FEDERAL ROYALTIES: WHO MUST PAY?

• Jurisdiction: United States

Federal and Indian Oil and Gas Royalty Valuation and Management Vol. 1
(Jan 1992)
CHAPTER 2A
FEDERAL ROYALTIES: WHO MUST PAY?
Marla J. Williams ^*
Holme Roberts & Owen
Denver, Colorado

TABLE OF CONTENTS

SYNOPSIS

Page

INTRODUCTION

I. COMMON LAW PRINCIPLES OF LIABILITY FOR ROYALTY PAYMENT

A. Effect of a Complete Assignment

1. Continuing Liability of the Assignor

2. Liability of the Assignee

B. Effect of a Partial Assignment

1. Continued Liability of the Assignor

2. Liability of the Assignee

3. Right of Contribution as Among Co-Owners of the Leasehold

C. Effect of a Sublease

II. FEDERAL ROYALTY LIABILITY IN COMMON LAW TERMS

A. Background: Operating Rights Versus Record Title Ownership

B. Effect of a Complete Assignment (Record Title)

1. Continuing Liability of the Assignor

2. Liability of the Assignee (Record Title)

C. Effect of a Partial Assignment (Record Title)

1. Continuing Liability of the Assignor

2. Liability of the Assignee 2A-23

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D. Transfer of Operating Rights 2A-24

1. Background 2A-24

2. Continued Liability of the Transferor (Operating Rights) 2A-25

3. Liability of the Sublessee 2A-26

III. BEYOND THE COMMON LAW: LIABILITY OF THE PAYOR 2A-28

A. Analysis of the MMS Position 2A-29

1. Payor Liability: Agency 2A-30

2. Payor Liability: Assignment of Lease Contract Obligations 2A-30

3. Payor Liability: FOGRMA 2A-31

4. Payor Liability: PIF Filings 2A-39

B. Analysis of the IBLA Position 2A-40

1. Payor Liability: Agency 2A-40

2. Payor Liability: Assignment of Lease Contract Obligations 2A-41

3. Payor Liability: FOGRMA 2A-41

4. Payor Liability: PIF Filings 2A-42

IV. CONCLUSION 2A-43

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In the Good Old Days,¹ oil and gas producers generally believed that the obligation to pay royalties rested with the person who owned the production on which the royalties in question accrued. In the Good Old Days, the rule was straight forward; appealing not only in its simplicity, but in its inherent fairness. In today's new word of federal royalties, the Good Old Days have given way to the Age of Confusion — so much so, that one wonders whether the Good Old Days ever really existed. Perhaps they did not.

Much has been written about federal royalties since enactment of the Federal Oil and Gas Royalty Management Act (FOGRMA)² and the stepped-up audit and collection activity that followed in its wake. But while much discourse has been generated regarding the "big" issue of valuation, i.e., how much royalties are due, surprisingly little attention has been directed to the question of who is liable to the MMS³ for their payment. Is it the lessee of record? The operating rights owner? This new-fangled thing called a "payor"? Are co-lessees jointly and severally liable? Is a lessee liable for royalties accruing before he acquired his interest in the lease? Is a lessee liable for royalties accruing after he assigns his interest?

It is these questions I seek to address and, hopefully, clarify. Certainly the MMS has its own notions as to how these questions should be answered, and I gladly leave it to my able colleague, Cecelia Williams, to set forth those notions in her companion paper. My analysis, although unfettered by the practical concerns of royalty administration and collection with which the MMS must contend, is undoubtedly influenced to some degree by my secret longing for the Good Old Days.

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Having disclosed that particular bias, I will proceed. I have organized the paper into three parts. Part I is an overview of the common law of landlord/tenant as it has been adapted to the unique arena of oil and gas leases⁴ and, in particular, to the issue of direct liability to the lessor for the royalty payment. Part II is an attempt to analyze federal royalty liability in common law terms. In this regard, the paper primarily addresses leases issued under the Minerals Lands Leasing Act of 1920, as amended (MLLA).⁵ Part III is devoted to a discussion of the impact of FOGRMA and, in particular, the advent of "payor" liability.

