any part or all of said lands are now or hereafter mortgaged, lessor willpromptly execute a recordable assignment of all royalties and rentals as payable hereunder,to the owner of such mortgage, upon request of Lessee, if necessary to secure recordableagreement from such owner that said mortgage shall be subordinated to this lease. Lessorsconsent to the subordination to this lease of any mortgage, deed of trust or lien now upon

said land.” Id.176See id. at 622.1776 Walter L. Summers, The Law of Oil and Gas §1222 (1967). See also Larry L.

Skeen, West Virginia Oil and Gas Law 271 (1984).

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lessee held under and by virtue of said oil and gas lease fromthe lien of said mortgage, but without waiving or releasingany rights of said undersigned under said mortgage as againstthe royalty interest under said lease, and agrees that said oiland gas lease shall have the same validity and effect as ifexecuted, delivered and recorded prior to the date ofexecutions of said mortgage.177

Representative language that may be included in a subordinationagreement with respect to the subordination of a prior deed of trust is asfollows:

NOW THEREFORE, the undersigned present holder andowner of said indebtedness and lien for and in considerationof Ten Dollars ($10.00), receipt of which is herebyacknowledged, and in order to induce the Lessee to acquiresaid Oil and Gas Lease, does hereby agree that the lien shallbe and is hereby made subordinate, subject to, and inferior tosaid Oil and Gas Lease, and in the event of the sale of saidlands by the trustee under the power of sale in said Deed ofTrust, it is hereby agreed that the leasehold estate created bysaid Oil and Gas Lease shall in no wise be affected by suchsale. It is understood and agreed, however, that said lien shallnot be impaired hereby as to the Lessors reversionary mineralestate, the possibility of reverter, or as to the royalties thatmay have been or may be reserved by the Owner of the abovedescribed lands in said Oil and Gas Lease.178

Representative language that may be included in a subordinationagreement with respect to the subordination of a prior lien (other than amortgage or deed of trust lien) is as follows:

NOW THEREFORE, in pursuance of said agreement and fora valuable consideration in hand paid to the undersigned bythe Lessee, the receipt whereof is hereby acknowledged, theundersigned, does hereby covenant, consent and agree withthe said Lessee, that the aforesaid indebtedness and liens held

1787 Eugene Kuntz, The Law of Oil and Gas §140.6. (3d ed. 1991).

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by the undersigned are and shall continue to be subject toand subordinate to the Oil, Gas and Mineral Leasehereinabove described and all rights and estates grantedtherein.

. . .

This agreement and subordination shall in no wise affect orimpair the rights of the undersigned or his or its heirs,successors, legal representatives or assigns, to hold, forecloseor sell under said lien or liens in any manner prescribed bycontract or law, all of the lands, hereditaments andappurtenances and estates therein, save and except the rights,titles, estates and privileges of the said Lessee under theaforesaid Oil, Gas and Mineral Lease and any extensionsthereof; and any renewals or extensions of said lien and anyforeclosures or sales of said lands or any part thereof underthe aforesaid liens shall expressly except and be subject tosaid Oil, Gas and Mineral lease and rights thereunder.179

Oil and gas development may enhance the value of property, thelienholder’s collateral, to the benefit of the lienholder. Therefore, as acondition to the subordination of its prior lien, the lienholder may requirethat all payments, or a portion thereof, accruing under the oil and gaslease be assigned to the lienholder and applied to the indebtedness of thelessor that is secured by the lien.180 Such an assignment may be an absoluteassignment or a conditional assignment.181 Representative language thatmay be included in a subordination agreement to effectuate an absoluteassignment of all amounts accruing under an oil and gas lease is as follows:

179Id. at §140.3.180See 4 Howard R. Williams and Charles J. Meyers, Oil and Gas Law §697 (1991).181See Federal Land Bank of Wichita v. Koch Oil Co., No. 65313, 1991 Kan. App.

LEXIS 440 (Kan. Ct. App. June 7, 1991).1826 Walter L. Summers, The Law of Oil and Gas § 1222 (1967). See also Larry L.

Skeen, West Virginia Oil and Gas Law 271 (1984).183See Dover Mobile, 270 Cal. Rptr. at 185-86 (citing Nelson & Whitman, Real Estate

Finance Law § 15.11 (2d ed. [Lawyer’s Ed.] 1985)).

