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.

gas processingWhat’s a sure way to destroy untold millions of dollars of energy infrastructure value built in reliance on the promise of reimbursement for huge capital investments necessary to move a producer’s product to market for the next 20 years or more?

Here’s another one: What’s a helpful way to effect the goal of bankruptcy reorganization, to give a bankrupt energy producer and its shareholders a fresh start by shedding burdensome contracts?

The answer to both questions: Allow a bankrupt energy producer to reject, as in walk away from with no remorse, gas gathering, processing and transportation agreements.

This is the hot issue

Can the E&P debtor reject, under Section 365 of the Bankruptcy Code, what is in today’s environment an above-market agreement?

The typical contract dedicates the producer’s oil and gas interests and associated acreage to its midstream counterparty.  These dedications assure that the producer and everyone who follows will be bound by the original bargain. Midstream companies invest billions of dollars to develop the infrastructure necessary to gather, process, and transport oil and gas for their E&P counterparty-producer.

A significant right of a debtor is to reject burdensome executory contracts. Upon rejection, the debtor no longer can be compelled to perform, leaving the counterparty with a breach of contract claim, which generally an unsecured claim worth very little. Bankruptcy courts apply a business judgment standard to the debtor’s decision, and generally do not consider the effect on the counterparty.

The legal question

From the midstream company‘s point of view: Dedications of producers’ underlying mineral interests are covenants running with the land that are real property interests and therefore, cannot be rejected in bankruptcy.

From the debtor’s point of view: The gathering and processing agreements are executory commercial services agreements and only affect personal property interests – oil and gas that has already been severed from the land.

How it will be resolved

Reconciling the issue requires examination of state law. At least in Texas, courts have not been asked to determine whether a producer’s dedication of reserves is a real property interest or a commercial agreement. Bankruptcy courts are left to speculate how a state court would rule on this issue.

What does it mean for the future?

The resolution could have a far-reaching effect on the structural and financial underpinnings of both midstream and E&P companies. If these agreements can be shed, the sanctity of thousands of bargained-for contracts is in jeopardy, investor confidence in midstream companies will be shaken, and the cost of capital and thus the price producers would have to pay for gathering and processing services, will increase.

On the other hand, saddling a bankrupt producer with an above-market contract would limit its ability to restructure.

Bragging on Gray Reed

In the Quicksilver bankruptcy, see the objection by Crestwood Midstream Partners to the debtor’s motion to reject a gathering, processing and transportation agreement. Kudos to Gray Reed lawyers Philip Jordan, Lydia Webb, Jonathan Hyman and James Ormiston.

Our musical interlude: A message from litigants to judges everywhere.

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.

“Back in the day, when the Yankees always won the World Series and you could name a park after a Confederate general, we didn’t need no written contract; a man’s word was his bond, … yadda, yadda, yadda”.

Three things about that saying strike me. First, it was always a man; second, “the day” was always a time before the listener came on the scene; third, those fellows used some really bad grammar. R E LeeThe timeless truth is, a written agreement is always better, which returns us to Railroad Commission v Gulf Energy, discussed last week. Another question arose in that dispute: When did the Commission and Gulf Energy form a contract?  The trial court, in effect, decided as a matter of law that the parties had a binding contract.

What the trial court missed: Contract formation

The trial court deprived the jury of the ability to determine when the contract was formed:  At a May 19 meeting between the Commission and Gulf, or shortly after via conversations and emails, either of which was before the well was plugged – or on June 9 when a formal agreement was signed, which was after the unfortunate incident.  You can’t have a breach of contract claim without a contract, so the question was essential.

At trial there was disagreement aplenty among the witnesses about whether a meeting of the minds between the parties was achieved before or after the well was plugged. The Supreme Court decided that when a meeting of the minds occurred was a question of fact to be answered by the jury.

