Court Opinion

ID: 9773938
Source: CourtListenerOpinion
Date Created: 2023-08-29 18:04:29.534817+00
Date Added: 2024-06-11T07:31:59.715435
License: Public Domain

RICKHOFF, Justice,
dissenting.
Are royalty owners to be left entirely to the “good will” of the gas producers despite the terms of their agreements and the implied covenants arising thereunder? The majority opinion relies upon this court’s en banc decision in TransAmerican Natural Gas Corp. v. Finkelstein, 933 S.W.2d 591 (Tex.App.—San Antonio 1996, writ requested) as support for its holding that no royalties are owed in the instant case. Although writ has been requested in TransAmerican, no action has been taken to date by the Texas Supreme Court. Because the majority opinion refuses to recognize the cogent distinction between recoupable and nonre-coupable take-or-pay settlement payments and because the majority opinion fails to acknowledge the full extent of the appellees’ duties under the implied covenant to market, I respectfully dissent.
1. Division Orders
In TransAmerican, this court considered whether royalties were payable on a portion of a take-or-pay settlement paid as repudiation damages for gas not taken when there was subsequent production. 933 S.W.2d at 595 (royalties sought on gas produced and sold between October 1, 1987 through December 31, 1989). In the original panel opinion, which became the dissenting opinion after rehearing en banc, the court quoted footnote 8 of the second Bruni decision and held that royalties were due on that portion of the settlement payment to which actual production could be attributed.1 Id. at 607-OS (Duncan, J., dissenting). After reconsideration en banc, the new majority opinion reversed the original panel’s position and held that no royalties were due because the *74repudiation damages still represented non-production. Id. at 599.
After the original panel opinion in Trans-American issued, subsequent courts addressing the issue approved and adopted the original panel’s reasoning. See, e.g. Williamson v. Elf Aquitaine, Inc., 925 F.Supp. 1163, 1169-70 (N.D.Miss.l996)(interlocutory appeal certified to Fifth Circuit, 1996 WL 671660 (N.D.Miss. July 25, 1996)); Neel v. HECI Exploration Co., 1996 WL 426066, at *8-9 (Tex.App.—Austin, July 31, 1996), withdrawn on rehearing, 942 S.W.2d 212 (Tex. App.—Austin 1997, n.w.h.)(revising opinion on unrelated grounds and deleting citation to TransAmerican). Most directly on point is the Mississippi district court’s decision in Williamson. In that ease, the pipeline settled with the producer/lessee for a single lump sum payment of $6,578,000.00 in exchange for the lessee’s agreement to waive any past claims and to decrease the sales price for any future gas purchases. 925 F.Supp. at 1166. In addition, the pipeline’s make-up rights were eliminated. Id. In reb-anee on the panel opinion in TransAmerican, the court held that “a court’s finding that nonreeoupable settlements are indeed royalty-bearing, based on the fact that production has occurred, is consistent with the Texas court’s literal interpretations of the lease language.” Id. at 1170. The court noted that this interpretation of the lease takes into account “the practical realities of the gas market” and infuses “an examination of the equities of settlements within an interpretation of the lease language itself.” Id.
Even more compelling than the use made of the original panel opinion as authority in subsequent decisions, however, is the manner in which one court followed this court’s en banc decision while reaching a result similar to that reached in the original panel opinion and clearly applicable to the case at hand. See Harvey E. Yates Co. v. Powell, 98 F.3d 1222 (10th Cir.1996). In Yates, a gas lessee and oil and gas trade association brought a declaratory judgment action seeking to invalidate a regulation promulgated by the New Mexico Commissioner of Public Lands (the “Commissioner”). Id. at 1226. The Commissioner counterclaimed seeking royalties on certain proceeds received by the gas lessee in settlement of take-or-pay disputes. Id.
The Tenth Circuit initially applied the same reasoning asserted in this court’s en banc decision in TransAmerican and held that no royalties were due on the settlement payments under a “production”-type lease until actual physical extraction. Id. at 1234-35. This conclusion, however, was only the first of three guiding principles adopted by the Tenth Circuit and did not completely resolve the dispute over the royalties. The third principle adopted by the Tenth Circuit required the payment of royalties on 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 producer. Id. at 1231. The Tenth Circuit held that such royalties were payable at the time of such production. Id. The court reasoned that it could attribute settlement proceeds to production if the settling purchaser took actual production at a reduced price because of the settlement provisions. Id.
