CHAPTER 1 BASIS OF THE IMPLIED COVENANTS

JurisdictionUnited States
Implied Covenants
(Nov 1986)

CHAPTER 1
BASIS OF THE IMPLIED COVENANTS

WILLIAM P. PEARCE
Pearce & Durick
Bismarck, North Dakota

It has been pointed out so often that citation to authorities is hardly necessary that whatever an oil and gas lease is, it certainly is not a "lease."1 Under the law of most jurisdictions which have been required to come to grips with the conceptual nature of the oil and gas lease, it is regarded as creating some sort of interest in land.2 The precise nature of that interest, which depends in many cases upon the context in which the query is posed, need not concern us here. One corollary that follows from the characterization of the lease as a grant of an interest in real property is that it is not a "contract."3 Though a court will often make loose statements to the effect that an oil and gas lease is a contract between the parties, what is usually meant is that the lease provisions will be construed to ascertain the parties' intent under the same rules as applied to written contracts.4 Yet the lease normally contains certain "contractual" provisions, principally the obligation to pay royalties, and perhaps also a provision to bury pipelines below plowing depth, or to compensate the surface owner for damage to growing crops, or to drill offset wells under specified conditions.

ORIGIN OF THE IMPLIED COVENANTS

The oil and gas lease, therefore, may be thought of as a grant burdened with certain contractual elements, which may be express or implied.5 If the lease really were, pure and simple, a grant of a fee simple determinable in the oil and gas in place, a doctrine first clearly articulated by the Texas courts and fairly widely followed,6 the lessee would retain ownership until the condition causing termination of the estate was triggered or until he abandoned the lease.7 In fact, however, his continued ownership of the leasehold is dependent on his continuing compliance with certain obligations, or covenants, which, although they appear nowhere in the lease, are nonetheless real and an ever-present source of concern to the lessee. It is these implied covenants fashioned by the courts that generate some of the unique flavor to the hybrid creature that we call an oil and gas lease.

It is well to keep in mind, however, that the existence of these implied covenants, which reflects the underlying presence

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of the contractual viewpoint in the analytical framework of the oil and gas lease, is not unique to this field of law. Williams and Meyers find the notion to be rooted in the contract law principle of cooperation:

"It is clear, however, that the implication of duties in an oil and gas lease is not an isolated phenomen peculiar to oil and gas law. On the contrary, the covenants implied in oil and gas leases reflect a broader principle of law applicable to all contractual arrangements. This is the principle of cooperation found in the law of contracts."8

The principle of cooperation dictates that the contracting parties cooperate with each other so as to accomplish the purpose of the agreement, and is based upon the reasonable expectations of the parties.9

The question naturally arises, therefore, whether the implied covenants are implied "in fact" or are they implied "in law." If they are implied in fact, the traditional framework of the law of implied contracts unfolds. The courts will read into the parties' express contract certain implied obligations and duties which are deemed to reflect their unspoken or unarticulated intent about what their expectations as to the performance of each would be had they thought about the particular item in question when writing the contract. If the covenants are implied in law, on the other hand, the courts will intervene, regardless of the actual or imputed intent of the parties, whenever it is perceived to be necessary to do justice between the parties. This is essentially the doctrine of quasi-contract, created in order to prevent one party from being unjustly enriched at the expense of the other. In theory, regardless of the parties' intent, the courts will act to balance the equities and preserve fairness between the parties.

Each of these views has had its adherents,10 but Williams and Meyers believe this to be "jurisprudentially, a false dichotomy," in the context of the oil and gas lease:

"If the principle of cooperation is accepted as the correct basis for implying covenants, then there is an element of both fact and law in the implication. The duty of cooperation requires the parties to conduct themselves in such a manner as to promote the basic objectives of the contract. To this extent it

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is rooted in fact, because undoubtedly parties do enter into a contract with the expectation that conduct will be directed towards the end of accomplishing its purposes. Undoubtedly the principle of cooperation also represents an ethical norm; but an ethical norm can be a fact, and can be the predicate for reasonable expectations. When it comes to the application of an implied covenant to a particular dispute, courts may move some distance away from the fact of the parties' intention and closer to the law as an instrument for enforcing ethical norms. Thus when the lessor sues the lessee for his failure to use sandfracing to increase production, he may claim as a fact that he expected diligent efforts to be made to maximize production, but he can hardly claim that he expected the use of sandfracing when the lease antedated the invention of the process."11

The theoretical distinction between covenants implied in fact and covenants implied in law, therefore, is much less important than the fact that the courts have traditionally used the notion of implied contracts as an instrument to accomplish what they perceive to be equitable results in specific cases.12 The fact that the implied covenants arise from equitable considerations and the natural expectations of the parties rather than from their express agreement, is the key.13

As with most bodies of law, a set of general rules has developed in the context of the implied covenants in oil and gas leases, which will be summarized below. The general approach in the balance of this paper will be to demonstrate how these principles have been applied by the courts in several recent cases and how the courts have used the general principles as a framework for fashioning equitable relief in specific cases. The aim is to stress that the forest should never be lost sight of in looking at the trees, that is that it should always be kept in mind that the origin of the implied covenants is equitable in nature. A particular case should be approached not with the goal of fitting it into a rigid pre-existing framework, but rather with the aim of using the framework as a starting point for achieving a desirable result. This process is always, of course, open to the criticism that stability and predictability may suffer, but is appears to be what the courts actually do in the implied covenant cases, and the results generally appear to be sound.14

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The concept that law, whether codified in statutory form or as developed by the courts from basic common law traditions, is anchored upon a bedrock of equitable principles is an old one.15 It is not surprising that the early decisions recognizing the existence of implied covenants in oil and gas leases built upon this foundation. The landmark early case is Brewster v. Lanyon Zinc Co.,16 in which the court, although it couches its opinion in terms of the implied intentions of the parties, is clearly reaching for a result that is fair to both parties in the circumstances of oil and gas development:

"It is conceded, as indeed it must be, that the lease contains no express stipulation as to what, if anything, should be done in the way of searching for and producing oil or gas after the first five years; but it does not follow from this that it is silent on the subject, or that the matter is left absolutely to the will of the lessee. Whatever is implied in a contract is as effectual as what is expressed. Implication is but another name for intention, and if it arises from the language of the contract when considered in its entirety, and is not gathered from the mere expectations of one or both of the parties, it is controlling. Light will be thrown upon the language used, and the intention of the parties will be better reflected, if consideration is given to the peculiar and distinctive features of the mineral deposits which are the subjects of the lease. [discussing migratory character of oil and gas]

...

The implication necessarily arising from these provisions [the lease provisions theretofore reviewed by the court]—the intention which they obviously reflect—is that if, at the end of the five-year period prescribed for original exploration and development, oil and gas, one or both, had been found to exist in the demised premises in paying quantities, the work of exploration, development, and production should proceed with reasonable diligence for the common benefit of the parties, or the premises be surrendered to the lessor....

"Considering the migratory nature of oil and gas, and the danger of their being drawn off through wells on other lands if the field should become fully developed, all of which must have been in the minds

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of the parties, it is manifest that the terms of the lease contemplated action and diligence on the part of the lessee. ... [discussing the difficulty of expressly providing for the appropriate number of wells to be drilled] The subject was, therefore, rationally left to the implication, necessarily arising in the absence of express stipulation, that the further prosecution of the work should be along such lines as would be reasonably calculated to effectuate the controlling intention of the parties as manifested in the lease, which was to make the extraction of oil and gas from...

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