Justin H. Werner of Reed Smith. Justin H. Werner of Reed Smith.

On July 29, a seven-judge panel of the Pennsylvania Commonwealth Court, on remand from the Pennsylvania Supreme Court, decided that two thirds of the rental payments and up-front bonus payments received by the commonwealth of Pennsylvania for oil and gas leases on state forest and park lands must be reserved for oil and gas conservation purposes pursuant to Article I, Section 27 of the Pennsylvania Constitution, see Pennsylvania Environmental Defense Foundation v. Commonwealth of Pennsylvania, No. 228 M.D. 2012 (June 29, 2019). The panel reasoned that the other one third of rental payments and up-front lease bonuses constituted "income" that was outside the scope of Article I, Section 27, also known as the Environmental Rights Amendment (the ERA). Absent an appeal to the Pennsylvania Supreme Court, this decision temporarily concludes the years-long dispute regarding how proceeds earned by the commonwealth of Pennsylvania from oil and gas leasing must be spent.

This opinion resolved outstanding issues remaining after the Pennsylvania Supreme Court's earlier decision in Pennsylvania Environmental Defense Foundation v. Commonwealth of Pennsylvania, 161 A.3d 911 (Pa. 2017). In that case, a challenge had been asserted to the Pennsylvania legislature's statutory enactments that directed proceeds and other funds received from oil and gas leasing to a general fund, rather than a fund used exclusively for conservation purposes in the commonwealth of Pennsylvania. The Pennsylvania Supreme Court, on appeal, applied the language in the ERA with the context of private trust principles that existed at the time of its passage in 1971, and concluded that the legislative enactments were unconstitutional, and that the proceeds from oil and gas royalties had to be directed to a fund used only for conservation purposes under the ERA. The Pennsylvania Supreme Court's decision regarding royalties was based on the fact that royalties by definition are proceeds received from the sale of oil and gas resources, and such proceeds were constitutionally required to be used for conservation purposes.

However, the Pennsylvania Supreme Court remanded back to the Commonwealth Court the issue of how to address oil and gas rental and lease up-front bonus payments, which are separate and distinct from royalties that are paid based on oil and gas production. The Supreme Court found that the factual record was insufficiently developed to determine the precise nature and characterization of these payments. The Commonwealth Court, on remand and operating under its original jurisdiction, was tasked with the issue of determining whether the proceeds from such rentals and payments constituted an asset of the trusts, and therefore had to be used solely for conservation purposes under the ERA.

In its recent opinion in Pennsylvania Environmental Defense Foundation, the Commonwealth Court concluded that two thirds of the rentals and up-front bonus payments must be held in trust for conservation purposes, while one third of the rentals and up-front bonus payments could be allocated for general purposes. First, after a detailed analysis of the history of oil and gas leases and the forms of payment that accompany them, as well as testimony regarding these forms of payment, the Commonwealth Court distinguished rental payments and up-front lease bonus payments from royalties. It noted that unlike royalties, rental payments were consideration for "the exploration for oil and gas on public land" and not for "the severance of natural resources." The Commonwealth Court went on to explain that rentals "secure the lessee's right to enter the property for exploratory and development purposes and rents accrue based on the mere passage of time, not the production of oil and gas." The Commonwealth Court explained that the purpose of bonuses "is to determine the highest bidder for the award of the lease … the bonuses are consideration for the execution of the lease, and not the consideration." The Commonwealth Court concluded that such bonus payments "were received as rent or payment on a lease and were not received as consideration for the permanent severance of natural resources from the land."

Then, following the same mode of analysis the Supreme Court did in its earlier decision on the ERA, the Commonwealth Court looked to the "Principal and Income Act of 1947," which defined "income" and "principal" in the context of private trust law at the time the ERA was enacted in 1971. Under that act, one third of the "rent or payment on a lease" was characterized as "income," and two thirds of the rent or payment on a lease was characterized as "principal." Using this numeric distinction, the Commonwealth Court concluded that two thirds of the rental and up-front bonus payments constituted part of the trust, which must be allocated for conservation purposes, while one third of the rental and up-front bonus payments constituted "income." The Commonwealth Court found that proceeds from income were not subject to the ERA and therefore could be transferred to the general fund. The Commonwealth Court concluded by finding this result provided an "equitable balance" and fulfilled the ERA requirements of conserving and maintain Pennsylvania's natural public resources for the benefit of all persons in the commonwealth of Pennsylvania.

Justin H. Werner is a partner in Reed Smith's energy and natural resources group and focuses his practice on all aspects of oil and gas law, representing energy clients on a range of litigation issues relating to the production of natural gas throughout the Appalachian region. Contact him at [email protected].