Practice tip

In lieu of our usual, customary, and frequently unconscionable fees for matters such as this, here is some free advice: If you want to avoid the “When was the contract formed?” dilemma, or worse, “Do we even have a contract?”, make it clear in your negotiations (emails, draft agreements, phone calls) something to the effect that that your understandings are subject to a final, binding agreement satisfactory to all parties. Or, if an enforceable agreement is your goal, say something like: The parties agree to cooperate in drafting and execution of future documents. The fact that such additional documents are contemplated does not affect the binding nature of this agreement.

Caveat

I call it “advice”, but what I say in this blog is not fact- or case-specific; I don’t know your situation, so don’t rely on what I say here without consulting a lawyer of your own choosing.

Musical interlude

At a loss for a song celebrating contract formation, think about this: New Orleans isn’t alone in the Africa-inspired musical universe, right? How about the Godfather of Soul and Africa itself?

beasts of southern wild“You are my friend, kind of.” Hush Puppy, as she stares down the Aurochs in Beasts of the Southern Wild. Is our “friend” the Texas Railroad Commission?

Gulf Energy bought a package of offshore wells out of bankruptcy. Eight needed to be plugged and the Commission undertook that task, given the operator’s insolvency. Oops! The Commission’s contractor plugged one it shouldn’t have. Can Gulf Energy recover damages? The jury, trial court, and appellate court said yes. The Texas Supreme Court said maybe not. The question: Was the Commission entitled to have a jury determine whether it was in good faith when it mistakenly plugged the well?

The Commission awarded Superior Energy Services a contract to plug the wells. A Commission employee made a clerical error by transposing well numbers and Superior plugged well 708S-5 instead of well 707S-5.

Gulf sued the Commission and Superior for breach of contract and negligence. Superior settled.

Lawyers: See the discussion about preserving error when the court rejects your objection to a jury charge.  The result was the jury was not asked to determine whether the Commission was in good faith when it plugged the well.

The Statutory Defense

Under Commission rules, if the owners of a well can’t be found or don’t have sufficient assets, the Commission may plug an abandoned well. Under Chapter 89 of the Natural Resources Code the Commission and its employees “… are not liable for any damages that may occur as a result of acts done or omitted to be done by them … in a good—faith effort to carry out this chapter.”

How many ways can you say “good faith”

Gulf Energy alleged that the defense applies only to acts that involve discretion and do not extend to ministerial acts like plugging a well.  The Supreme Court rejected the argument based on the plain reading of the statute.

The Court had to determine what “good faith” means. After considering definitions from Webster’s Third New International Dictionary, Black’s Law Dictionary, the Uniform Commercial Code, and earlier Supreme Court rulings, it decided that good faith:

“refers to conduct which is honest in fact, free of improper motive or willful ignorance of the facts at hand.  It does not require proof of “reasonable” investigation … stating the proposition conversely …, “bad faith” means more than merely negligent or unreasonable conduct; it requires proof of an improper motive or willful ignorance of the facts.”

Good faith – judge or jury?

Was the good faith defense to be determined by the jury as a fact question or by the judge as a matter of law?  There were enough contradictory facts to raise a question about whether the Commission acted in good faith. For example, there was evidence that the employee presented correct information to Superior several days before the 708S-5 plugged, but they failed to pass it on to the crew boat conducting the operation. Energy urged that there was willful ignorance, which would nullify the good faith defense.

Result

Back to the trial court from whence it came for a new trial.

Things you only learn here 

Beasts of the Southern Wild is, to my knowledge, the only movie ever that employed a nutria consultant.

And a musical interlude worthy of Hush Puppy.

wild goose chaseCo-author Alexandra Crawley

Thanks to In re Reichmann Petroleum Corp., we know one that works in Texas: A lien affidavit attaching either a plat or a plat and a Texas Railroad Commission Form W-1 provides an adequate property description for a mineral lien against an entire lease under the Texas Property Code.

Current practice – chase the wild goose

To have a valid mineral lien the claimant must file an affidavit in the Official Public Records of the county where the lease lies containing a “description of the property”.

