Co-author Chance Decker

“The only sensible way to live in this world is without rules”. The Joker to Batman, The Dark Knight

Subject-to, reservations-from, and exceptions-to problems have been lurking in the shadows of Texas jurisprudence for a while now, and the courts have been all over the map in recent holdings (Title nerd and proud of it? Compare this example with this one.)

In Wenske v. Ealy, the Supreme Court channeled our superhero’s painted friend, essentially jettisoning the old rules and confirming the new rule in deed construction cases: There are no “rules”.  Continue Reading Does Texas Have a New “Rule” in Conveyancing?

Co-author Brooke Sizer

Prevails over what, you ask? In Gladney v. Anglo-Dutch Energy, LLC, a conditional allowable from the Office of Conservation didn’t supersede lease royalty obligations.

How did we get here?

Anglo-Dutch completed a gas well on the Gladneys’ lease and then filed a pre-application notice for a compulsory drilling and production unit and applied for a conditional allowable. On May 17, 2012, the application was granted:

All monies generated from the date of first production, the disbursement of which is contingent upon the outcome of the current proceedings before the Office of Conservation for the Frio Zone will be disbursed based upon results of those proceedings.

The next day Anglo-Dutch began sales of production from the well and later submitted a formal unit application. Order No. 124-Y established the unit, effective on and after October 30, 2012.

Perhaps to the surprise of Anglo Dutch, but certainly to its chagrin, the Gladneys demanded payment of the full one-fifth royalty for production from the well prior to October 30th, rather than settle for their share of production on a unit basis.

Anglo-Dutch refused, relying on the conditional allowable which, it said, superseded its lease obligations.

The trial court ruled for Anglo-Dutch, holding that the “allowable covers the royalty payments” because the allowable dated back to first production. The court found no provision in the lease which would require that the Gladneys be paid more than that provided by the commissioner under the allowable and the unitization order.

Reversal from the court of appeal

The court of appeal reversed. “The Mineral Lease … clearly provided Plaintiffs were to get lease-basis royalties on all production from the well and that lease governed the parties’ relationship prior to the unitization order, which was not effective until October 30, 2012.”

Under the Order, the effective date of the unit was October 30, 2012, not the first date of production. The Gladneys were entitled to a full one-fifth royalty from first production until the effective date of the Commission’s Order.

The Gladneys argued, and the court agreed, that the Office of Conservation can’t impede private contract rights. According to an affidavit from a long-time Office of Conservation representative, the conditional allowable was not meant to abridge privately negotiated contract rights. That is consistent with settled Louisiana jurisprudence that meddling in private contracts is beyond the Office of Conservation’s authority.

The court helps those who help themselves

 The court was unpersuaded by Anglo-Dutch’s plea that it had no choice other than to pay royalty on a unit basis because otherwise it would have had to pay double royalties. Anglo-Dutch could have amended its lease obligations through a royalty escrow agreement. The Gladneys noted that they suggested this alternative and it was rejected, and that such an arrangement is a common practice in these situations. The court also rejected the argument that the Gladneys were improperly attacking the Commission’s actions.

Anglo-Dutch should have listened to Alabama Shakes.

flea flickerWestport Oil & Gas Company, L.P. v. Mecom et al. presented this questionWas the lease royalty based on a gas purchase agreement formula or on the royalty clauses’s market value at the well provision?

Spoiler alert: Invoking the seminal Texas Supreme Court decision in Texas Oil and Gas Corporation v. Vela, the court went with market value at the well.

Dueling paragraphs

Under Paragraph 3, the royalty clause, gas royalty was 42 percent (not a typo!) of the “market value at the well … “.

Paragraph 17: “Notwithstanding any other provision of this lease to the contrary … a contract for the sale of gas … shall provide for the sale price computed on the average of the highest price paid by three separate Intrastate Purchasers of gas of like quality and quantity in [RRC] District 4 …”.

The court instructed the jury to compute the gas royalty’s market value based on Paragraph 17. The jury found that Kerr McGee failed to pay those royalties and awarded millions in damages and attorney fees.

The Court’s analysis

Mecom argued the significance of “Notwithstanding any other provision” language. Ignoring Paragraph 17, requiring that the three highest prices become the formula to calculate the market value, renders the paragraph meaningless.