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The interest owners hereby authorize the lessee to pay anyrentals, royalties and bonuses that may become due andpayable to the interest owners under the lease to the lienholderuntil the lienholder gives written notice to the lessee that thelien has been released or discharged. All amounts receivedby the lienholder hereunder shall be applied to the lien.182

Subordination agreements are particularly important for avoidingproblems involving termination of leases and waste. General commerciallaw has indicated that a subordination agreement effectively replaces, viacontract, the recording system of a particular state.183 Cases construingoil and gas subordination agreements generally find that the parties’ intentis the controlling consideration for an oil and gas subordinationagreement.184 Cases have ruled that just as a subordination agreementcan change the priority of parties, it may also be essential in preventing afinding of waste.185 For example, in a state that provides that oil and gasextraction constitutes waste, a subordination agreement should be obtainedeven if the mortgage assigns to the mortgagee all of the mortgagor’s profitsand royalties.186

184See Century Offshore Management Corp. v. K.E. Resources, Ltd., 119 F.3d 409 (6thCir. 1997)(parties agreed to change Louisiana race statute’s prioritization regarding oiland gas lease); Oakes v. Michigan Oil Co., 476 So. 2d 618 (Ala. 1985); Ranier v. Mount

Sterling Nat’l Bank, 812 S.W.2d 154 (Ky. 1991).185See In re Burris, 109 B.R. 1018 (Bankr. E.D. Okla. 1990).186See id. at 1020.187For a discussion on the negotiation of non-disturbance agreements in a general context,see Joel R. Hall, “Subordination and Nondisturbance Agreements: The Tenant’sPerspective,” American Law Institute – American Bar Association Continuing LegalEducation (1995)(available on Westlaw, C121 ALI-ABA 307). For a sample Non-Disturbance Agreement, see Ronald H. Wilcomes, “Mortgagee’s Non-DisturbanceAgreement and Lessee’s Agreement to Attorn,” ALI-ABA Continuing Legal Education(1996)(available on Westlaw at SB08 ALI-ABA 1539). For example, the pertinent partsof a non-disturbance agreement may state:1. The Lease is and shall be subject and subordinate in all respects to the Mortgage andto any renewal, modification, replacement or extension of the same and to any subsequentmortgages with which the Mortgage may be spread and consolidated.2. That, provided Lessee complies with this Agreement and is not in default under theterms of the Lease in the payment of rent or additional rent or the performance of any of

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OilCo should attempt to obtain a subordination agreement from theholder of each interest in the chain of title that may be in a position to (i)cut off OilCo’s leasehold interest, (ii) enjoin OilCo from developing andproducing its leasehold interest, (iii) pursue a cause of action against OilCofor waste, or (iv) otherwise affect or interfere with OilCo’s leaseholdinterest.

[3] — The Non-Disturbance Agreement.Another method of dealing with the ability of a prior lienholder to cut

off the rights of a junior interest in or lien on property is the use of a non-disturbance agreement.187 Such an agreement provides that the prior lienwill not, by foreclosure or otherwise, disturb the lessee’s possession, aslong as the lessee is not then in default under the lease.188 A non-disturbance agreement provides the lessee with the assurance of thereasonable safety for its expenditures in the development and operationof its leasehold interest so long as the lessee is not in default under thelease and provides the prior lienholder with an agreement that providesthat its lien will remain superior. It also provides the prior lienholder witha stream of income to apply toward payment of the outstanding lien/debt

the terms, conditions, covenants, clauses or agreements on its part to be performed underthe Lease, as of the date Mortgagee files a lis pendens in, or otherwise commences aforeclosure action, or at any time thereafter, no default under the Mortgage, as modified,extended, increased, spread or consolidated, and no proceeding to foreclose the samewill disturb Lessee’s possession under said Lease and the Lease will not be affected orcut off thereby, (except to the extent that Lessee’s right to receive or set off any moniesor obligations owed or to be performed by the Mortgagee’s predecessors in title shall notbe enforceable thereafter against Mortgagee or any subsequent owner) andnotwithstanding any such foreclosure or other acquisition of the Demised Premises byMortgagee, the Lease will be recognized as a direct lease from Mortgagee or any otherparty acquiring the Demised Premises upon the foreclosure sale, except that theMortgagee, or any subsequent owner, shall not (a) be liable for any previous act or omissionof landlord under the Lease, (b) be subject to any offset which shall theretofore haveaccrued to Lessee against landlord, (c) have any obligation with respect to any securitydeposited under the Lease unless such security has been physically delivered to Mortgagee,or (d) be bound by any previous modification of the lease or by any previous prepaymentof fixed rent for a period greater than one (1) month, unless such modification orprepayment shall have been expressly approved in writing by the Mortgagee. Id.188See Dover Mobile, 270 Cal. Rptr. at 187 (citations omitted).189See supra § 2.06[2].

