CHAPTER 16 SEARCHING FOR A SQUARE CORNER: A ROYALTY LAWYER'S LOOK AT VALUATION, ETHICS, AND LEGAL ADVICE

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management Book 1
(Feb 2004)
CHAPTER 16
SEARCHING FOR A SQUARE CORNER: A ROYALTY LAWYER'S LOOK AT VALUATION, ETHICS, AND LEGAL ADVICE
Jonathan A. Hunter
Liskow & Lewis
New Orleans, Louisiana

I. Introduction

In 1920, Justice Holmes admonished that, "Men must turn square corners when they deal with the Government." ¹ Although this statement continues to be cited in reported decisions, it is frequently the case that a court is highlighting the reciprocal nature of the principle that Justice Holmes articulated - i.e., that "the Government must turn square corners with men." ² While the concept of having to "turn square corners with the Government" arguably applies to a federal lessee's obligation to pay royalty, lawyers who counsel oil companies concerning their federal royalty obligations are often heard to mutter, "Show me a square corner, please." The fact is that royalty valuation can be uncertain, complicated, and frequently the subject of disagreement. I would submit that the frequency of these disputes is not the product of intransigence by producers or the royalty defense bar, but rather that it results from the complex legal framework that governs in this area; from frequently changing factual scenarios produced by changes in technology, the economy, and governmental regulation; from the uncertainties and vagaries inherent in the concept of "value"; and from the royalty lawyer's duty to "zealously" or "diligently" represent her or his client.

As we will see, notwithstanding the deference that may usually be owed to a federal agency in a dispute over an agency's decision affecting a regulated party, federal lessees have available to them a series of potential defenses to MMS claims to recover additional royalties. Of course, like all lawyers, those practicing in the royalty valuation arena are constrained by the ethical duty to the tribunal to assert only "meritorious claims" on behalf of her or his client.

The purpose of this paper is to examine the legal framework within which federal royalty valuation disputes arise, considered with regard to the particular ethical duties owed by counsel for the lessee - viz., the lawyer's ethical duty to the tribunal to advance only meritorious claims, while at the same time discharging the duty of "zealous" or "diligent" representation of the client.

II. The Substantive Legal Context

First and foremost, the United States and its lessees are parties to a contract and are governed by the law of contract. ³ Of course, these contracts are granted pursuant to and are governed by federal statutes - the Mineral Lands Leasing Act ⁴ for onshore leases, the Outer Continental Shelf Lands Act ⁵ for federal offshore leases, and the Federal Oil and Gas Royalty Management Act ⁶ for all leases - and a series of federal regulations. ⁷ As is generally the case with private oil and gas leases, federal oil and gas leases may continue indefinitely, as long as the lessee continues to conduct lease-holding activities. ⁸ Thus, although Interior frequently modifies its regulations governing lease operations, because so many federal leases are held for so long by lease-holding production and operations, the federal lessor frequently finds itself in the position of attempting to apply new regulations to leases granted prior to the promulgation of the regulations. This is routinely the case with respect to new royalty valuation regulations.

With respect to royalty valuation in particular, federal leases have a royalty clause which generally provides something like the following:

The value of production for purposes of computing royalty on production from this lease shall never be less than the fair market value of the production. The value of production shall be the estimated reasonable value of the production as determined by the Lessor, due consideration being given to the highest price paid for a part or for a majority of production of like quality in the same field or area, to the price received by the Lessee, to posted prices, to regulated prices, and to other relevant matters. Except when the Lessor, in its discretion, determines not to consider special pricing relief from otherwise applicable Federal regulatory requirements, the value of production for the purposes of computing royalty shall not be deemed to be less than the gross proceeds accruing to the Lessee from the sale thereof. In the absence of good reason to the contrary, value computed on the basis of the highest price paid or offered at the time of production in a fair and open market for the major portion of like-quality products produced and sold from the field or area where the leased area is situated will be considered to be a reasonable value... ⁹

