CHAPTER 9 ROYALTY CALCULATION WHEN THE PRODUCER|LESSEE IS DEALING WITH AN AFFILIATED ENTITY

• Jurisdiction: United States

PRIVATE OIL & GAS ROYALTIES
(Sept 2003)
CHAPTER 9
ROYALTY CALCULATION WHEN THE PRODUCER/LESSEE IS DEALING WITH AN AFFILIATED ENTITY
Judith M. Matlock
Davis, Graham & Stubbs L.L.P.
Denver, Colorado

"And," said Freddy, I don't see why we couldn't run such a company ourselves. Since we got back from Florida, lots of other animals, not only on this farm, but on other farms round here, have been wanting to take such a trip....

"Let's call a meeting in the cow barn tonight and talk it over." "Right," said the pig.- "And-then we'll form a company and incorporate." -

"Incorporate?" asked Robert. "What's that?"

"Oh, I ran across it in reading," said Freddy importantly. "It's what all companies do. You draw up rules and bylaws and then you pay the government a fee, and then you're incorporated. That means that whatever you do after that is legal."

"Then we ought to do it," said Robert. "Good-bye, you animals. See you later."

Walter R. Brooks, The Freddy Anniversary Collection, pg. 153 (The Overlook Press).

Introduction

As the above quotation from the American children's classic story "Freddy Goes to Florida" illustrates, it is common in this country, when starting a business, to form a corporation or other entity to engage in that business. For most forms of entities, this has the legal effect of isolating the liabilities of the entity from the individual assets of the owners. It is also common for companies to create separate legal entities to engage in different, although sometimes related, lines of business. Again, this is often done for the purpose of isolating liabilities among the separate entities and this is perfectly legal. See

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Cascade Energy and Metals Corp. v. Banks² in which the court explained that the law permits the incorporation of businesses for the very purpose of isolating liabilities among separate entities. However, when affiliated entities engage in business transactions with each other that have consequences to third parties, there can be a question as to the propriety of the transaction vis-a-vis the third parties. Thus, for example, when the operator under a joint operating agreement purchases drilling supplies from an affiliated entity, the other working interest owners want to be certain that the operator does not overcharge for those supplies.

When a producer uses the transportation or processing services of an affiliate or sells production to an affiliate, royalty owners may question the propriety of the transaction because the costs charged for affiliated services or the proceeds received in sales to an affiliate factor into the calculation of the royalties.

Both in the private royalty context and in many other contexts, there is a developed body of case law which establishes the standard by which affiliated transactions are to be measured and that standard is one of comparability to arm's- length transactions. In affiliated transactions, third parties are to be no worse off than if the transaction had been with a third party. On the other hand, under the comparability standard, third parties are not entitled to be better off than if the transaction had been with a third party. The comparability standard thus balances the lawful right of companies to isolate liabilities among separate entities and the rights of third parties not to be adversely impacted by transactions between affiliated entities. When a transaction does not meet the comparability standard, generally the remedy is the ordinary breach of contract remedy of damages measured by the extent to which the affiliated transaction does not meet the comparability standard. In this manner, that third parties receive their expectation interest are kept in a neutral position.

For decades there have been vertically integrated oil companies. These are companies which are involved not only in the exploration and production business but also in other downstream segments of the oil industry such as transportation, refining, or retail distribution. Historically, vertical integration was relatively rare in the gas industry because the primary purchasers of natural gas were regulated interstate and intrastate pipelines purchasing at the wellhead. Occasionally, a producer would become involved in the construction of a gathering line or a processing plant when there were no existing facilities in the field.³ In the early 1990's, as a result the federal government's restructuring of the

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interstate pipeline segment of the gas industry, interstate pipelines became mandatory open access transporters only.⁴

Today, wellhead buyers of natural gas are more likely to be brokers, marketers, local distribution companies ("LDCs") or large industrial consumers rather than owners of pipeline facilities in the vicinity of the production.⁵ Additionally, because of transportation access, producers also have the ability to have their gas production transported to off-lease markets as distant as the citygate⁶ and, in some cases, the burnertip. To access these markets, however, requires expertise, manpower and financial creditworthiness which many producers do not possess. It also requires participants to take on new liabilities not associated with the exploration and production of natural gas. The scope and magnitude of these liabilities have increased dramatically, just in the short time since Order No. 636 was implemented in the fall of 1993.

To protect their gas reserves and their exploration and production assets from liability for such risks, some producers have created affiliates in order to separate their exploration and production business from the separate business of downstream marketing of natural gas (the business which was historically the domain of the interstate pipelines).⁷ As a result, there is more partial vertical integration in the gas industry than there was historically. There is also a renewed interest in the question of how royalties should be paid when a producer sells its production to an affiliate or uses an affiliate to provide transportation or other services necessary to deliver production to a distant market.

What is an affiliate

There are numerous statutory, regulatory and case law definitions of affiliate, all involving the concept of control by one person or entity of another person or entity. Black's Law Dictionary defines affiliate as a company effectively controlled by another company.

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Note that this definition is not limited to corporations and is broad enough to include other types of business entities. The concept of control is often defined in contracts to mean possession, directly or indirectly, of sufficient power to direct or cause the direction of management or policies of another person or entity.

For some purposes, presumptions are made based upon the degree of ownership. For example, the gas valuation regulations adopted by the Minerals Management Service provide that:

Two persons are affiliated if-one person controls, is controlled by, or is under common control with another person. - For purposes of this subpart, based on the instruments of ownership of the voting securities of an entity, or based on other forms of ownership: (a) ownership in excess of 50% constitutes control, (b) ownership of 10 through 50% creates a presumption of control, and ownership of less than 10% creates a presumption of noncontrol which MMS may rebut if it demonstrates actual or legal control, including the existence of interlocking directorates.⁸

Similarly, under the United States Bankruptcy Code, the control necessary to create an affiliation is defined in terms of ownership, or control or holding power to vote 20 percent or more of the outstanding voting securities.⁹

Why affiliates are created

This articles begins with a quotation from a children's book which conveys the very common understanding that the first thing to do when starting a new business is to incorporate. The idea is to create some type of entity to conduct the business which will protect the personal assets of the investors from the liabilities of the company. Up until recently, corporations were the most common legal entity created for this purpose.¹⁰ It is the rare individual who is willing to engage in business as a sole proprietorship so that his or her personal assets (such as a home) are at risk for the liabilities of the business.

In the case of companies which are going to be in more than one line of business or more than one segment of an industry, prudent business practice is to create separate entities for each in order to protect the assets of one from the liabilities of the other. This is

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particularly advisable when a company is entering into a new line of business with which it may have very little experience and, therefore, greater financial risk.

In the oil and gas context, the use of affiliates allows a company to separate downstream activities from the business of oil and gas exploration, so that assets of the oil and gas business are not at risk for the obligations of the downstream business.

Recognition of corporate separateness

The creation of affiliates to isolate liabilities has been found by the courts to be lawful. As stated in Cascade Energy and Metals Corp. v. Banks.¹¹ "[t]he law permits the incorporation of businesses for the very purpose of isolating liabilities among separate entities."¹² The ability to isolate liabilities among separate entities has fostered progress by enabling companies to take risks which they might otherwise not be willing to take.¹³ So strong is this right in the law to isolate liabilities through the use of affiliates, that the courts have held that only under extraordinary circumstances should the corporate veil be pierced.¹⁴

This principle of corporate separateness was recently affirmed by a unanimous decision of the United States Supreme Court in United States v. Bestfoods.¹⁵ The case involved the question of whether...