Opinion ID: 741837
Heading Depth: 2
Heading Rank: 1

Heading: arco's duty to pay royalties

Text: 16 The district court granted summary judgment to ARCO on Lessors' claim for royalties because the leases did not provide for royalties to be paid on the proceeds of settlements and because none of the proceeds constituted payment for the production and sale of gas. The court reasoned that because the ARCO/Arkla litigation involved disputes over gas quality and Arkla's obligation to take gas from ARCO's wells, the settlement consideration did not constitute payment for the production and sale of gas. Thus, the district court concluded that the settlement consideration was not royalty bearing. In so holding, the court analogized such settlement consideration to non-royalty bearing take-or-pay payments. 17 On appeal, Lessors contend that the district court erred in concluding that the settlement proceeds were not royalty bearing. Lessors argue that Arkla would not have made the settlement payments to ARCO if Arkla were not to receive something in return. What Arkla received in return could only have been gas production: 18 The only good or service sold by ARCO to Arkla under the 1989 Settlement Agreement is natural gas. The disputes between ARCO and Arkla over interpretation of purchase contract and collateral issues were disputes over the terms (i.e., price and quality) under which this gas production was to be sold. There is nothing in the record to show that ARCO provided anything to Arkla under the 1989 Settlement Agreement other than gas production. Because whatever settlement consideration ARCO received was necessarily for the production of gas, it was subject to royalties. 19 App't. Reply Br. at 11-12. 20
21 We begin our analysis by looking to the royalty clauses in the leases between ARCO and Lessors. Although containing slightly varying language, all of the leases require royalties to be paid only on the proceeds from the sale of gas produced from the wells--that is, gas physically extracted from the earth and sold. Under the plain terms of these so-called production-type leases, the lessee is not obligated to pay a royalty on the value of gas in the abstract, but only on the cash value of gas that is actually produced and sold from the leased property. See Yates, 98 F.3d at 1230 (discussing production-type leases); see also Roye Realty & Dev., Inc. v. Watson, No. 76,848, 1996 WL 515794, at  9 & n. 8 (Okla. Sept.10, 1996) [hereinafter Roye Realty ] (stating that royalties are payable under production-type lease language only when gas is produced and sold and distinguishing cases in which royalties are payable on the amount realized from the sale of gas). 22 Because the leases expressly require royalties to be paid on gas actually produced, we hold that the district court erred in concluding that royalties are not payable here because the leases do not expressly require the payment of royalties on settlement proceeds. If the settlement proceeds constitute payment for gas actually produced and sold, it is immaterial that the leases do not explicitly provide for the payment of royalties on settlement proceeds. Rather, for the proceeds to be non-royalty bearing, the leases would have to expressly exclude settlement proceeds. See Yates, 98 F.3d at 1231 ([A]ny portion of a settlement payment that is ... for gas actually produced and taken by the settling purchaser is subject to the lessor's royalty interest.). Thus, the mere failure to expressly include settlement proceeds in the royalty provision of a lease, by itself, does not preclude the payment of royalties on such proceeds. 23 Similarly, we hold that the district court erred in concluding that the proceeds in this case should be treated like nonrecoupable take-or-pay settlements. Under a take-or-pay clause, a purchaser must take a specified volume of gas or, failing that, must pay a sum representing the difference between the specified minimum and the volume of gas actually taken--that is, a payment in lieu of production. See Diamond Shamrock Exploration Corp. v. Hodel, 853 F.2d 1159, 1164 (5th Cir.1988) [hereinafter Diamond Shamrock ] (discussing take-or-pay clauses). Thus, proceeds received by the lessee in settlement of the take-or-pay provision of a gas supply contract (for either accrued take-or-pay deficiencies or to abrogate future take-or-pay obligations) are not royalty bearing because they are payments for non-production. Yates, 98 F.3d at 1236; see also Roye Realty, 1996 WL 515794 at  9; Diamond Shamrock, 853 F.2d at 1167-68. 24 The non-royalty bearing nature of take-or-pay proceeds does not mean that all settlement proceeds are non-royalty bearing. The relevant question in both cases (take-or-pay payments and settlement proceeds) is whether or not the funds making up the payment actually pay for any gas severed from the ground. Independent Petroleum Ass'n of Am. v. Babbitt, 92 F.3d 1248, 1260 (D.C.Cir.1996). In short, the nature of the settlement proceeds determines whether they are royalty bearing. The central question in this case, therefore, is whether the settlement consideration paid to ARCO constitutes payment, at least in part, for gas actually produced and sold or whether it constitutes payment for something other than the production and sale of gas. To that question we now turn. 25