Within this royalty clause (and the regulations that purport to implement the federal Lessor's "determination of" the "estimated reasonable value of production"), lies the rub of virtually all federal royalty disputes - viz., what is the "value of production"? Any economist worth their salt will opine that the marketplace rarely, if ever, produces a single "value" of any product, but rather that "value" virtually always falls somewhere within a "range." And, indeed, MMS has for years embraced the concepts that (1) prices generated in arm's-length transactions "will normally be accepted as the value for royalty purposes," ¹⁰ even if separate transactions for similarly situated production produce different values; and (ii) "value is a range." ¹¹

Although for many years the federal lease royalty clause generally tracked Interior's royalty valuation regulations, that ceased being the case in 1988 when MMS adopted lengthy new valuation regulations. The 1988 regulations not only were quite different substantively from the prior regulations, but, for the first time, they created a single set of regulations that applied to both onshore and offshore federal leases. As noted, these regulations are lengthy and complex, and they are frequently the subject of revision by the agency, generally following a lengthy rulemaking process. Thus, while federal royalty valuation regulations at one time were contained in a single paragraph, those regulations now occupy numerous pages of Title 30, and they address virtually every aspect of royalty reporting and valuation. ¹²

In addition, an ever-increasing number of federal judicial decisions establishes and affects federal royalty valuation law. Federal lessees have been litigating royalty valuation disputes with the federal lessor for decades in a variety of courts, ¹³ and - based on the attendance at this seminar alone, if on nothing else - there is every indication that such disputes will continue to be litigated in the future.

Finally, in addition to the statutes, regulations, and judicial decisions addressing substantive valuation issues, the federal lessor has potentially available to it a unique set of remedies created by the statutes underlying the federal oil and gas leasing system - civil and potentially criminal penalties for a lessee's violation of its royalty obligation. ¹⁴ In addition to these penalties, in recent years there have been significant allegations that a federal lessee's royalty obligations are subject to scrutiny under the False Claims Act, which contains its own special set of remedies and penalties. ¹⁵

III. Select Rules Of Conduct

(1) Duty Of "Zealous" or "Diligent" Representation

For many years, the ethical rules governing attorneys bound an attorney to "represent a client zealously within the bounds of the law." ¹⁶ The Model Rules of Professional Conduct (hereinafter the "Model Rules") rephrased that duty to provide that, "Ýa¨ lawyer shall act with reasonable diligence and promptness in representing a client." ¹⁷ The comments to this rule retain the concept of "zealous" representation, subject to a restriction of reasonableness:

A lawyer should pursue a matter on behalf of a client despite opposition, obstruction or personal inconvenience to the lawyer, and take whatever lawful and ethical measures are required to vindicate a client's cause or endeavor. A lawyer must also act with commitment and dedication to the interests of the client and with zeal in advocacy upon the client's behalf. A lawyer is not bound, however, to press for every advantage that might be realized for a client. ¹⁸

A lawyer not only owes a duty of diligence to its client, however, but because a lawyer is an officer of the court, a lawyer also owes the tribunal a series of duties, including duties of candor and good faith. This is where the question of "asserting meritorious claims" arises.

(2) Duty To Assert Meritorious Claims

Model Rule 3.1 commands that, "Ýa¨ lawyer shall not bring or defend a proceeding, or assert or controvert an issue therein, unless there is a basis in law and fact for doing so that is not frivolous, which includes a good faith argument for an extension, modification or reversal of existing law." ¹⁹ The Comments to Model Rule 3.1 make clear the tension that every lawyer faces, because the advocate "has a duty to use legal procedure for the fullest benefit of the client's cause, but also a duty not to abuse legal procedure." Id. at cmt. 1. An attorney's obligation to assert only those claims that are meritorious is based on the following principles:

Our system of jurisprudence is designed to insure that all disputants with colorable claims have access to the courthouse. Relatively low barriers to entry have, however, generated an undesirable result--a deluge of frivolous or vexatious claims filed by the uninformed, the misinformed, and the unscrupulous. These claims clog court dockets and threaten to undermine the ability of the judiciary to efficiently administer the press of cases properly before it. Perhaps the greatest safeguard against this danger is the integrity and good sense of practicing lawyers who, as officers of the...