Kerr McGee argued that the Paragraph 17 formula pertained only to future gas purchase agreements and did not alter the commonly accepted meaning of “market value at the well” as stated in Paragraph 3.

The court concluded that the royalty provision is not “contrary” to the gas purchase agreement provision and did not elevate Paragraph 17’s price mandate over Paragraph 3’s market value provision. Paragraph 3 defined the royalty owed and Paragraph 17 set a minimum contract price for future gas purchase agreements. Nothing more.

Remembering Vela

In that case the working interest owners sold gas at a price fixed by a gas sales contract. The market value of gas at the wellhead rose to be far in excess of the gas contract price.  The lease specified the royalty would be “1/8th of the market value … ”. The royalty owed was determined from the royalty provision, which was wholly independent of the gas contract. The court declined to conflate the gas contract price with the market value requirement. Victory for the royalty owner.

… and Yzaguirre

Bastard child of Vela (if you are a royalty owner). This time the market value measure worked for the lessee. The gas purchase price was far in excess of the market value.

What did we learn?

  • The lease dated to 1974. As with Godzilla, leaky shower pans, and a flea flicker in the fourth quarter, dangerous situations can lie dormant for a long time, bringing misery when the victim least expects it.
  • Despite the lessors’ best efforts to protect themselves, the case turned on one short phrase in a comprehensive, three-page royalty clause.
  • “Notwithstanding anything to the contrary … ” is a favored device for scriveners. Make sure it addresses that which you are trying to protect. What if Paragraph 17 had addressed the market value clause directly?

Merry Christmas.

It’s a multiple choice question:

a.  The royalty interest reserved by the lessor.

b. The drillbit, courtesy of fearless, risk-taking entrepreneurs, the backbone of the great American free enterprise system and the sworn enemies of collectivism.

c.  A cache of DNC emails, discovered by Vladimir Putin himself.

d.  The working interest.

e. It doesn’t matter. Trump won. Get over it.

Can’t stand the suspense? It’s “d”. If the override doesn’t spring from the working interest, you don’t have it.

How did this happen?

EnCana Oil & Gas (USA) et al v. Brammer Engineering et al involved a Power of Attorney under which Brammer would manage minerals for the mineral owners. Terms in the POA regarding Brammer’s compensation:

  • “. . . mineral leases executed in the future by Agent . . . will provide for the reservation of an additional free overriding royalty interest on behalf of the lessors.”
  • Brammer’s compensation would be “on . . . leases under the terms of which not less than 1/16th override royalty is reserved, [Brammer] shall be entitled to 1/32nd free overriding royalty”.

WW&M represented other mineral owners. With Brammer’s permission WW&M negotiated a lease with EnCana with a 1/4th royalty. The lease did not include overriding royalty language Brammer believed it was entitled to, so Brammer executed the lease and an assignment of a 1/32nd override in favor of itself out of the lessor’s royalty.

Then, the litigation 

The mineral owners’ point: Brammer didn’t carve the override out of the working interest and thus was not entitled to it.

Brammer’s response: The additional override was a contractual obligation payable to Brammer from the total royalty reserved in the lease.

The court decides

If Brammer obtained any lessor’s royalty greater than 1/8th, was it entitled to an override, or was Brammer required to expressly reserve an additional free override for itself?

Brammer had to expressly reserve an additional royalty interest for the mineral owners in order to trigger its right to the override. To the court, Brammer redefined “royalty” to mean the standard royalty, whatever that standard might be at any given time. This would require the court to look beyond the words of the unambiguous contract. Further, to the court, “additional” means an override in addition to the lessor’s royalty.

Stated another way: Brammer argued it was entitled to a 1/32nd override anytime that it acquired, in favor of the mineral lessors, at least 1/16th more than the “typical” 1/8th. This, it did not do. Brammer did nothing to obtain the 1/4th royalty in WW&M’s bid package. Judgment for the mineral owners.

What is an overriding royalty anyway?

The Mineral Code does not expressly define an override. Citing plenty of authority, the court concluded that the term describes a royalty carved out of the working interest, different from and in addition to the lessor’s royalty.  This is acknowledged in Brammer’s assignment language:  “It is hereby reserved in favor of Brammer . . . from the Lessors’ royalty . . . a free overriding royalty 1/32nd of  . . .  .”