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if it forecloses on its lien. As discussed in connection with the subordinationagreement, as a condition to entering into a non-disturbance agreement,the lienholder may require that all, or at least a portion, of the paymentsaccruing under the oil and gas lease be assigned, either absolutely orconditionally, to the lienholder and applied to the indebtedness of thelessor that is secured by the lien.189

In the case of Blackbeard, assuming the mortgage of FreeMoney Bankwas the only lien to the OilCo’s leasehold interest, then a non-disturbanceagreement should include FreeMoney Bank and OilCo as the partiesthereto. If the non-disturbance agreement also contained an assignmentof income provision, then Blackbeard should also be a party to the non-disturbance agreement. In essence, the agreement should provide thatshould Blackbeard default, and FreeMoney Bank forecloses on itsmortgage, such foreclosure will not cut off, terminate or change the OilColease so long as OilCo is not in default under the terms of the lease. Theeffect of such an agreement is that FreeMoney Bank is assured that itsmortgage is prior to the leasehold interest of OilCo and that, in the eventof default, or as otherwise provided by the non-disturbance agreement,OilCo will pay all amounts due under the lease directly to FreeMoneyBank. As for OilCo, so long as it is not in default under the lease, there isno need for OilCo to be concerned with its leasehold interest being cutoff, the lease being terminated, it being evicted due to a foreclosure, itbeing forced to renegotiate its lease or it being concerned that normal oiland gas removal will result in a finding of waste.

§ 2.08. Business Curative of Prior Liens.[1] — Purchase Lienholder’s Position.It is not unlikely that FreeMoney Bank and/or the other prior

lienholders will refuse to subordinate their interest to the leasehold interestof OilCo or refuse to enter into a non-disturbance agreement. Many priorlienholders–in particular lenders–view the retention of lien priority as aprimary goal, viewing the benefits of subordination as relatively

190Subrogation has been defined as “The substitution of one person in the place ofanother with reference to a lawful claim, demand or right, so that he who is substitutedsucceeds to the rights of the other in relation to the debt or claim, and its rights, remedies

or securities.” Black’s Law Dictionary 1427 (6th ed. 1990).

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unimportant. Should such a situation occur to OilCo, OilCo should lookfor other business solutions in an attempt to eliminate the risk of itsleasehold interest being cut off, it being enjoined from developing itsleasehold interest and/or it being subject to a cause of action for waste.One such alternative is for OilCo to purchase the prior lienholders’positions and be subrogated to (step into the shoes) of such priorlienholders.

[a] — Subrogation.“Subrogation” is most easily analogized to substitution.190 Therefore,

if OilCo were to purchase FreeMoney Bank’s interest, OilCo may thenbecome the mortgagee.191 As the substitute for FreeMoney Bank, OilCowould hold the mortgage with the same level of priority that FreeMoneyBank did.192 The primary prerequisite to subrogation is that the personpurchasing the prior lien must have a protectable interest, such as a juniorlien or partial ownership of the property.193 Courts have consistently foundthat a lessee, such as OilCo, does have a protectable interest in real

191Some authorities hold that the purchase of a prior lien does not act as a puresubstitution, but rather adds the prior lien onto whatever the purchaser already owns. SeeNew England Loan & Trust Co. v. Robinson, 76 N.W. 415 (Neb. 1898); 51 Am. Jur. 2d

Liens § 61 (1970).192See 83 C.J.S. Subrogation § 14 (1953).193“The holder of a lien upon property, either real or personal, may discharge any priorvalid lien existing against the property, for his own protection . . . .” New England Loan,

76 N.W. at 416.194See Leno v. Prudential Ins. Co. of America, 46 S.E.2d 471, 474-75 (N.C. 1948) and

cases cited therein; 73 Am. Jur. 2d Subrogation § 93 (1953).195See Huffman v. Martin, 10 S.W.2d 636, 639 (Ky. 1928).196“A party who has an interest in property to be protected by discharging an encumbranceupon it has the right to pay it, and to substitute himself to the rights of the lienholder,whether either the creditor or debtor give his assent or not.” Fievel v. Zuber, 3 S.W. 273,

275 (Tex. 1887).197See 4 Eugene Kuntz, The Law of Oil and Gas § 52.3 (1990).198An example of such a clause: “Lessor . . . agrees that the lessee, at lessee’s option,may pay and discharge any taxes, mortgages, or other liens existing, levied, or assessedon or against the above described lands, and in the event lessee exercises such option,