26 In determining whether the settlement proceeds constitute payment for gas actually produced and sold, we begin with our recent decision in Harvey E. Yates Co. v. Powell, 98 F.3d 1222. In Yates, we addressed whether proceeds from the settlement of take-or-pay and pricing disputes were subject to the lessee's duty to pay royalties. The parties in Yates, as in this case, operated under a standard production-type lease where the duty to pay royalties was contingent upon the actual production and sale of gas. Id. at 1230. After deregulation of natural gas pricing, the gas purchasers in Yates reduced their gas takes and unilaterally lowered to market level the purchase price of gas actually taken, prompting a lawsuit by the gas producer. Id. at 1227. The parties subsequently entered into a settlement agreement in which the producer agreed to accept a nonrecoupable buy-down payment in exchange for certain price and take reductions in the gas supply contract. Id. The producer paid royalties on the proceeds from gas sold at the lower market price but failed to pay royalties on the nonrecoupable buy-down payment. Id. at 1227-28. 27 In Yates, we developed three guiding principles in deciding whether royalties are payable on settlement proceeds: 28 First, royalty payments are not due under a production-type lease unless and until gas is physically extracted from the leased premises. Second, nonrecoupable proceeds received by a lessee in settlement of the take-or-pay provision of a gas supply contract are specifically for non-production and thus are not royalty bearing. Third, any portion of a settlement payment that is a buy-down of the contract price for gas that is actually produced and taken by the settling purchaser is subject to the lessor's royalty interest at the time of such production, but only in an amount reflecting a fair apportionment of the price adjustment payment over the purchases affected by such price adjustment. 29 Id. at 1231. In effect, we concluded that when a lessee accepts a settlement payment in exchange for a reduced future price term, the lessors are entitled to a royalty payment on two components, each of which constitutes consideration for actual production: (1) the proceeds obtained by the lessee from the sale of gas at the bought-down price; and (2) a commensurate portion of the settlement proceeds that is attributable to price reductions applicable to future production under the renegotiated gas sales agreement as production occurs. Id. at 1236. 30 In this case, the parties apparently do not dispute that ARCO has already paid royalties on the sixty monthly prepayments of $5 million (or $300 million) as gas was taken by Arkla during the five-year period from February 1, 1989 through January 31, 1994. This amount represents the first component addressed in Yates, the proceeds from the sale of gas at the bought-down price. Because royalties have already been paid on this amount, the sole controversy is whether ARCO must pay royalties on any of the other items of settlement consideration. Under Yates, if Arkla gave any of the other items of consideration in exchange for ARCO's settling past price deficiencies or agreeing to future sales at a lower price, Lessors are entitled to a royalty on the value of those items. 31 On appeal, Lessors contend that Yates, handed down after the district court's decision in this case, is dispositive and requires reversal of the grant of summary judgment in favor of ARCO. In particular, Lessors assert that the record contains evidence that a portion of the settlement proceeds constitutes consideration for a reduction in the price ARCO was willing to accept for gas under the terms of its contract with Arkla. According to Lessors, prior to the 1989 Settlement Agreement, Arkla was obligated to purchase gas at the NGPA § 103 price, which ranged between $3.40 and $4.60 per MMBtu. Lessors point to the complaint ARCO filed in its lawsuit against Arkla, in which ARCO alleged damages of $279 million based on its claim that the parties' contract required Arkla to pay a price in excess of the $2.20 per MMBtu for which ARCO ultimately settled. Lessors also point to Section 4.1 of the 1989 Settlement Agreement, which explicitly refers to the new price as a price reduction. Lessors contend that under Yates, royalties are payable on any portion of settlement proceeds that constitutes consideration for a reduction in the price a purchaser is obligated to pay for gas production. 32 ARCO contends that Yates is not controlling in this case because there is no evidence that the 1989 Settlement Agreement resulted in a buy down of the actual price Arkla paid for gas. At argument, counsel for ARCO insisted that Arkla has never paid the higher NGPA § 103 price and, in fact, paid a pre-settlement price below the $2.20 price which ARCO ultimately accepted. ARCO thus contends that the Settlement Agreement actually resulted in a price increase for Lessors' gas. As counsel for ARCO confirmed at argument, however, the record before us does not show what price Arkla actually paid for gas prior to the 1989 Settlement Agreement. Even if ARCO were correct that an actual price increase removes this case from the ambit of Yates, providing an alternate basis for affirmance, such facts are not in the record, and thus, summary judgment in favor of ARCO on this basis is premature. 