Have a happy holiday.

Fractions


“Blood may be thicker than water, but oil is thicker than both.”  J. R. Ewing.

This family dispute among Ethel’s descendants arose when Ethel’s will employed double fractions in bequeathing royalty interests to her children. Did the instrument create a fixed fractional royalty or a floating fraction of royalty?

Straight to the takeaway

Don’t like math? Avoid a pop quiz by remembering, when describing a royalty conveyance:

  • Do not convey a fraction of a fraction unless that is what you intend to do. Why let ambiguity and confusion ruin your carefully crafted document?
  • Use language appropriate for the time and circumstances, but think ahead. Is change foreseeable in a way you can plan for?

If you don’t believe me read Hisaw v. Dawkins, from the Texas Supreme Court.

Times were different then

When Ethel’s will was written in 1947 Jackie Robinson was a rookie, LSU beat Texas A&M 19-13 (some things never change), and the standard royalty was 1/8th. Was that figure in Ethel’s will a synonym for the lessor’s royalty, or was the royalty interest fixed without regard for the possibility of a higher royalty in the future?

There were three separate parcels of land and each child received the surface and executive rights to one. Ethel’s will contemplated three scenarios for the royalty under all the tracts. Each child would receive:

  • an NPRI of an undivided 1/3rd of an undivided 1/8th of all oil, gas ….
  • 1/3rd of 1/8th royalty  …
  • 1/3rd of the remainder of the unsold royalty, if a conveyance occurred while she was alive.

Clarity from the Supreme Court

The court said it would not embrace a “mechanical approach” to a royalty conveyance that would require “rote multiplication of double fractions”. Bright line rules are arbitrary and will not always give effect to what the conveyance provides as a whole. The court of appeals erred in construing each royalty provision in isolation.

In what it called an analytical approach, the court applied the four corners rule, and attempted to harmonize all provisions of the document. The court reaffirmed its commitment to a “holistic” approach to contract construction by ascertaining the parties’ intent from all words and all parts of the instrument. To harmonize would resolve apparent inconsistencies or contradictions in the document.

The third royalty clause governed. It clearly showed Ethel’s intention to equally divide the royalties among the three children. Each would receive a 1/3rd floating royalty, not a 1/24th fixed royalty (that is, 1/3rd of 1/8th).

The antiquated assumption that all future royalties would be 1/8th did not evidence Ethel’s intent. This is not to say that reference to 1/8th won’t ever mean just that. It might, if the language is clear and unambiguous.

 Prince RIP. His voice and an acoustic guitar are all you need to see what a force he was.

production paymentMust a production payment out of four oil and gas leases be proportionately reduced if two of the leases expire because production ceased? In Apache Deepwater, LLC v. McDaniel Partners, Ltd., the Texas Supreme Court says yes. Absent express language in the assignment to the contrary, this general rule applies:  When an assigned lease terminates, a production payment (like an override) created in that lease is extinguished.

The instrument

A 1953 assignment of a production payment to McDaniel’s predecessor covering four leases in Upton County was a 1/16th of 35/64ths of 7/8ths in all four leases. Apache Deepwater acquired the four leases (after a wrong turn at Sabine Pass?). By the time of the acquisition two leases were of a 35/64ths mineral interest and two others were 3/64ths.

Tracts on two leases had expired for lack of production. Apache reduced the payment proportionately.

McDaniel’s losing proposition

The equation, 1/16th of 35/64ths of 7/8ths, states the production payment as a percentage of the cumulative working interests. This indicates the parties’ intent to burden the individual leases jointly with a production payment based upon the original cumulative working interest conveyed. The production payment was reserved from the conveyance as a whole, binding all of the leases jointly.

The result, and why

The production payment must be reduced when a lease expires. Neither the inclusion of four leases in a single instrument nor the instrument’s statement of the cumulative interest as a single fraction demonstrates that the parties intended the production payment to be carved from other than each lease. To the contrary, the phrase following the fraction ties the reservation to the assigning party’s interest in the “respective” leases. The court referred to Webster’s for the meaning of “respective’ and concluded it means “particular” or “separate”. This indicates that the interest pertains to each lease separately. The assignment neither states, implies, nor suggests the production payment would be unaffected by the termination of the leaseholds from which it was carved.  The assignment fixed the dollars in volume of oil to be delivered but that does not necessarily inform the rate at which it was to be delivered.