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property.194 However, courts have also found that the purchasing partycannot make the purchase if there is no crisis impinging upon whateverinterest the purchaser already owned in the property.195 Finally, a purchaserdoes not need the landowner’s permission to do so.196

However, because the complexities of the application of conventionallaw relating to subrogation as it applies generally and to co-tenants aremore complex because of the nature of the oil and gas lease and the relationthereby created, the application of the conventional law of subrogation inthe context of oil and gas leases is not free from doubt.197 Therefore, thelessee under an oil and gas lease should insist that the lease contain asubrogation clause198 that specifies the claims/obligations that the lesseeis authorized to satisfy, whether the lessee may satisfy such claims/obligations prior to their maturity and whether the lessee is authorized towithhold the payment of rentals, royalties and other amounts payable tothe lessor under the lease in satisfaction of the lessee’s claim for amountsadvanced by the lessee to protect its leasehold interest.199

In the case of OilCo, if OilCo were aware of the prior liens beforedeveloping its leasehold interest and was unable to obtain a subordinationor non-disturbance agreement with respect to such liens, then OilCo mayconsider eliminating the risks associated with such liens by purchasingthese liens and being subrogated to (stepping into the shoes) the positionof the prior lienholders. Alternatively, OilCo may choose to proceed withthe development of its leasehold interest, knowing that it will have theopportunity to redeem the interest of the prior lienholders before itsleasehold interest is cut off by a foreclosure/execution sale. OilCo mustconsider many practicalities when making its business decision on theissue of purchasing the prior liens, such as (i) the applicable state law, (ii)the underlying transaction documents (e.g. do such documents permit theunderlying obligations to be extended/increased under the sameinstruments so that such an extension/increase would retain the priority

lessee shall be subrogated to the rights of any holder or holders thereof and may bereimbursed by applying to the discharge of any such mortgage, tax or other lien, anyroyalty or rentals accruing thereunder.” 3 Howard R. Williams and Charles J. Meyers,

Oil and Gas Law § 656.1 (1991).199See 4 Howard R. Williams and Charles J. Meyers, Oil and Gas Law § 685.3 (1991).

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of the existing lien), (iii) the amount of the prior liens, (iv) the value–albeit possibly speculative–of its leasehold interest, and (v) the projectedcosts of developing its leasehold interest.

[b] — Redemption.Should FreeMoney Bank have begun a foreclosure process on its

mortgage, OilCo still has an option that closely resembles subordination.An owner or junior lienholder enjoys what is called a right of redemption.The right of redemption is available to “Any person who may haveacquired any interest in the premises, legal or equitable, by operation oflaw or otherwise, in privity of title with the mortgagor, may redeem, andprotect such interest in the land. . . . But it must be an interest in the land,and it must be derived in some way, mediate or immediate from or through,or in the right of the mortgagor; so as, in effect, to constitute a part of themortgagor’s original equity of redemption. Otherwise it cannot be affectedby the mortgage, and needs no redemption.”200 It has been held that thisright to redeem extends to lessees, as lessees have an interest in theproperty.201 The effect of a redemption varies, due to variations amongstate redemption statutes, but a likely result is that the junior lienholderwill acquire rights superior to all other parties in the property.202 Thesubrogation clause in an oil and gas lease, previously discussed, shouldbe broad enough to encompass the amounts expended by a lessee in orderto exercise its right of redemption to protect its leasehold interest.

[2] — Use of Lease Royalties.The royalties and other amounts to be paid to the lessor under an oil

and gas lease may be used in at least two ways to assist or facilitate anacceptable business solution to deal with the risks associated with priorliens.

200George E. Osborne, Grant S. Nelson, and Dale A. Whitman, Real Estate Finance Law

§ 7.2 (1979)(citing Christiancy, J. in Smith v. Austin, 9 Mich. 465, 474 (1862)).201See Sever v. Yetter, 16 A.2d 461, 462 (N.J. Ch. 1940).202See 55 Am. Jur. 2d Mortgages § 915 (1996).203See supra discussion at 2.06[2].

