Court of Appeals Answers Certified Question from Second Circuit Regarding Interpretation of Oil and Gas Leases

On March 31, 2015, the Court of Appeals issued a decision in Beardslee v. Inflection Energy, LLC, 2015 NY Slip Op. 02677, addressing a certified question from the Second Circuit regarding the interpretation of oil and gas leases. Our earlier post about the Second Circuit's decision is here.

Beardslee focused on the interplay between two provisions in the leases: (1) the so-called "habendum" clause, which sets the duration of the lease, and (2) a force majeure clause, which concerns delays or interruptions in drilling. The habendum clauses at issue provided for a five year initial term, and an option for a secondary term, which would extend "as long thereafter" as the land "is operated by the Lessee in the production of oil or gas." The force majeure clauses stated: "If and when drilling . . . [is] delayed or interrupted . . . as a result of some order, rule regulation . . . or necessity of the government, or as the result of any other cause whatsoever beyond the control of the Lessee, the time of such delay or interruption shall not be counted against the Lessee, anything in this lease to the contrary notwithstanding." After the expiration of the five-year term, the lessee had still not commenced drilling because the only "commercially viable" method of drilling in the property—high-volume hydraulic fracturing, or "fracking"—was subject to a regulatory moratorium in New York (although permits for other unprofitable methods were in theory available).

The lessees took the position that the regulations amounted to a force majeure event under the leases, and that the force majeure clause extended the initial term in the habendum clause. A federal district judge in the Northern District of New York entered a declaratory judgment that the leases had terminated, and on appeal the Second Circuit certified two questions to the Court of Appeals: (1) Under New York Law, and in the context of an oil and gas lease, did the State's Moratorium amount to a force majeure even? (2) If so, does the force majeure clause modify the habendum clause and extend the primary terms of the leases? The Court of Appeals, in a decision by Judge Pigott, concluded that the force majeure clause did not modify the habendum clause, and declined to answer the first questions as academic in light of the Court’s resolution of the second question.

The Court began its analysis by noting that the contract must be construed with awareness of the special context of the oil and gas industry:

The analysis should take into account that oil and gas leases stand on an entirely different basis from any other leasehold agreements. Such leases are made in the context of a highly technical
industry, which employs distinct terminology used by those in the business. For these reasons, an agreement for the production of oil and gas must be construed with reference to both the intention of the parties and the known practices within the industry.

(Citations omitted.) With these principles in mind, the Court first observed that the force majeure clause did not expressly reference the habendum clause. The Court rejected the argument that the use of the phrase "anything in this lease to the contrary notwithstanding" in the force majeure clause meant that clause modified all provisions of the contract, including the habendum clause. Judge Pigott explained:

Under New York law, clauses similar to the phrase 'notwithstanding any other provision' trump conflicting contract terms. Accordingly, the language in the force majeure provision does not supersede all other clauses in the leases, only those with which it is in conflict. Based upon our analysis, because the force majeure clause is not in conflict with the provisions of the primary term of the habendum clause, the words "anything in this lease to the contrary notwithstanding" alone are insufficient to compel the conclusion that the force majeure clause modifies the primary term, as compared to the secondary term, of the habendum clause.

Because the force majeure clause expressly refers to a delay or interruption in drilling or production for any enumerated reason, it follows that the clause only conflicts with and, therefore, modifies the secondary term of the habendum clause, in which the lessee has the obligation to operate in the production of oil or gas, or the lease terminates. Moreover, the second sentence in the force majeure clause, which deals exclusively with governmental regulations, pertains only to the energy companies' express or implied covenants — the lessee's obligations. As the energy companies made no express or implied covenants applicable to the primary term (other than to pay delay rentals, which are not at issue here), the force majeure clause must relate to only continuous drilling/production operations during the secondary term of the leases Furthermore, this latter sentence in the force majeure clause expressly indicates that the subject clause deals with lease termination, not lease expiration. The corresponding habendum clause provision is its secondary term, which also addresses the conditions under which the leases would terminate, whereas the primary term deals with lease expiration.

Thus, we interpret the "notwithstanding" language of the force majeure clause as excusing the energy companies' performance only during the secondary term of the habendum clause, during which operations in the production of oil and gas would be necessary for leases to remain viable. To read the force majeure clause as applying to the primary term would be to interpret the leases in a manner contrary to the plain intent of the parties.

(Citations omitted.) Finally, the Court noted that its construction of the lease "is consistent with out-of-state 'oil' jurisdictions [i.e., Texas and California], in which courts, applying similar contract principles, have held that language identical or similar to the force majeure clause at issue here cannot extend the primary term set forth in the habendum clause."