Takeaways

  • If the remaining leases hold up McDaniel will get his money, just not as quickly;
  • The parties could have written the assignment differently to achieve a different result;
  • Title examiners: Study the language carefully but keep the general rule in mind;
  • Everybody else: Hand off an instrument like this one to your title examiner.

Musical interlude

Many great song covers vary so much from the original as to be almost unrecognizable. For example, here is the original. Here is the cover. NOT SO FAST!  Having squandered so much of your precious allotment of waking hours reading this far, take a moment to waste a little more.  Go to the second cover; obscure enough of the screen so you can’t see the title (use that notepad where you’re recording your post-rebound getting-rich fantasies); hit “play”; see how long it takes to recognize the tune.

Or just forget it and get back to work.

ceasarApparently unsatisfied with its analysis in Chesapeake Exploration v. Hyder, the Texas Supreme Court revisited its original opinion on an overriding royalty clause. The Hyders remain the winners. In effect, the court replaced its reliance on earlier decisions interpreting royalty clauses with its own analysis (which looks a lot like the original).

The Basics

Let’s start with the rules:

  • An override is free of production costs but bears its share of post-production costs.
  • The parties to a contract are free to agree otherwise.
  • A royalty paid on the market value of oil at the well bears post-production costs.  That value is the commercial value less processing and transportation expenses that must be paid before the gas reaches the commercial market.
  • A royalty based on the price a lessee actually receives for gas (a “proceeds lease”) does not bear post-production costs.  The price-received basis is sufficient in itself to excuse charges to lessors of post-production costs.

The analysis

The override at issue is: “cost-free (except only its portion of production taxes) … of five percent … of gross production obtained …”.

The exception for production taxes (which are post-production expenses) cuts against Chesapeake.  It would make no sense to say that the royalty is free of production costs except for post-production taxes (no dogs, except for cats, opined Justice Hecht).

The court doesn’t agree with Hyder that cost-free cannot refer to production costs.  Drafters frequently specify that an override does not bear production costs even though it is already free of costs because it is a royalty interest. I call it the “belt and suspenders” school of document drafting.

Chesapeake argued that because the override is paid “on gross production” the reference is to production at the wellhead, making the royalty based on the market value of production at the wellhead, which bears post-production costs.  The court concluded that gross production is a reference to volume only. Specifying that the volume is determined at the wellhead says nothing about result:  “Cost-free” includes post-production costs.

The dissent

Four justices dissented, essentially seeing the same language as did the majority and disagreeing on just about every point. A highlight is their analysis of so-called production taxes. They are really post-production costs, according to the majority.

 The dissent thinks not everyone understands that distinction, and parties can allocate taxes differently than other post-production costs.

The dissent believes a statute does not turn a production cost into a post-production cost.  It simply creates a statutory exception to the common law default rule that an override is free of production costs. Second, the pro rata nature of production taxes bolsters the reading that cost-free does not refer to post-production costs.  The dissent believes that “cost free” is indicated to emphasize the default rule, clarifying that Hyder was still obligated to pay its share of production taxes.

Takeaways

  • Some operators, Chesapeake chief among them, have been condemned for gangsterism in their treatment of lessors. Think Imperator Ceaser ravishing the Roman hinterlands. Will Chesapeake go the way of most of the Ceasers? Maybe, but losing five-to-four twice suggests a legitimate legal position this time.
  • Don’t look for a policy you an count on in this case or in Heritage, other than the court will read the lease and interpret the text.

Our musical interlude – dedicated to the dissenters.

still freeWhat is your guiding principle when writing agreements?

“The more the words the less the meaning, and how does that profit anyone?” Ecclesiastes 6:11.

or

“The beginning of wisdom is the definition of terms.” Socrates

The Legal Issue

A lease grants “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent … of gross production obtained” for directional wells drilled on the lease but bottomed on nearby land (emphasis mine). Are deductions of post-production costs allowed? No, says the Texas Supreme Court in Hyder v. Chesapeake Exploration, a decision long-awaited by those of us who pay attention to these matters.

