Lessees and Operators Beware

In Pennaco Energy Inc. v. KD Company LLC, 2015 WL 7758324 (Wyo.) (“Pennaco I”), the Wyoming Supreme Court recently confirmed a precedent that subjects lessees and operators to liability for successors’ acts and failures under surface use agreements. At issue was the continued liability of Pennaco for obligations contained in a surface use agreement (“SUA”) entered into by Pennaco and the lessor. Under the terms of the SUA, Pennaco was obligated to make annual payments to the lessor and to reclaim the surface after wells are plugged and abandoned. Pennaco, having fulfilled all of its obligations while holding the lands subject to the SUA, assigned the lands and rights under the SUA to a successor, who then defaulted on these obligations and ultimately declared bankruptcy. In this suit to impose liability on Pennaco for its successor’s failures, the parties took widely different approaches as to what law should control obligations imposed in a SUA.

Using a colorful analogy, Pennaco likened its obligations to that of a football being passed from the quarterback to the receiver. Once Pennaco, as the quarterback, passed its obligations to its successor, KD Company, the successor held the obligations as the receiver would hold the football. Pennaco grounded its argument in property law, reasoning that its obligations were covenants running with the land, just as the SUA expressly provided that the benefits or rights received by Pennaco were covenants running with the mineral lease. In property law, covenants running with the land are obligations which are connected with an interest in land so that future owners of the interest will also have to fulfill them. Conversely, when an entity no longer owns the interest, that entity also no longer owes the obligation because it is connected with the interest, not the entity. Thus, once Pennaco assigned its lease and SUA interests to KD Company, under well-established property principles, Pennaco was no longer liable for these obligations.

In equally colorful language, KD Company likened the obligation imposed on Pennaco to a communicable disease. Just because Pennaco, the carrier of a disease, passed the disease to KD Company did not mean that Pennaco was cured. KD Company argued that established principles of contract law, rather than property law, controlled the issue. It reasoned that rights can be freely divested absent a contractual provision to the contrary, but a duty or obligation can only be divested with the approval of the party to whom the duty is owed. Thus, Pennaco would only be relieved of its contractual obligations if the SUA expressly released Pennaco from further liability upon assignment, or if Pennaco obtained a “novation” (the substitution of a new agreement for an old agreement, which could be in the form of an agreement with the surface owner to release Pennaco from those obligations). Because Pennaco had no such relief in this case, KD Company argued that Pennaco would still be liable under the SUA pursuant to contract law.

The Wyoming Supreme Court agreed with KD Company’s contract law approach, despite significant evidence that the obligations were intended to be covenants running with the land, including language that these covenants would run with the surface ownership. Instead, the Court reasoned that if the parties intended that the obligations, as well as rights, of the parties were to be covenants running with the land, they should have included language expressly stating that the obligations, like the rights, were also covenants running with the mineral estate. Thus, the Court held that while Pennaco’s rights ended upon assignment, its obligations continued because they were not covenants running with the mineral estate, and there was no express provision in the SUA relieving Pennaco of liability upon assignment.

Interestingly, the Court added a caution in dicta (authoritative language but not binding) in footnote 4, which reads in full: “By this analysis we do not determine that a clause stating Pennaco’s obligations were ‘covenants running with’ its mineral leases would have indicated intent that Pennaco was no longer responsible after assignment of the leases and agreements. An exculpatory clause must expressly terminate the assignor’s obligations upon assignment.” Emphasis added. With this language, the Court cautioned lessees and operators that they should not rely solely on the rules of property law to relieve them of liability in a SUA. Instead, they should insert express exculpatory language in the SUA to make it clear that they will be relieved of future liability after transferring their interest.

The Wyoming Supreme Court heard arguments in a related case on December 16, 2015 (“Pennaco II”). Pennaco has described Pennaco II, in its appellate brief, as presenting “the same/similar issue—under a different surface use agreement—as that presented” in Pennaco I. Prior to the argument in Pennaco II, Pennaco filed a motion for rehearing of Pennaco I. Pennaco therefore focused its oral argument in Pennaco II on why the Court’s decision in Pennaco I was wrong.

In response to questions from the judges, Pennaco also tried to distinguish the two cases by pointing to additional language in the Pennaco II SUA stating that the rights were covenants running with the land. However, one justice pointedly asked whether Pennaco believes that the surface owner knew and intended that Pennaco would be able to develop the minerals but then assign the lease and SUA shortly before the obligation to reclaim came due and thereby pass on the obligation. The facts of the case brought this concern to the forefront because Pennaco had given the surface owner assurances about reclamation in writing three weeks before assigning the lease and SUA to a small company that declared bankruptcy before reclaiming the surface. Thus, it appears likely that the outcome in Pennaco II will be the same as in Pennaco I. Pennaco could not point to any language in this SUA that relieves it of its obligations after the assignment, and the Court did not seem inclined to believe that the surface owner intended the SUA to allow Pennaco to do so.