CHAPTER 9 STRATEGIES AND PROCEDURAL ISSUES IN ROYALTY CASES
Jurisdiction | United States |
(Apr 1993)
STRATEGIES AND PROCEDURAL ISSUES IN ROYALTY CASES
Theresa A. Rohr
Butler & Binion
Houston, Texas
§ 9.01 Introduction
§ 9.02 Causes of Action
[A] Breach of Contract
[1] The Nature of the Lease
[2] The Express Obligation to Pay Royalty
[a] Vela, Monsanto and Middleton
[b] Diamond Shamrock
[c] The Bruni Case
[d] Other Take-or-Pay Cases
[3] The Implied Lease Covenants
[a] The Covenant of Reasonable Development
[b] The Covenant to Protect the Leasehold
[c] The Covenant to Manage and Administer the Lease
[i] Marketing
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[ii] Other General Management and Administrative Responsibilities
[d] The Covenant of Further Exploration
[B] Tort
[1] No Fiduciary Relationship
[2] Duty of Good Faith and Fair Dealing
[C] Lease Cancellation
§ 9.03 Defenses
[A] Acceptance of Delay Rentals or Royalty Payments
[B] Effect of Division Orders
§ 9.04 Procedural Issues
[A] Venue
[B] Joinder
[C] Use of Experts
[1] Decision to Employ
[2] The Consulting Expert
[3] The Testifying Expert
[a] Foundation, Predicate Requirement and Qualification
[b] Opinion Testimony
[c] Value Testimony
[4] Deposition of Your Expert
[5] Deposition of the Opposing Expert
[6] Direct Examination
[a] Preparing the Expert
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[b] Hypothetical Questions
[c] Basis of Opinion
[d] Testimony Based on Hearsay
[e] Opinion on Ultimate Issue
[f] Legal Conclusions
[7] Cross-Examination
[D] Discovery Issues
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§ 9.01 INTRODUCTION
The thorough treatment of a subject as broad as "royalty litigation" would involve considerably more than simply a consideration of "royalty", which Professor Kuntz described as follows:
The word "royalty" originated in England, where it was used to designate the share in production received by the Crown from those to whom the right to work mines and quarries was granted; it consists of a share in the oil and gas produced under a lease as compensation. As applied to an existing oil and gas lease, the ordinary meaning of the term "royalty" is the compensation for the privilege of drilling for and producing oil and gas and consists of a share of the oil and gas produced.1
In a typical lease transaction, the lessor may contract to receive income through a variety of mechanisms, including bonus payments, delay rentals, royalties on actual production, shut-in payments and minimum royalties. An in-depth treatment of all aspects of today's complex litigation between lessors and lessees is therefore well beyond the scope of this paper. Instead, the focus will be on those causes of action most frequently litigated and certain strategic and procedural considerations common to most cases likely to be encountered today.
In all such litigation, however, it is important to keep in mind Professor Kuntz's definition of royalty, as well as its generally-accepted meaning: a lessor retains an interest that is free of the costs and expenses of exploration, development and production, and royalty is characterized as an expense-free interest (except as to taxes) in a specified share of the gross production.2 At the very essence of a royalty interest is the lessor's decision to avoid all economic risks associated with exploration, production and development and to retain a fixed benefit, through royalty, payable exclusively as a percentage of
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production (either in value or in kind)3 , while the lessee bears the risks, costs and expenses of exploration, production and development.
Once these benefits and risks, and their proper allocation among the parties to the lease, are understood, courts are reluctant to restructure the parties' agreement in order to alleviate a particular burden or lessen an inequity. Thus, it is not surprising that many of the key decisions that make up the great body of lessor-lessee jurisprudence are premised on an examination of the language of the written lease in an attempt to discern the parties' intentions concerning the specific rights and benefits bargained for and the risks they sought to allocate between themselves.
§ 9.02 CAUSES OF ACTION
[A] BREACH OF CONTRACT
Generally, the cause of action most frequently litigated is usually brought by the lessor and is for breach of contract. Contract actions may be based on either the express terms of the lease or on covenants implied at law.
[1] The Nature of The Lease
Because the royalty obligation is created by agreement of the parties, embodied in a written lease instrument, the lessor-lessee relationship is, in most states, strictly contractual.4 While special circumstances may create a de jure trust or confidence,5 those special circumstances do not exist in the typical lessor-lessee relationship, which is governed by the specific terms of the written lease.