The court of appeals decision was the subject of a prior post.  The Supreme Court affirmed the court of appeal, which had affirmed the trial court.

Is This a Big Deal?

It certainly is for the Hyders and lessors with the same provision. Otherwise, I’m not so sure.

  • The court was split five to four.
  • The court emphasized that it was merely determining the parties’ intentions based on the language of the lease, disclaiming a broader agenda.
  • The court recognized a basic proposition in Texas law: A royalty is usually subject to post-production costs, but the parties can modify the general rule by agreement. They just didn’t do it in this case, said the court.
  • The court declined to read into Heritage Resources, Inc. v. NationsBank anything other than that the meaning of a lease is governed by a fair reading of its text.

The Rationale

In the Hyder lease the basis for royalty payment is the price received by the lessee, which the court noted is often sufficient in itself to excuse lessors from bearing post-production costs. “Cost free”, said the majority, is not merely a synonym for an ORRI. Scriveners often include “cost free” in a royalty clause to make certain that everybody understands the royalty is free of production costs, but not necessarily post-production costs, even though the language is not necessary (royalties are cost-free as a matter of law).

The court did not believe that “cost free” means free of post-production costs. But the Ecclesiastes way didn’t serve Chesapeake well.  In order to prevail Chesapeake had to prove that “cost free” could not refer to post-production costs.  The court concluded that the ORRI was to be paid on the price received by Chesapeake after post-production costs are paid.

The Dissent

Four justices would have gone with the default – ORRIs bear post-production costs. The way they saw it:

  • The ORRI clause did not allow valuation of the ORRI downstream at any point of sale. It implicated only one location – the wellhead. Post-production activities would add value to the Hyders’ ORRI, but had not yet done so at the wellhead.
  • Although the ORRI may not have been expressed using the familiar market-value-at-the-well language, they read its value to be just that. The “cost free” designation did not express an intent to abrogate the default rule. They would recognize that “cost free” simply stressed the cost free nature of the royalty without struggling to ascertain any additional meaning.
  • Siding with Socrates, they focused on the vast differences between the royalty and ORRI provisions in the Hyder lease, concluding that if the extensive, specific, and detailed free-and-clear language in the royalty clause was surplusage, so should be bare bones “cost free” designation in the ORRI clause. “Cost free” is redundant, but not meaningless. We discussed the court of appeal interpretation of the detailed royalty clause in another post.

Today’s musical interlude: Backup singers.

Bobby King, Terry Evans, and (?) Herman Johnson

Mary Wilson and Florence Ballard

All of the Platters except the dude in the middle

michael-fredo-corleone-jpgCo-Author Brooke Sizer

What must a Louisiana lessee do to avoid statutory penalties for non-payment of royalty, and what must a royalty owner do to put the lessee on notice that royalties are not being paid? The answers are, more than the lessee did in Samson Contour Energy E&P, LLC v. Smith and less than the lessee argued for.

What the Lessee Did

  • When calculating royalty payments for six new wells on a lease, mistakenly used old and obsolete ownership information and paid royalties attributable to a disputed interest to one party not entitled to it.
  • Ignored notices of unpaid royalty under Mineral Code Art. 137 that did not include a demand for payment.

What the Lessee Could Have Done

  • Pay closer attention to its lease records.
  • Pay closer attention to notices from the royalty owner of deficient royalty payments.
  • Suspend disputed funds (which requires paying closer attention … ).

Facts

Half of the property belonged to the mother, one-quarter to the son, and one-quarter to the daughter. The land was HBP under a lease from 1970s. In 1996, the mother executed an act of donation giving her half of the mineral and royalty interest to son Billy. Similar to what Michael did to Fredo but not as permanent, after Momma died daughter Betty sued to annul the 1996 donation. Samson was informed of the annulment action and suspended royalty for the one-half interest. In 2005 Samson received an uncertified photocopy of a judgment annulling the donation and transferred the subject one-half to the Succession.

Samson drilled six wells that were completed sometime after the disputed interest was originally suspended. When calculating royalty for the new wells, Samson mistakenly used old ownership information and paid the royalties attributable to the disputed one-half to Billy.

A Legitimate Mistake?

