Bad faith breach of contract in the insurance context and in the oil and gas context: a comparison.

• Author: Graves, Sheila R.

PART I. THE INTRODUCTION

In 2007, the Alabama Supreme Court issued Exxon Mobile Corporation v. Alabama Department of Conservation and Natural Resources; a fifty-one page opinion that begins like a chemical engineering textbook with vocabulary including slop oil, diamondoids, cogenerated electricity, flare offs, and sweetened sour gasses. The complex thirty-four volume transcript (1) and a jury award that was the largest punitive damages award in Alabama's history (2) made one justice wishfully consider handing-off the decision to the Rotary Club (3) whose simple Code of Ethics would ask only whether Exxon was an honest, fair, and friendly corporation and did it seek the benefit of all concerned? (4)

Exxon rightly answered to the highest court of the State which applied the legal elements of fraud and breach of contract. Alabama's citizens should applaud the wisdom and courage of those elected to Alabama's Supreme Court for their ability to justly apply the law of the State, to simplify complex and evolving science, to root out the correct legal issues, and to resist the temptation of wrongfully accepting enormous punitive damages. The task of the Court was at once simple and complex. In one sense, the case required only a relatively straightforward determination of whether the disputed issue arose under contract or fraud principles. (5) Did Exxon have an intentional scheme to cheat Alabama out of royalties due under the lease deserving of punitive damages, or is this case simply a question of contract interpretation that, even if breached in bad faith, would not allow punitive damages? The fact that $3.5 billion rested upon this answer complicated the question. (6) The Court applied the law of the state and determined that a fraud claim could not stand. Though correct in its application of the current law, the Alabama Supreme Court has twice alluded to a remedy that would have far-reaching effects on future oil and gas litigation. (7) Justice Lyons called this remedy "tortious bad faith breach of contract," (8) also known as the no reliance fraud standard in breach of contract. (9)

Part I section A of this note includes a necessarily simplified recitation of the facts where the issue in Exxon emerged as a question of whether a fraud was perpetrated on the State, deserving of punitive damages, or whether Exxon and the State were in a contract dispute where only compensatory damages were available. The note investigates the overlap where a tort is the basis of the breach so that traditional compensatory contract damages may give way to tort's punitive damages in Part I section B. Part I section C explores the elements of the tort in question in Exxon; namely fraud. Section C gives special attention to the element of justifiable reliance. The section reveals the element of reliance as the bottleneck for cases like Exxon, where the State cannot provide proof that it adopted a different course of action after it perceived the alleged fraud. Part II is a careful examination of the current law in bad faith breach of contract where punitive damages are awarded. Here, the note refers to the three exceptions to the general rule that allow punitive damages in contract disputes. (10) Two exceptions have no application in Exxon, but the third exception, the no reliance fraud standard in the insurance context, is explored in depth. Part II includes the exception's history and its application in Alabama and other jurisdictions. The note examines policies behind insurance contract protections. The part exposes several motives that form the basis of the willingness for courts and legislatures to routinely allow punitive damages in insurance contracts even when the element of reliance cannot be proved. These motives are: to protect the non-breaching party from severe financial damage, to provide deterrence to the breaching party, to punish the culpable party who demonstrates malice, fraud, or a conscious disregard for the rights of others, and to guard against violations of public policy. Part III proposes that it is consistent for the Alabama legislature to protect Alabama's valuable natural resources by expanding the law to apply the no reliance fraud standard to oil and gas contracts for the same reasons they already do so in the insurance context. Part IV concludes by presenting the argument for the Alabama Legislature to extend the no reliance fraud standard from the insurance context to include the oil and gas contract context. An oil corporation would thereafter be on notice that, in Alabama, (the state that may hold the largest natural gas deposits in our nation) it will be subject to punitive damages for bad faith breach of contract in the oil and gas context even if each element of fraud cannot be proved.

