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Newsletter

Scratching the Surface: Understanding the Potential Impact of Minerals Rights on Your Texas Loan
Perspectives on Real Estate Newsletter - Spring 2012
Authors: James S. Lloyd

Spring 2012
Texas oil and gas law presents unique issues for real estate secured lending. In Texas, the mineral estate can be severed from the surface estate, resulting in a separate fee estate with rights to use the surface for purposes of exploring and extracting minerals. Over the past decade, energy prices, combined with new technologies such as hydraulic fracturing, have resulted in increased exploration and development in urban areas, typified by the Barnett Shale play in North Texas. Lenders should be aware of the potential impact of such exploration and development on their real property collateral.

Severance of the Mineral Estate
Prior to severance, an owner of real property in Texas owns both the surface and all of the oil, gas and other minerals beneath the surface. For a lender whose loan is secured by a lien on real property that has not been severed, the lien attaches to all of the real property described in the security instrument, including the oil, gas and other minerals below the surface (even if the same are not expressly referenced). Conveyance or leasing of the mineral estate by the borrower will be subject to the terms of the loan documents.

If the mineral estate has been severed, however, a security instrument imposing a lien on the surface estate has no effect on the mineral estate. Severance results in the existence of two separate fee estates—the mineral estate and the surface estate—and these two estates exist independently. Each is subject to its own ad valorem taxes, and may be conveyed and financed separate and apart from the other. The mineral estate can be severed by either conveyance or reservation (e.g., express language in a deed conveying the surface estate that reserves all or a portion of the minerals to the grantor) in an instrument satisfying statute of frauds requirements and other requirements applicable to transfers of real estate. Unless the surface owner also owns some portion of the mineral estate, a surface owner has no rights at all with regard to the minerals, including no right to explore, develop, lease, convey or collateralize the mineral estate. Indeed, doing so could result in an action for slander of title, trespass, conversion or other claim against the surface owner by the owner of the mineral estate or its lessee.

How can a lender determine whether the property securing its loan has been severed? As a general rule, because of the long history of oil and gas development in Texas, one can assume that the surface and mineral estates for most real property in Texas have been severed, but a lender's negotiations with the borrower should include discussions to confirm the status of the property, and appropriate representations and warranties should be included in the loan documents regarding such information provided by the borrower. Proper title examination also is crucial. As severance instruments typically are recorded, a title commitment for a lender's policy of title insurance should include the severance instrument in the listing of exception documents. Subsequent conveyances of the mineral estate, or partial interests therein, if recorded, also will be included in the title commitment.

The Mineral Estate and Surface Estate
The owner of the mineral estate has, among other rights, the exclusive right to develop and lease the mineral estate. Additionally, under Texas law, the mineral estate is the dominant estate, and the mineral estate owner has an implied easement to use the surface and subsurface as may be reasonably necessary to explore, develop, produce, transport and store the minerals from its property. In other words, a surface owner's use of the surface estate is subordinate to the mineral owner's use of the surface to the extent such use is reasonably necessary to exploit the minerals. As a general rule, provided that a mineral owner's use of the surface is reasonably necessary, a mineral owner will not be liable to the surface owner for damage to the surface estate resulting from the mineral owner's activities. Surface uses by the mineral owner that have been confirmed by Texas courts as reasonable include conducting seismic testing, building storage tanks and roads, and using water from the property. The mineral owner also may enjoin actions by the surface owner or its lessees that interfere with the reasonable use, operation and development of the mineral estate.

The requirement that the mineral owner's activities on the surface estate be reasonably necessary provides surface owners with some protection. To the extent such activities are not reasonable, or if the mineral owner's negligent acts damage the surface, the surface owner may be able to enjoin the action and/or seek damages. Texas courts also have limited the mineral owner's rights by requiring that the mineral owner accommodate existing surface uses where reasonably possible. It should be noted, however, that this doctrine, known commonly as the accommodation doctrine, requires that the mineral owner accommodate only existing uses, not future uses, and that liability is imposed on the mineral owner only if there are established alternate industry practices that can be used and such alternate practices are not unreasonably expensive. Lenders should be aware of the limitation of the accommodation doctrine in situations in which the real property collateral will be subsequently developed following the closing of the loan (as with construction loans), but oil and gas activity, including leasing, already exists on the property. Although the outcome in any such situation will depend on the specific facts at hand, Texas courts have generally concluded that surface development not under way when the exploration or extraction of minerals commenced is not an existing use and therefore does not have to be accommodated.

Additional Restrictions on Mineral Owner's Right to Use the Surface Estate
Although the general rule in Texas is that the mineral owner may utilize the surface estate to the extent reasonably necessary to exploit the minerals beneath the surface, there may be additional restrictions that limit a mineral owner's rights, including any provided for in the severance instruments or other agreements between the surface and mineral owners, as well as related state or local regulations and ordinances.

Contractual Restrictions
A mineral owner's rights are established at the time of severance, and such rights may be contractually restricted in the severance instrument. Again, title review is crucial as the examination of the severance instrument and subsequent instruments will provide a lender with the scope of the mineral owner's rights to use the surface estate. Contemporary severance instruments, whether through conveyances or reservations, often include restrictive covenants whereby the grantee's right of access to and use of the surface estate is limited to a particular area or altogether prohibited. Lenders will find, however, that such restrictions are relatively rare in earlier severance instruments, and mineral owners under such instruments typically will have the broad rights regarding surface use discussed earlier. Lenders should carefully examine the terms of surface waivers in oil and gas leases, as the waiver language in such agreements does not always extend to benefit the successors or assigns of the surface owner. In such cases, a lender may not receive the benefit of the waiver if it forecloses on the surface estate or receives the property from the borrower by a deed in lieu of foreclosure.