The co-administrators of the Succession requested that suspended royalty funds be paid to the Estate. Samson acknowledged receiving the letters of administration and stated that the records had been updated. Later, one of the administrators informed Samson that the records they had received from Samson failed to include the six wells. Samson responded that the Estate did not own any interest in those wells. The administrators each sent Samson another copy of the annulment judgment. Samson then issued a check that still underpaid the Estate by failing to include royalties attributable to the six wells.

The Argument

Samson claimed:

  • Payment to son Billy was the same as paying the Succession; they should not be treated separately.
  • Based on language in the lease, because it did not receive a certified copy of the annulment it could not be liable.
  • Notice under Mineral Code Art. 137 was insufficient to trigger the penalty because it did not include a demand for payment and did not provide information so that payment could be made.

The  Result

Samson failed to follow industry practice in using old information for paying royalties and not adjusting royalty payments after the mistake was discovered.

Samson failed to fulfill its duty as a lessee under the Mineral Code to pay or respond with a reasonable cause for nonpayment within 30 days after receiving notice that payment was incorrect.

The Art. 137 notice has a purpose: To merely inform the lessee he has not paid the royalties deemed by the lessor to be due. It is a chance for the lessee pay royalties due while giving them a chance to avoid the harsh remedy of a lease cancellation. Numerous communications reasonably alerted Samson to the payment failure pursuant to Article 137. Samson failed to explain what caused the error, instead choosing to ignore the error and question the administrator’s right to act on behalf of the Succession.

Samson owed the Succession $1,301.149.13 in royalty payments and double the amount due as penalty. Judgment rendered for $2,602,298.26 in damages, plus interest and $505,000 in attorney fees.

Takeaways

  • Send this post – or better yet the entire opinion – to all of your lease administration personnel.
  • The operator who swings and misses this often is not going to like the justice meted out by most Louisiana trial judges and juries.
  • Woe to the operator who fails to recognize that Louisiana courts set a low bar for a lessor to comply with statutory notice provisions similar to Art 137.
  • Hats off to Samson lawyers for a creative but – given the facts – predictably unsuccessful effort.

 Our musical interlude honors Samson’s “fighting spirit”.

win loseYou are negotiating to take a big oil and gas lease. The run sheets show you are dealing with an executive right owner on behalf of himself and his NPRI owner.  His proposed terms are odd: a lower-than-market royalty and a higher-than-market bonus. After reflecting, you get it: The terms aren’t odd; they are just better for him than the NPRI owner. Is he cheating his NPRI owner? If you suspect he is, must you come to the aid of the soon-to-be-shortchanged NPRI owner or else get sued along with the larcenous executive?

Don’t worry. Bradshaw v. KCM leaves virtually no chance that a lessee will be derivatively liable to an NPRI owner for an executive’s wrongdoing. We discussed the NPRI owner’s claims against the executive last week. The NPRI owner also sued Range Resources, the lessee who took the lease from the executive.

Bradshaw’s claim against Range was that KCM’s breach of its duty should be imputed to Range under civil conspiracy and aiding and abetting theories. Not so, said the court. Range and KCM were not affiliated with one another except as adverse parties in an arms-length transaction (to-wit, the oil and gas lease). There was no claim that Range owed an independent fiduciary duty to Ms. Bradshaw. This is obvious because the lessee’s interests are inherently adverse to both the executive and the NPRI.

There was no evidence that Range was complicit in KCM’s alleged underlying tort. In negotiations between the two, Range sought to extract the best deal it could on the most favorable terms. The mere fact that Range knew the estate was burdened with Bradshaw’s NPRI was insufficient to impute KCM’s liability, if any, to Range.

The court observed that if it were to validate Bradshaw’s theory of liability it would be difficult to conceive of a context in which a lessee would not owe a derivative fiduciary duty to the other side of the bargaining table.

Even if there were an imbalance in the lease terms that substantially favored Range, that would not be evidence that Range acted improperly. The court believed that in a broad sense almost any bargain for a commercial exchange might be considered benefiting one party at the expense of the other. (Ironically, the court cited a Wal-Mart case for this proposition.)

Simply put, said the court, a lessee is not be expected to consider an NPRI owner’s economic interests. That is the executive’s responsibility.

In the spirit of today’s musical interlude, the court has made negotiating easier on the lessee.