Contractors often only identify a well name and county on their invoices.  When they run to their lawyers at the last minute for a lien, the wild goose chase ensues:  The lawyers navigate the user-unfriendly Railroad Commission web site and online county records (where available) seeking a “sufficient” description of the property for the affidavit. (Clients: Why do you wait so long? You’ve known for weeks the operator is a deadbeat.)

A better way

Reichmann provides much needed clarity, especially when the claimant can’t obtain the best description – from the lease – because of the pressure of time. Now, a plat or a plat and a Form W-1 will get you a lien on the entire lease, not just the portion depicted on the plat.

The court looks at what the statutory says 

Reichmann was an operator of oil and gas properties and sought bankruptcy protection. Creditors claimed mineral liens on  leases. Reichmann objected to several liens on the grounds that the property descriptions were inadequate, arguing that “a description of the land, leasehold interest, pipeline, or pipeline right-of-way involved” should be construed to be equivalent to the statute of frauds standard, which requires “exactness”.

In finding that Chapter 56 does not require a description as stringent as the statute of frauds, the court looked to the statutory mechanic’s lien standard, which requires a “legally sufficient” description.  That is lesser than the statute of frauds standard, and the mineral lien statute requires even less, by omitting “legally “sufficient”.

Said the  court: An affidavit with an RRC plat was adequate because it would “enable a party familiar with the locality to identify with reasonable certainty the premises intended.”

The objectors argued that the lien did not attach to the entire lease, but only to that part reflected in the attached plat.  The court disagreed, citing Mercantile National Bank at Dallas v. McCollough Tool Co., where in 1953 the “Texas Supreme Court gave a materialman a lien on an entire lease for work done on just one well under what is now Sections 56.001 and 56.003”, and Dunigan Tool  & Supply v. Burris (1968) “where a Texas Court of Appeals interpreted what is currently Chapter 56 to hold that the statutory language allows a lien to exist upon an entire leasehold interest upon which materials were delivered to or used.”

The liens applied to the entire lease “because the information provided helped to identify the nucleus of information that would identify relevant leases even without a complete lease attached.”

Musical interlude

The common element of today’s offerings is feathers: This kind and then there is this kind.

Honus-Wagner-100-Years-Ago-Today1-650x365Co-author Brooke Sizer

A baseball question: You’ve got men on late in the game; a base hit to the right side wins. Do you put the bat on the ball for a single or swing for the deep seats, risking the game-ending strikeout?

The Stiles leases were executed in 1907, when Honus Wagner was in his prime. Covering 3,214 acres in Caddo Parish, Louisiana, they were for a primary term of ten years ” … and as much longer thereafter as gas or oil is found or produced in paying quantities … ”  The leases are held by several hundred shallow wells.  In 2007, in Regions Bank v. Questar Exploration the plaintiffs sued for failure to reasonably develop at depths below 6,000 feet. The suit was amended to assert that the leases had terminated by operation of Civil Code Art. 2679, which limits the duration of a lease to 99 years.

The trial court dismissed the case: Civil Code Art. 2679 does not apply to mineral leases.  Plaintiffs appealed.

Plaintiffs’ argument

Article 2679 applies because of Mineral Code Section 2: The Code is supplementary to the Civil Code and its provisions apply specifically to the subject of mineral law.  In the event of conflict between the two, the Mineral Code prevails. If this Code does not expressly or impliedly provide for a particular situation, the Civil Code or other laws apply.

Exxon’s argument

The habendum clause (“thereafter … ”) is connected directly to the production of oil and gas and Article 2679 has no application for mineral leases.  Mineral Code Section 115(A) requires that a mineral lease have a term, and prohibits a term of more than 10 years without operations or production.

The conclusion

Exxon wins. The Stiles leases are are mineral leases governed by their terms and the Mineral Code.  The habendum clause balances the interests of the lessor and lessee.  Plaintiff’s argument runs contrary to well-established practices.

The habendum clause is two-tiered. The first is of a definite duration and the second is of an indefinite duration.  For the habendum clause to  extend the lease a well must have already been drilled and tested or began producing, and still producing, when it entered the second term.  That the “secondary term” is limited to 99 years is contrary to the concept of maintaining a lease for as long as minerals are producing in paying quantities.

