On September 26, 2014, the Ohio Court of Appeals for the Seventh District issued its opinion rejecting a trial court opinion in a statewide class action that had invalidated thousands of oil and gas leases based on a commonly used lease form. Hupp v. Beck Energy Corp., 2014 Ohio App. LEXIS 4174 (Ohio Ct. App., Monroe County Sept. 26, 2014). The trial court had held that the leases were void as against public policy because they were perpetual or no-term leases that could be extended indefinitely by payment of delay rentals. The trial court also held that the lessees had violated an implied covenant to develop because no wells were drilled during the primary term.
The Seventh District squarely reversed the trial court on both grounds. As to the validity of the leases, the Court of Appeals held that the trial court erred in four ways. First, the trial court erred in holding that the leases were perpetual – they had a typical term provision with a primary term of a defined duration and a secondary term of indefinite duration that continued only so long as a well was drilled and was capable of producing oil and gas. Second, the trial court erred in holding that the leases were invalid because payment of delay rentals could indefinitely hold the leases – in fact, delay rentals could only hold the lease during the primary term. Because the defined primary term of 10 years had not expired when the plaintiffs brought their claim, the delay rentals were effective in holding the lease. Third, the trial court erred in holding that the leases’ provision that a lease could be extended into the secondary term so long as “oil or gas. . . [were] produced or capable of being produced on the premises in paying quantities, in the judgment of the Lessee,” rendered the lease invalid because the land could always be capable of production even without a well being drilled. The Court of Appeals disagreed, holding that the lease language required the drilling of a well capable of production in order to extend the lease. Because the leases were still in the primary term, the lessees still had time to drill a well. Fourth, the trial court erred in holding that leaving the determination whether a well was capable of production in paying quantities to the “judgment of Lessee” rendered the term invalid. The Court of Appeals held that such a provision is valid and is not as unlimited as the trial court feared. Rather, it is subject to a good-faith belief that a well is capable of production in paying quantities, which is in the joint economic interest of both parties.
The Court of Appeals also rejected the trial court’s holding that the lessees had violated an implied covenant by not drilling wells during the primary term. An implied covenant to develop can only exist when the parties’ lease does not contain any agreement regarding development. Here, the parties had expressly agreed that the payment of delay rentals during the primary term expressly excused any implied obligation to drill. The Court of Appeals also reversed the trial court’s conclusion that a lease provision disclaiming implied covenants was not effective because another provision required lessor to give notice of any alleged breaches of express or implied covenants. Requiring notice of lessor’s belief of a breach of an implied covenant did not create such an implied covenant.
The Hupp decision was unanimous. Reed Smith was co-counsel for one of the lessees.
Client Alert 2014-252