Courts have consistently defined a lessee's obligations to its lessor strictly in reference to the language of the written lease. Thus, for example, the Texas Supreme Court held in Texas Oil & Gas
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Corp. v. Vela,6 and again in Exxon Corp. v. Middleton,7 that the royalty obligation must be determined from the provisions of the lease.
Courts have also held that the lease is governed by general principles of contract law and construction.8 Thus, an obligation to perform under a lease is determined from the lease language itself, as mutually agreed by the parties.
[2] The Express Obligation to Pay Royalty
In recent years, the most actively litigated royalty issues have arisen out of the resolution of the enormous take-or-pay liabilities and accompanying litigation of the last decade.9 The related royalty litigation is instructive because the published decisions are founded upon and illustrate many of the established legal principles underlying the broader range of lessor-lessee litigation that went before.
[a] Vela, Monsanto and Middleton
Three Texas decisions, which had a profound impact at the time they were issued, continue to have a significant effect on today's royalty litigation.
It can be fairly said that Texas Oil & Gas Corp. v. Vela10 addressed the obverse of the situation that has spawned much of the royalty litigation of the last five years. Vela involved a 1933 "market price" lease. In 1935, the lessee entered into a life-of-the-lease gas contract with its purchaser for 2.3 cents per Mcf. Market prices rose considerably above that, of course, but the lessee's position was that "market price" meant a price "contracted
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for in good faith by the lessee in pursuance of its duty to market gas from the premises."11 The lessor disagreed and a lawsuit followed.
The analysis of the Texas Supreme Court began with the observation that the lease is "wholly independent of the gas sales contract,"12 and that no royalty owner had agreed to accept royalties on the basis of the price stipulated in the gas contracts. Rather, the agreement was to pay royalty based on market price at the time of sale or use of the gas and gas was being sold at the time of delivery, not at the time of execution of the gas contracts. Quoting Foster v. Atlantic Refining Co.,13 the court noted that the lessee took the risk of its gas contracts providing sufficient revenues to satisfy its royalty obligations. To alleviate the lessee's burden would require the court to rewrite the parties' lease, which it refused to do.14
Monsanto Co. v. Tyrrell,15 involved a lease that provided an increase in royalty at such time as certain costs were "recovered...from production" by the lessee. The issue was whether a $1.3 million advance gas payment received by the lessee was to be counted as "recovered from production." Noting that, as a matter of law, the term "production" has the clear and unambiguous meaning of "actual production" or the actual physical extraction of the mineral from the soil,16 the court held that the advance payment proceeds were not recovered from production at the time received by the lessee.
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In Exxon Corp. v. Middleton,17 the Texas Supreme Court considered again the question when gas is "sold" for purposes of royalty determinations.18 The court held that gas must be produced before royalty is due, that "production means actual physical extraction of the mineral," that "under the royalty clause, production of gas is a prerequisite to its sale or use",19 that gas is sold or used when it is delivered, and that for royalty purposes no sale of gas occurs when the gas contract is executed. The court also restated the important policy considerations that the lease and the gas contract are separate and that the lessee undertook the risk that its revenues from the sale of gas would not cover its obligation to pay royalty on a "market value" basis. The lessee's royalty obligations are "fixed and unaffected" by its gas contract; subsequent increases in market value may have made the lessee's royalty obligation more burdensome, but not enough so to cause the Court to rewrite the parties' contract.20
It was against the background of these decisions that lessors have undertaken to recover royalty on take-or-pay payments and settlements of gas contract disputes.
[b] Diamond Shamrock
In Diamond Shamrock Exploration Co. v. Hodel,21 the Fifth Circuit consolidated the appeals of two district court cases,22 in which the federal government as lessor sought a royalty share of
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take-or-pay payments received by its lessees. The Fifth Circuit held squarely that royalty payments are not due on take-or-pay payments and are only due on gas actually produced and taken.23
Mesa involved a 1973 federal offshore lease under which royalty was payable on 16-2/3% in amount or value of "production saved, removed or sold from leased area."24 After audit, the Mineral Management Service ordered royalty on take-or-pay payments that Mesa had received from...
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