Statutory Subordination of Liens to Oil and Gas Leases

In a measured victory for oil and gas companies operating in Texas, the 84th Texas Legislature has passed House Bill 2207, codified as TEX. PROP. CODE § 66.001, and titled “Sale of Property Subject to Oil or Gas Lease.” Chapter 66 became effective January 1, 2016, and applies with respect to foreclosure sales or judicial foreclosures commenced on or after that date.

Prior to the enactment of House Bill 2207, the general rule of priority between mortgages and oil and gas leases was “first in time, first in right.” If an oil and gas lease was taken prior to a mortgage, then it was superior to and unaffected by the subsequent foreclosure of the junior lien. Conversely, if the mineral estate was burdened by an outstanding mortgage at the time it was leased, a lessee would often have to go through the time-consuming and sometimes difficult task of obtaining a subordination agreement from a bank or other lien holder. Otherwise, foreclosure of the mortgage would extinguish the junior lease.

This harsh result had become especially problematic in areas such as the Barnett Shale, where many owners of small tracts of land in population-dense areas own the minerals under their land. Properties were being mortgaged frequently, and these mortgages were often transferred numerous times in a short period. Foreclosures were common and obtaining subordinations from uncooperative financial service companies was becoming more burdensome and impractical. This resulted in frequent lease forfeiture if an operator was not vigilant, or encountered delays in obtaining subordination agreements.

The Texas legislature has intervened, resulting in Chapter 66 of the Texas Property Code. Under Section 66.01(b), “an oil or gas lease covering real property subject to a security instrument that has been foreclosed remains in effect after the foreclosure sale if the oil or gas lease has not terminated or expired on its own terms and was executed and recorded in the real property records of the county before the foreclosure sale.” Therefore, if a lease was dated and filed of record prior to the foreclosure sale it is given statutory priority and will no longer be extinguished, even if it was recorded after the original mortgage. Instead of lease forfeiture, the purchaser of the foreclosed property acquires the property subject to the lease, along with the right to receive lease royalty payments.

However, with regard to tracts of land in which the surface and mineral estates have not been severed, Section 66.01(c) provides that, “the foreclosure sale terminates and extinguishes any right granted under the oil or gas lease for the lessee to use the surface.” Therefore, the right of “ingress and egress” granted under most any oil and gas lease is extinguished by foreclosure, and the operator loses the right to conduct surface operations on the foreclosed tract.

This loss of surface rights stands in opposition to the general rule that the mineral estate is the dominant estate. The loss of the right of ingress and egress could have a substantial impact on larger tracts of land. This outcome could be particularly onerous for a current or intended drill site tract, necessitating an additional surface use agreement. Further, it leaves uncertain those situations where surface operations have commenced prior to the foreclosure. The lease could remain in effect, but the operator could lose its right to use the surface. Therefore, pursuant to Section 66.01(d) lessees may seek to “contract around” Chapter 66 and obtain a subordination agreement that clearly reserves their surface rights in the event of foreclosure.

Although Chapter 66 was made retroactive, the retroactive nature of Chapter 66 has already come under constitutional fire for its potential harm to lenders. See Michael P. Vargo, Forced Subordinations of Liens to Leases: Is Texas Property Code Chapter 66 an Unconstitutionally Retroactive Law?, J. LAND USE & ENVTL. L. (forthcoming 2016). An early draft of House Bill 2207 expressly stated that the Act would only apply to transfers of property or contracts entered into on or after the effective date of the Act. Under this early draft, prior transfers of property would have continued to be “governed by the law in effect immediately before the effective date of this Act, and that law is continued in effect for that purpose.” However, that language was not included in the final Act, and Chapter 66 applies to all foreclosure sales or judicial foreclosures occurring after January 1, 2016. Therefore, Chapter 66 retroactively applies to liens that attached prior to January 1, 2016, and laws with retroactive effect are generally disfavored on constitutional grounds. See id.; see also Robinson v. Crown Cork & Seal, 335 S.W.3d 126 (Tex. 2010); TEX. CONST. art. I, § 16 (“No bill of attainder, ex post facto law, retroactive law, or any law impairing the obligation of contracts, shall be made.”).

Due to the potential constitutional challenges to Chapter 66 of the Texas Property Code, operators should continue to obtain subordination agreements for all liens that attached prior to the execution date of an oil and gas lease, and prior to January 1, 2016. For those liens that attached after January 1, 2016, subordination agreements should be obtained on drill site tracts that clearly and unambiguously reserve surface rights in the event of foreclosure.