33 We are not convinced, however, that an actual price increase would relieve ARCO of its duty to pay royalties on proceeds received from the settlement of its pricing claim. ARCO is correct that Yates involved a buy-down, or a reduction in the actual price paid for gas. In Yates, the settling purchaser explicitly sought and received a price reduction in exchange for a lump sum payment. See Yates, 98 F.3d at 1227. A buy down, however, is not the shibboleth that ARCO claims it to be. Even absent a buy down (i.e., an actual price reduction), a lessee's refusal to pay royalties on the proceeds received from the settlement of a pricing dispute would result in a windfall for the lessee. More importantly, such a refusal would constitute a breach of the lessee's duty to pay royalties on proceeds from the production and sale of gas. A brief example illustrates this point. 34 Suppose that a purchaser is obligated to take 1,000,000 units of gas at $4.00 per unit payable in two equal installments of $2 million. Upon receiving the first 500,000 units, the purchaser unilaterally reduces the price to $3.00 per unit (claiming that the gas is of substandard quality) and remits payment of only $1.5 million. In response, the producer files a lawsuit for $1 million, the amount due on the past price deficiency and the anticipated future shortfall. Instead of litigating the gas quality issue, the parties agree to settle their dispute. In exchange for a one-time lump sum payment of $500,000, the producer agrees to forgive the past price deficiency and to accept the lower price of only $3.00 per unit for future production. In this situation, there has been no buy down (i.e., actual price reduction). The pre-settlement price and the post-settlement price are both $3.00 per unit. Despite the absence of a price reduction, however, the lump sum payment still constitutes proceeds from the sale of gas because it represents a component of the true price paid for both past and future production under the supply contract. No one would dispute, therefore, that the royalty owners are entitled to their royalty share of the lump sum payment. The important factor triggering the duty to pay royalties is not an actual price reduction, as ARCO contends, but rather an agreement by the producer to compromise its right to pursue a higher price in exchange for a lump sum payment. 35 Although Yates involved an actual price reduction, the general rule announced in Yates also applies in situations where the settlement of a pricing dispute results in a post-settlement price that remains the same, as in the example above, or where the price actually increases, as appears to be the case here. In either situation, the lessee has agreed to compromise its pricing claim in exchange for valuable consideration. From the point of view of the royalty owner, the lessee has decreased the price at which it is willing to sell gas and thus has unilaterally decreased the amount subject to the lessor's royalty interest. Therefore, whatever settlement consideration the lessee receives is a component of the true price paid for the gas and is subject to the lessors' royalty interest. In sum, a lessor's royalty interest is not limited to settlements involving an actual buy-down, as in Yates, but extends to any settlement in which a producer receives consideration for compromising its pricing claim, assuming of course that the pricing claim relates to either past or future production actually taken by the settling purchaser. 36 In this case, the 1989 Settlement Agreement included several items of non-cash consideration in addition to Arkla's agreement to make monthly prepayments of $5 million for five years. ARCO does not dispute that royalties have not been paid on the value of these non-cash items. Thus, if such items constitute consideration for the settlement of ARCO's pricing claim, Lessors are entitled to a royalty on their fair market value. Producers such as ARCO cannot escape the duty to pay royalties merely by disguising the form of consideration received in the settlement of pricing disputes. This is true irrespective of the collateral benefits the items have conferred upon Lessors. 37 In Yates, we concluded that there exists a genuine issue of material fact whether the ... settlement proceeds are attributable solely to take-or-pay deficiencies (i.e., non-production), or whether they are attributable, at least in part, to a price adjustment for the actual production of gas. 98 F.3d at 1235. Similarly, in this case, we conclude that there is a genuine issue of material fact whether the settlement proceeds received by ARCO are attributable solely to the resolution of collateral disputes (i.e., the Mississippi Canyon) or whether they constitute payment, at least in part, for ARCO's agreement to compromise its pricing claim for gas actually produced and sold from the Wilburton Field. Although the district court concluded that none of the settlement proceeds were related to the production and sale of gas, the record does not allow us to rule out such a finding. We therefore reverse the grant of summary judgment in favor of ARCO on the royalty issue and remand to the district court for further proceedings on this question. 3 38