The 99-year limit has no rational application to mineral leases. Article 115 provides for a maximum secondary term based upon continued operations or production.  A mineral lease will terminate at the expiration of the agreed term or upon the occurrence of an express resolutory condition.

The takeaway

Should plaintiffs have stayed with failure to reasonably develop instead of swinging for the fences? (We ask rhetorically, ignorant of why they did what they did.) The court said that if it found the leases were perpetual then they would be void from inception, as in from 1907. What were the chances of such a radical and unsettling result? About as much as Jeb Bush winning in Iowa. Or a Bigfoot sighting. Or Bigfoot winning in New Hampshire. Intermediate appellate courts are not known for legal adventurism.

 A musical interlude about Louisiana by a Texan.

taxesThis is to be expected in these dark days of diminished cash flow. Imagine:  You are the operator and the non-ops have given you their share of ad valorem taxes, expecting you to pay them to the taxing authority at the right time. Things are a little tight, if you know what I mean, so you divert “borrow” the funds for more pressing obligations. You intend, of course, to replace the money “when things get better”.  Time passes; “things” don’t get better; your entity – a corporation, LLC, whatever – collapses. Not to worry; your personal assets are protected because that’s what corporations are for, right?  Wrong, at least in Texas.

The Texas Tax Code imposes personal liability upon any person who receives or collects an ad valorem tax from another person. The recipient holds the funds in trust for the benefit of the taxing unit and is liable to the taxing unit for the full amount collected plus penalties and interest.

Who is the ”responsible individual”?

It’s not just the entity that is liable:

“ … [A]n individual who controls or supervises the collection of tax or money from another person, or an individual who controls or supervises the accounting for and paying over of the tax or money, and who willfully fails to pay or cause to be paid the tax or money is liable as a responsible individual for an amount equal to the tax or money, plus all interest, penalties, and costs, not paid or caused to be paid.”

Lest there be doubt, the Code defines a ”responsible individual” for us:

“A  ‘responsible individual’ includes an officer, manager, director, or employee or a corporation, association, or limited liability company or a member of a partnership who, as an officer, manager, director, employee, or member, is under a duty to perform an act with respect to the collection, accounting, or payment of a tax or money … “.

If you are “robbing” Peter to pay Paul, make sure Peter isn’t a governmental entity.

The other side of the coin

Non-operator, do you know what your operator is doing with the tax money being collected from you?

Musical interlude

Where to start! RIP David Bowie and Glenn Frey.

elvis_presleySpecial thanks to Gray Reed colleagues Paul Yale and Dominic Salinas for this post.

Weary of having to solicit those pesky subordinations of pre-existing mortgages to your recently-acquired oil and gas leases? Tired of chasing down the third assistant to the fourth vice president for loan servicing just to obtain one simple document? The 2015 Texas legislature was listening to you.

Beginning on January 1, the “first in time, first in right” rule no longer applies to the relationship between a real estate mortgage and a later-recorded oil and gas lease. By House Bill 2207 a prior mortgage is, for the most part, subordinated to a subsequent oil and gas lease.  Where a lease is taken on land that is already subject to a mortgage and the mortgage is foreclosed, the oil and gas lease will not terminate, even if the lease has not been subordinated to the mortgage.

But wait – a practice tip!

It’s not that simple. One historical effect of mortgage foreclosure does not change: The lessee loses the right to use the surface of the foreclosed property for oil and gas operations. It is an improvement; prior to HB 2207 the entire lease was extinguished.  The loss of surface rights will not likely be an issue on smaller tracts, but could pose a problem on larger tracts. If you intend to use the lease for a drillsite, go ahead and get the subordination.

Another thing that didn’t change:  Royalty payments coming due after the sale pass to the purchaser of the foreclosed property.