While the Tenth Circuit’s decision is distinguishable from the original panel opinion’s decision in TransAmerican because in TransAmerican the actual production was sold to third parties, and not the settling purchaser, the Tenth Circuit’s decision does recognize that a lessee would be granted a windfall if the lessee were permitted to retain the entire settlement payment without ever paying a royalty to the lessee “on the buy-down settlement amount that is used as a partial up-front payment for later gas that is produced and taken at below-contract prices.” Id. at 1236. Furthermore, the decision also acknowledges that if royalties were never paid, “ a lessee would be encouraged to avoid its royalty obligations by accepting large nonreeoupable payments in exchange for reduced prices on future production.”
I continue to believe that cogent arguments support a distinction between recoupa-ble and nonreeoupable take-or-pay settlements. Hurd Enterprises, Ltd. v. Bruni, 828 S.W.2d at 106 n. 8. I agree with the distinctions drawn between these types of payments by the district court in Williamson, 925 F.Supp. at 1168-69. Therefore, I dissent *75from the majority’s steadfast refusal to recognize the inequities flowing from its holding that royalties are not payable on a nonrecou-pable take-or-pay settlement payment because it represents nonproduetion.
2. Covenant to Market
Although the majority decision is correct in recognizing that an implied covenant to market exists that is enforceable by the assignees, I believe the majority again errs in following TransAmerican and holding that the duty to market is not triggered in the absence of production.
The majority relies in part on the holding in Mandell v. Hamman Oil and Refining Co., 822 S.W.2d 158 (Tex.App.—Houston [1st Dist.] 1991, writ denied). In analyzing the decision in Mandell, however, the fact that a jury issue was submitted as to whether the implied covenant to market was breached is a critical fact to be considered. 822 S.W.2d at 164. Similarly, in Brun% an issue regarding the alleged breach of the implied covenant to market was submitted and rejected by the jury. Hurd Enterprises, Ltd. v. Bruni, 828 S.W.2d at 104 (jury asked whether Hurd failed to reasonably market the gas by (a) agreeing to the two contract amendments and (b) settling the contract claims as it did). Both of these cases lend support for the proposition that the lessee’s actions in settling a take-or-pay claim, particularly the manner in which it is structured, raises a question of fact as to whether the implied covenant to market has been breached.
Nevertheless, the unqualified legal pronouncements in both Mandell and Trans-American that the duty to market is only triggered by production requires a re-examination of the scope of the implied covenant to market in order to determine whether such a covenant can be breached by a lessee’s actions in settling a breach of a take-or-pay provision. See Randy King, Note, Royalty Owner Claims to Take-Or-Pay Payments under the Implied Covenant to Market and the Duty of Good Faith and Fair Dealing, 33 S. Tex. L.Rev. 801, 813 (1992)(noting that no decision before Mandell had held the implied covenant to be so limited). In analyzing the scope of the implied covenant as it relates to these settlements, it is important to recognize that settlements in this context have been divided into three categories depending upon their structure. First, the term “take- or-pay settlement” is generally used to refer to a compromise of a take-or-pay claim, usually for less than its face amount, “without exchanging the contract provisions.” John S. Lowe, Defining the Royalty Obligation, 49 SMU L.Rev. 223, 226 n. 15 (1996); see also Independent Petroleum Ass’n of America v. Babbitt, 1995 WL 431305, at *7 (D.D.C. June 14, 1995), rev’d, 92 F.3d 1248 (D.C.Cir.1996). The second category, a “buy-out payment,” extinguishes a purchaser’s obligation to take volumes in the future by the reformation or termination of the contract. John S. Lowe, Defining the Royalty Obligation, 49 SMU L.Rev. 223, 226 n. 16 (1996); Randy King, Note, Royalty Owner Claims to Take-Or-Pay Payments under the Implied Covenant to Market and the Duty of Good Faith and Fair Dealing, 33 S. Tex. L.Rev. 801, 828 (1992); Babbitt, 1995 WL 431305, at *7. Finally, a “buy-down” refers to a settlement that reduces the price of future production to the original purchaser under an amended or successor contract. John S. Lowe, Defining the Royalty Obligation, 49 SMU L.Rev. 223, 226 n. 17 (1996); Randy King, Note, Royalty Owner Claims to Take-Or-Pay Payments under the Implied Covenant to Market and the Duty of Good Faith and Fair Dealing, 33 S. Tex. L.Rev. 801, 828 (1992); Babbitt, 1995 WL 431305, at *7. The structure in the instant case appears to be in the form of a “buy-out” since El Paso was no longer obligated to take any gas under the gas purchase contract after the settlement.2
The assertion that the implied covenant to market is only triggered by production ig-*76ñores an entire line of existing ease law. For example, it has been held that where the gas purchase contract dictates the gas price on which royalties are to be paid, the producer has an implied duty to act in good faith in entering into such a contract. See Le Cuno Oil Co. v. Smith, 306 S.W.2d 190, 192 (Tex. Civ.App.—Texarkana 1957, writ ref'd n.r.e.), cert. denied, 356 U.S. 974, 78 S.Ct. 1137, 2 L.Ed.2d 1147 (1958). Thus, the implied covenant was held to be applicable to the negotiation of the gas purchase contract before production because the contract governed the terms under which the gas would be disposed after production.