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First, such amounts may be used by the lessee, with the consent ofthe lessor, to negotiate an acceptable business agreement with priorlienholders that will eliminate or reduce the business risks previouslymentioned as they relate to the lessee, in particular the risk of the lessee’sleasehold interest being cut off as a result of foreclosure. In connectionwith a subordination or non-disturbance agreement, the lessor may berequired to assign all, or a portion, of the amounts to be paid to the lessorunder an oil and gas lease to the prior lienholders.203 Such an assignmentprovides additional security to the prior lienholders in the nature of anadditional income stream to apply toward the satisfaction of the priorliens that might not otherwise be available.

Second, as previously discussed,204 the subrogation clause in an oiland gas lease should authorize the lessee to withhold all amounts due tothe lessor under the oil and gas lease in satisfaction of the lessee’s claimsfor amounts advanced by the lessee on behalf of the lessor in order toprotect its leasehold interest. For example, if Blackbeard failed to makeits mortgage payments to FreeMoney Bank and FreeMoney Bankcommenced foreclosure proceedings, and OilCo redeemed the mortgageof FreeMoney Bank in order to protect its leasehold interest, then OilCoshould be authorized under the terms of its lease with Blackbeard towithhold all amounts due and owing to Blackbeard under the lease untilsuch time as OilCo has recovered all amounts it expended in connectionwith redeeming the mortgage of FreeMoney Bank.

[3] — Mandatory Notification by Lessor to Lessee of LienDebt Service or Default.

The oil and gas lessee is particularly interested in being apprised ofdebt service associated with any mortgage or other lien on the propertyand any delinquencies and/or defaults associated therewith that may affect

204See supra discussion at 2.07[a].205In its simplest form, such a provision may state: Lessor shall notify Lessee of anydelinquency and/or default by Lessor under any mortgage or other lien against the propertyand the debt service associated with any such mortgage or other lien on the property.Further, Lessor shall notify Lessee of the creation of any new mortgage or lien regardingthe property.

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its leasehold interest. Therefore, it is advisable to include in an oil andgas lease a provision in the oil and gas lease that requires landowners/lessors to notify the lessee of mortgage/lien debt service agreements,delinquencies and/or defaults, the creation of additional liens and othersimilar events.205 Such notice provides the lessee with the opportunity tocure defaults and to otherwise protect its leasehold interest.

§ 2.09. Summary and Conclusion.There may be substantial risks associated with developing an oil and

gas lease that is the subject of prior liens. These risks include the dangerof the lessee’s leasehold interest being cut off by a prior lienholder’sforeclosure/execution sale, the lessee being enjoined from developing itsleasehold interest, and/or the lessee being subject to a cause of action forwaste. However, the lessee has a number of alternatives available to itthat may be used in an effort to minimize these risks.

First and foremost, the lessee should be extremely careful whennegotiating the oil and gas lease and insist that the lease include threeimportant clauses: (i) the subordination clause, (ii) the subrogation clause,and (iii) the notice clause. The subordination clause should provide thatthe lessor consents to the subordination to the oil and gas lease of any lienaffecting the leasehold interest and upon the request of the lessee, to assign,in whole or in part, to the prior lienholders to be subordinated, all amountsdue to the lessor under the lease. The subrogation clause should authorizethe lessee to pay and discharge any amounts in connection with theproperty that the lessor was obligated but failed to pay, and be subrogatedto the rights of the lessor and withhold all amounts due to the lessor underthe lease to reimburse the lessee for amounts expended by the lessee toprotect its leasehold interest. The notice clause should require the lessorto notify the lessee of any default with respect to a prior lien and newliens that attach to the lessor’s property.

Second, the lessee should attempt to obtain a subordination agreementfrom each prior lienholder. Third, if any prior lienholder is unwilling tosubordinate its interest, the lessee should request a non-disturbanceagreement from such prior lienholders. While a non-disturbance agreementdoes not change the priority of liens, it should permit the lessee to develop

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its leasehold interest with an agreement from the prior lienholders thatthe prior lienholders will not interfere with the lessee’s rights under thelease so long as the lessee is not in default thereunder.

The lessee must not lose site of various practical issues when dealingwith prior liens. Such practicalities include (i) the applicable state law,(ii) the underlying transaction documents (e.g. do such documents permitthe underlying obligations to be extended/increased under the sameinstruments so that such an extension/increase would retain the priorityof the existing lien), (iii) the amount of the prior liens, (iv) the value,albeit possibly speculative, of its leasehold interest, and (v) the projectedcosts of developing its leasehold interest.

The oil and gas lessee that ignores the risks of developing a leaseholdinterest that is subject to prior liens, without considering the alternativesavailable to minimize such risks, does so at its own peril.

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the legal and business risks of developing an oil and gas ... · leasehold interest without...

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