A question remains

The Bill does not apply to a security interest that does not attach to a mineral interest. So what about proceeds of the sale of oil and gas, which are personal property, not a real property interest. If a security interest covers proceeds (and many of them do), could a foreclosure in effect wash out the oil and gas lease anyway? We don’t pretend to know the answer to that question.

Why did it pass?

The legislation will result in savings in time, energy, and legal and land costs. The bill was supported by producers and industry groups such as TIPRO and the Texas Alliance of Producers. Think about urban and suburban areas such as the Barnett Shale, where most lessors are homeowners with a mortgage. Under the new law the lease will continue. The only change will be that royalties payable to the lessor pre-foreclosure become payable to the purchaser post-foreclosure.

In 1954 Sam Phillips was looking for white guy who could sing like a black guy. He found him in Elvis Presley. To celebrate Elvis’s birthday (and with apologies to David  Bowie) our musical interlude features a worthy successor, Saint Paul and the Broken Bones.

 

ponziIn the spirit of Charles Ponzi, today we offer advice for attracting special attention from powerful federal authorities who want to punish you. Helms and Kaelin marketed a limited partnership to hold royalty interests in 2,000 oil and gas wells  Here’s how they did it, and you can too!

Make promises

In a private placement memorandum in which you raise $31,000,000 from 129 investors, promise:

  • 99.14% of the proceeds raised will be for  purchasing royalty interests;
  • Investment proceeds will be used for only two kinds of business expenses: loan payments and promotional expenses;
  • Every dollar that comes in goes out in acquisitions, “so if you put $1MM into the company, that $1MM is spent on acquisitions.”;
  • There are no material pending legal proceedings (when there are several).

Spiff up the resume

  • Represent in the PPM that you have “worked with various mineral companies over the last ten years advising managerial issues involving the acquisition and management royalty interests, mineral properties and related legal and financial issues” (none of which is remotely true);
  • Represent that you have managed other investments fund to the tune of $300MM (which is not remotely true);
  • Describe at length your “extremely successful history” in the off-shore oil and gas industry and your business relationship with a successful and well-known oil man and his $500MM energy fund (when your actual experience was cold-calling land owners to buy minerals).

Break the promises, what were they thinking?

  • Spend at least $8.4MM on yourselves, families, friends and associates, including $247,000 for your daughter’s wedding in Hawaii, $110,000 for airfare, $102,000 for tuition, $287,000 for mortgage payments, and the cost of a 23-day trip around the world;
  • Brag on social media about your “Journey of Man”, in which you (Helms, with girlfriend Kaelin) use 50 hours of flight time on a private jet, meet elephants in Thailand, ride camels in Jordan, and other fun adventures;
  • Spend $12.8MM on business expenses, including $1.1MM in bank loans, without telling your investors.

Create and cover up evidence

  • Forge an audit letter from a well-respected engineering firm, asserting that you own over 18,000 properties worth over $26MM.  In fact, there is nothing to audit because you own no properties;
  • Of the $31MM raised, make distributions using new investor funds totaling $4.7MM. Have the SEC’s witness deem every distribution a Ponzi payment.
  • Engage in “round-trip transactions” (moving money around in transactions for which there is no legitimate business purpose) to make it look like royalty revenue;
  • If you are Kaelin repeatedly fail to comply with subpoenas, court orders and the Federal Rules, assert mental incompetence without supporting evidence, engage in “evasive and manipulative” conduct to avoid discovery obligations.

What about the salesmen?

If you are Sellers and Barrera:

  • Receive a commission of 14% of a $3.1MM investment, more than eight times the PPM’s $50,000 limit for total promotional expenses;
  • Have lunch with the investor and lie to him when directly asked about the commission, call it “small”;
  • Allow a federal judge to define “small”;
  • Do all this while not a registered broker;
  • Don’t bother to participate in the legal proceedings.

What will happen to you?

  • The SEC will sue you and your corporate entities, throwing in a kitchen sink of securities fraud allegations.
  • There will be a judgment for $31MM, disgorgement, permanent injunction, and a civil fine of another $31MM.
  • The two lovebirds will end their sordid journey here.