In addition, in El Paso Natural Gas Co. v. American Petrofina Co. of Texas, 733 S.W.2d 541, 550 (Tex.App.—Houston [1st Dist.] 1986, writ ref'd n.r.e.), cert. denied, 485 U.S. 987, 108 S.Ct. 1289, 99 L.Ed.2d 499 (1988), the royalty owners contended the implied duty to market was breached by the lessee’s actions in applying for and receiving governmental authority to abandon a favorable pricing method for the sale of gas. Although the court held the implied duty was not breached under the facts in that ease, the court asserted that the producer does have an implied duty to act in good faith in marketing the gas where the amount of the royalty depends on the price at which the product is marketed. Id. The court noted that the duty to market is based on the assumption that the producer is “marketing something that belongs to the royalty owners, and retaining some benefit for itself that should rightfully be included in the benefit obtained for the royalty owners.” Id. Therefore, this case supports the proposition that the implied covenant to market attaches to the marketing activity whether such activity is undertaken before or after production.
Finally, in Amoco Production Co. v. First Baptist Church of Pyote, the producers committed and dedicated the gas from appellees’ wells to a long term contract whereunder the price would be one-half of the available market rate for such gas with no provision for future price redetermination. 579 S.W.2d 280, 284 (Tex.Civ.App.—El Paso 1979), unit ref'd n.r.e., 611 S.W.2d 610 (Tex.1980). By approving this new dedication, the producer was able to achieve a substantial price increase for the gas already dedicated, thereby obtaining extra benefits for itself to the detriment of the appellees. Id. at 284-286. The court held that this action by the producer was a breach of the implied covenant to market. Id. at 287.
The foregoing cases, therefore, hold that the implied covenant to market applies to the negotiation of a gas purchase contract based on the effect such a contract has on the royalty owners by determining the price at which gas that is produced will be sold. Thus, the duty is not limited to the marketing of gas already produced but extends to the negotiation of contractual terms under which future production is to be sold. See also Davis v. CIG Exploration, Inc., 789 F.2d 328, 332 (5th Cir.1986) (lessee breaches implied covenant to reasonably market by failing to obtain terms in gas sales contract that a reasonably prudent operator would have obtained); Parker v. TXO Production Corp., 716 S.W.2d 644, 646-47 (Tex.App.— Corpus Christi 1986, no writ)(contract did not constitute breach of implied covenant to market based on reasons for agreeing to terms thereof). Assuming the producer must comply with the implied covenant in first negotiating the gas purchase contract, it is axiomatic that the same obligation extends to amending the terms of the contract *77through settlement or otherwise. See Hurd Enterprises, Ltd. v. Bruni, 828 S.W.2d at 104 (jury asked whether Hurd failed to reasonably market the gas by (a) agreeing to the two contract amendments and (b) settling the contract claims as it did); see generally Steve A. Whitworth, Royalties on Gas Contract Settlement, 8th Ann. Advanoed Oil, Gas & Min. Law Couese M-l, M-27-31 (State Bar of Texas 1990)(discussing breach through renegotiation of gas purchase contract). The need to protect the royalty owners in both situations would be equally compelling. As one commentator has expressed:
Claims for a share of take-or-pay, settlements, buy-downs and buy-outs are likely to be another story. The classic and easy application of the implied covenant to market occurs when a lessee exchanges a benefit that the market or a contract would allocate to its lessor for a benefit to itself or to some other lessor. That is precisely what happens in most take-or-pay settlements. Generally, the lessee is given a cash payment in exchange either for a release or a modification of volume or price obligations imposed upon the purchaser by the gas contract. In either event, the lessee is trading off contract terms that benefit both the lessor and the lessee for benefits that go into the lessee’s pockets. The lessee’s judgment should be subject to scrutiny under the reasonable prudent operator standard, and there is a strong argument that the benefits of the settlement, buy-down or buy-out should be shared proportionately.
3A W.L. Summers, The Law of Oil and Gas § 589A (John W. Lowe Supp.l995)(endnotes omitted). Therefore, I would hold, as a matter of law, that the implied covenant to market is triggered by the renegotiation of a gas purchase contract because the gas purchase contract determines the price at which gas that is produced will be sold. See generally Bruce M. Kramer, Royalty Obligations Under the Gun—The Effect of Take-or-Pay Clauses on the Duty to Make Royalty Payments, 39th Inst, on Oil & Gas L. & Tax’n 5-1, 5-30-5-33 (1988)(recognizing implied covenant may be breached by settlement through amendment of gas purchase contract).