Exploration and drilling also may be limited by restrictive covenants running with the property, such as declarations or similar instruments. Such restrictions, however, must predate the mineral severance in order to restrict the mineral owner; if not, the mineral estate is not subject to the restriction unless the mineral owner subsequently ratified or otherwise accepted it. Because of the history of oil and gas development in Texas, severance of the mineral and surface estate typically will predate the recording of restrictive covenants prohibiting drilling or other activities on the surface. Careful examination of title documents is necessary to determine the rights by and between the surface and mineral owners.

Regulations and Ordinances
Drilling is regulated by the Texas Railroad Commission (TRRC), and a mineral owner must comply with the TRRC's regulations and requirements regarding surface and subsurface use. Although discussion of these regulations and requirements is beyond the scope of this article, lenders should be aware that the TRRC must approve the location of all oil and gas wells in Texas. Additionally, some municipalities have imposed "no drilling" ordinances or comparable zoning limitations within their jurisdictions. Review of applicable ordinances and zoning is crucial to determine the potential risk that drilling may have on the collateral. Lenders should keep in mind, however, that TRRC requirements and city ordinances and zoning are subject to change, and the possibility always exists that requirements and restrictions on drilling could be altered, repealed or be subject to variance such that activities previously limited or prohibited are made available to the mineral owner.

Mitigating the Risks of Surface Use by the Mineral Estate Owner
Once a lender has confirmed that the mineral estate and surface estate have been severed and identified the scope of the mineral owner's rights, a number of strategies exist for a lender to mitigate the potential impairment of its collateral.

Surface Waivers
If the severance instrument allows unfettered use of the surface estate and examination of title does not reveal a comprehensive surface waiver by the mineral owner, a lender may require that the borrower deliver a surface waiver from the owner or owners of the mineral estate and any lessees under existing leases, prohibiting either the mineral owner or its lessees from entering on or using the surface of the property for purposes of exploring for or extracting minerals. As a practical matter, however, obtaining a surface waiver from the mineral owner or owners can be difficult. In a typical instance, title in the mineral estate may have been divided and conveyed any number of times, whether by instrument, probate or intestacy, and often the conveyance documents are not recorded in the real property records. Obtaining surface waivers from tenants under oil and gas leases, or amendments to such leases to extend the benefit of existing surface waivers to the surface owner's successors and assigns, is usually less time-consuming and costly, although, in some instances, lessees are reluctant to give up surface rights and may heavily negotiate the terms of a surface waiver.

Loan Documents
Lenders also should ensure that the loan documents adequately address potential damage to the collateral that may arise as a result of a mineral owner using the surface estate. Indemnity and insurance provisions and the use of escrows or reserves can be drafted to mitigate potential diminution in the value of the collateral resulting from the mineral owner's exploration and extraction of minerals. In instances where drilling activities already have occurred on the property, or are likely to occur, a lender may consider requiring environmental insurance to ensure that funds are available to address contamination should it occur.

Title Policy Endorsements
The Texas Department of Insurance has promulgated endorsements that provide coverage to a lender under its title policy, up to its policy amount, for damages resulting from a mineral owner's exercise of its rights to use the surface estate. Coverage under the Restrictions, Encroachments, Minerals Endorsement (T-19) includes coverage for damages to existing improvements resulting from the future exercise of any right to use the surface for the extraction or development of minerals excepted in the description of the covered property or excepted in Schedule B of the title policy. Lenders should note that the T-19 covers only damages to existing improvements caused by activities after the date of the policy. Future improvements are not covered, nor are damages that existed at the time the title policy was issued. It also should be noted that a title company has the ability to exclude the insuring provision if it determines that the risk posed by the mineral exceptions are not acceptable. Despite these qualifications, issuance of a T-19 endorsement can provide a lender with assurance that potential damage to the collateral resulting from surface use by a mineral owner will be covered, up to the amount of the title policy. For a lender's policy, the cost of the endorsement is 10 percent of the premium amount for the base policy.

If a title company takes a general exception to mineral rights in the title policy, upon the insured party's request, the title company must issue a Minerals and Surface Damage Endorsement (T-19.2 and T-19.3). The T-19.2 endorsement applies to residential property of less than one acre and any property used or intended to be used for office, industrial, retail, mixed retail/residential or multifamily purposes. The T-19.3 endorsement applies to all other real property. Both endorsements provide coverage against damage resulting from the future exercise of any rights existing as of the date of the title policy to use the surface of the covered land to extract or develop oil, gas or other minerals, save damage resulting from subsidence, but the T-19.2 endorsement covers current or future improvements (excluding lawns, shrubbery or trees), while the T-19.3 endorsement provides coverage only for current or future permanent buildings. The cost of either the T-19.2 or T-19.3 endorsement is $50.

Mineral rights in Texas can present unique issues for lenders. Understanding the scope of the mineral owner's rights to use the surface estate and taking the actions necessary to mitigate the potential risks posed by such use should be part of every lender's due diligence activities and lending requirements.

For a copy of the entire Perspectives on Real Estate Newsletter including this article, please click the link in the adjacent "Download" section.
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