1. The Overview of Underlying Facts

   The events that gave rise to this complex case began in 1981 when Alabama first leased its newly discovered natural gas fields to the Exxon Corporation. (11) Exxon began production and started making lease payments on contacts, executed in 1981 and again in 1984, that included Exxon's agreement to pay over $5.5 million on the production from their wells. (12) The Alabama Department of Conservation and Natural Resources (DCNR) eventually audited the leases, and a discrepancy arose between the State and Exxon in their understandings for the method of calculating royalties. (13) This discrepancy amounted to over $50 million that, according to DCNR's calculations, Exxon owed the State. (14) Negotiations failed; the parties could reach no mutual agreement. (15)

   Exxon was the first to involve the courts when it sought a declaratory judgment in July of 1999. (16) It asked for the proper method of calculating royalties under the lease. (17) The State counterclaimed, alleging fraud and breach of contract. (18) In an amended counterclaim, the State requested punitive damages. (19)

   On December 19, 2000, the jury returned a verdict for the State, awarding $60 million for unpaid royalties plus interest of $27.4 million and an astonishing $3.4 billion in punitive damages. (20) Predictably, Exxon appealed and, almost exactly two years later, the Alabama Supreme Court reversed and remanded the case because the trial court heavily relied upon a letter protected by attorney-client privilege that was improperly admitted. (21)

   At the second trial, a jury again returned a verdict for the State in roughly the same amount of compensatory damages and interest; however, this time the jury awarded even more in punitive damages. (22) The full verdict amount was a stunning $11.9 billion. (23) On December 1, 2003, Exxon moved for a judgment as a matter of law (JML) and; alternatively, for a new trial or a remittitur on the punitive damages. (24) The judge reduced the punitive damages award to $3.5 billion, but denied the JML and the motion for a new trial. (25) Exxon appealed. (26) The Alabama Supreme Court concluded that the State failed to establish its fraud claim as a matter of law and it reversed the judgment, including the punitive damage award. (27)

2. The Overlap of the Theories of Contract and Tort Damages The Alabama Supreme Court's unpopular holding refused $3.5 billion and reversed two separate Alabama juries, but nevertheless correctly applied the current law of Alabama. The elected justices knew that the citizens of the State would very likely fail to understand its decision owing to the seeming complexity of the case. (28) However; this note, through a careful examination of the availability of damages in contract or tort actions (and, more to the point, the growing gray area where the two overlap) will reveal the actual simplicity and accuracy of the decision and offer a solution.

   Foundationally, breach of contract is based on strict liability principles. (29) For the aggrieved party, the typical remedy will simply be to make the party whole with an award of foreseeable contract damages. (30) By contrast, tort liability is based on punishing conduct which is socially unreasonable and for that reason an acceptable remedy for the harmed party will often include punitive damages. (31)

   Tidy, but in the real world, this neat, compartmentalized approach to contract and tort damages law must succumb to a more complex analysis. When the breach is accomplished though a tort, as was the allegation in Exxon, contract damages may be less appropriate than tort's punitive damages. Modern courts have created several exceptions, but have not completely overcome the more limited traditional rule.

   The traditional rule of contract damages has survived for over 150 years. Since 1854, the "Hadley Rule" has required the party that breached to pay any damages that arose naturally or were within the contemplation of both parties at the time they made the contract. (32) The Hadley Rule endures in modern times because of society's continued desire to encourage commercial and economic activity through predictable expectations of possible damages for breach. (33) The Revised Uniform Commercial Code (Revised UCC) Article II (34) and the Restatement (Second) of Contracts (35) continue to embrace the old notions of good faith performance of contracts. To this day, parties to a contract enter into an agreement that carries the implied covenant of good faith and fair dealing. (36) Neither party is expected to act in such a way as to affect the right of the other to receive the benefit of the contact. (37) Therefore, when one party deprives the other party of the benefit of the bargain, a breach may be said to have occurred. The parties have typically agreed to perform the contract or pay compensatory damages if there is a breach, regardless of the motive behind the breach. (38) The goal is to put the damaged party in only as good a position as he would have been if the contract had been performed. (39) But, when one party to the contract breaches by, for example, proposing not to perform the contract, the victim...