PART I: COMMON LAW PRINCIPLES OF LIABILITY FOR ROYALTY PAYMENT

Discussion of common law principles is important for two reasons. First, although we are talking about federal leases, federal courts borrow heavily from traditional common law principles in developing the federal common law necessary to interpret federal statutes and fill the inevitable gaps.⁶ Second, there can be no doubt that Congress borrowed heavily from the private leasing system when enacting the MLLA and

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instituting a new leasing system for federal lands.⁷ We can therefore expect the federal courts to continue to draw upon the common law if and when they are called upon to address the questions we address here.

A. Effect of a Complete Assignment.

1. Continuing Liability of the Assignor.

A lease is at once a contract and a grant of a leasehold interest in real property, thus giving rise to a legal relationship between the lessor and his lessee that is grounded in both privity of contract and privity of estate.⁸ Consistent with the presumption of free alienability of real property, the lessee's interest is assignable in the absence of express lease provisions to the contrary.⁹ While restraints on the assignability of a lease are generally upheld, they will be strictly construed.¹⁰ The issue of assignability rarely arises in the context of oil and gas leasing because the lease forms typically used in the industry contain language expressly permitting assignment of all or any part of the lessee's interest.

Once the lessee/assignor has assigned his entire interest in the lease, he no longer remains in privity of estate with the lessor. Absent express lease provisions or subsequent discharge by the lessor, however, the lessor and the lessee/assignor remain in privity of contract and the assignor will continue to be liable to the lessor for breach of the covenant to pay royalties for the life of the contract. In other words, the original lessee continues to be liable to the lessor for royalties accruing after the assignment and, in essence, guarantees the performance of his immediate assignee

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as well as any subsequent assignee.¹¹ This rule is based on the common law notion that the lessee/assignor, having subjected himself to contractual liability for royalties, cannot, by his unilateral action, divest himself of that liability.¹² Again, however, there are few occasions for the courts to determine how this principle applies to oil and gas leases because the typical lease form employed by the industry contains express provisions discharging the lessee/assignor from liabilities under the lease accruing after the date of assignment.¹³

2. Liability of the Assignee.

Just as assignment of the lease does not destroy privity of contract between the lessor and the assignor, it does not create privity of contract between the lessor and the assignee. Privity of estate, however, is created and by virtue of that privity the assignee becomes liable to the lessor for covenants running with the land for the period that the privity exists. The obligation to pay royalties is just such a covenant and, therefore, the assignee is liable to the lessor for royalties accruing during the time privity of estate attaches, but the assignee is not liable for royalties accruing before the privity of estate commenced or after it terminates.¹⁴

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Although mere acceptance of the assignment of the lease will not make the assignee liable for royalties accruing prior to assignment, the liability of the assignee to the lessor may be expanded if the assignee so agrees under the terms of the assignment. In his treatise,¹⁵ Professor Thompson describes the common law rule as follows:

The express covenant of an assignee to fulfill the covenants of the lessees in the lease is in legal effect that he will fulfill the unbroken covenants in said lease and that he will from that time take the place of the original lessees and fulfill their covenants. It would be a species of fraud to hold him responsible for the past neglect or breaches of covenant of the original lessee, but if the assignee, by express covenant with the assignor, binds himself to pay the rents and perform all the covenants in the lease contained and required to be done and performed on the part of the lessee, such a covenant not only binds the assignee to fulfill the covenants during his own time, but makes him liable for breaches before his time. [emphasis added, footnotes omitted].

I find the rule as stated by Professor Thompson and the cases cited¹⁶ less than helpful in trying to ascertain

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what, exactly, constitutes an agreement by the assignee to be liable for past breaches.¹⁷ While it is "a species of fraud" to hold an assignee liable for prior breaches when all he has done is expressly agreed "to fulfill" the covenants of the lessees in the lease, an agreement to pay the rents and "to perform" all the covenants in the lease to be performed by the

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lessee yields the opposite result. Surely the law is not so fickle that such subtle differences in wording should have such radically different consequences. The better rule would be that an assignee's agreement to "fulfill" or "perform" the covenants of the lease is an agreement to fulfill or perform the lease covenants from the date of assignment forward. Only if an assignee expressly agrees in no uncertain terms to be liable for past breaches by the assignor should an exception to the general rule be found.¹⁸ Application of such a rule, at least with respect to oil and gas leases, is certainly more consistent with industry custom where liabilities under the lease are typically allocated between the assignor and the assignee as of the effective date of the assignment.¹⁹

B. Effect of a Partial Assignment.

Unlike the typical commercial real estate lease, oil and gas leases...