In 1989, pipelines reported paying $8.2 billion to settle contract liability claims valued at $44 billion in order to avoid the less desirable result of forcing the pipeline into bankruptcy. 4 W.L. SummeRS, The Law of Oil and Gas § 762 n. 5 (John S. Lowe Supp. 1995). Therefore, as a general proposition, one might contend the failure to undertake settlement in such an environment would not be prudent; however, it is the manner in which the settlement is structured with which we need to be concerned. See Williamson, 925 F.Supp. at 1172 (holding implied covenant breached by failure to share economic benefits of settlement with royalty owners). As one court has noted:
Unquestionably, lessors’ interests are best served by facilitating settlement agreements instead of shutting in gas wells or forcing pipelines into bankruptcy. Still, inequity can result if a lessee re-negotiates terms with its pipeline customer that are of unilateral benefit and exclude the lessor. When a lessee fails to obtain the highest available price for the lessor’s gas supply, or behaves strategically in favoring itself over a royalty owner’s legitimate interest, there may be a breach of two implied covenants—first, to reasonably market the gas; second, to obtain terms in the sales contract that a reasonably prudent operator would have obtained. See, e.g., Davis v. CIG Exploration, Inc., 789 F.2d 328, 332 (5th Cir.1986). A breach of either covenant ought to be compensable.
1995 WL 431305, at *11-12.3
Under the implied covenant to market, the lessee/producer is required to comply with the reasonably prudent operator standard, and whether a lessee’s actions comply with this standard is a question of fact. See Amoco Production Co. v. First Baptist Church of Pyote, 579 S.W.2d at 284; see generally Walter Cardwell, Do Producers Owe Royalty on *78Take-or-Pay Settlements, 9th Ann. ADVANCED Oil, Gas & Min. L. CoüRSE S-l, S-ll (State Bar of Texas 1991). Focusing on the contractual amendments, it is arguable that each of the terms that were amended originally benefitted the royalty owners, i.e., the price was greater before the amendment, El Paso was required to take specific quantities of gas at the higher prices and the term of the contract was shorter. In fact, appellees expressly admitted that the royalty owners would benefit from maintaining the original contractual provisions.4 Therefore, the evidence raises a factual issue as to whether a reasonably prudent operator cognizant of the best interests of the royalty owners would have structured a settlement in the manner consented to by the appellees. For this reason, I would reverse the trial court’s judgment and remand this issue to the trial court for factual determination.

. Footnote 8 recognizes that "cogent arguments concerning the royalty owner’s interest in take- or-pay settlement funds, especially when, as here, the settlement terminates the purchaser’s recoupment rights,” but notes that ”[t]he recoupment issue ... was not submitted in the case before us.” Hurd Enterprises, Ltd. v. Bruni, 828 S.W.2d 101 (Tex.App.—San Antonio 1992, writ denied).

. Contrary to this court’s opinion in TransAmeri-can, the district court in Babbitt approved the reasoning of Assistant Secretary Ada E. Deer in an agency decision affirming an order to pay royalties on a take-or-pay settlement structured as a buyout:
The parties to a buyout arrangement ... know that subsequent production will be sold at lower prices and that the lessee-producer will not obtain the same price as under the original contract. A lump-sum payment to buy out the obligation to take required volumes at higher prices therefore compensates the lessee *76in some degree for the reduced price the lessee will receive when the gas is produced and delivered.
The fact that a substitute purchaser, instead of the original purchaser, is involved in the buyout situation does not change the result.... If bought out volumes are produced and delivered to the substitute purchaser under a successor agreement [or on the spot market], the amount paid by the original purchaser to be relieved of its obligation to take the gas is part of the benefit which the lessee derives from that production. The payment therefore is attributable to those volumes and becomes a part of the total amount paid to the lessee for that production.
1995 WL 431305, at *10-11 (citing Samedan Oil Corp., MMS-94-0003, at 16-17 (Sept. 16, 1994)); see generally Carroll Martin & Jane Webre, Gas Royalty Issues: Who, What, How, and When? Valuation and Payment in Today's Market, 46th Inst, on Oil & Gas L. & Tax’n 2-1, 2-24 (1995)(not-ing that neither the Bruni decisions nor Mandell address a royalty owner’s right to share in a contract "buy-out”).

. The district court in Babbitt also addressed the risk allocation argument relied on by the courts to support the nonpayment of royalties on take- or-pay settlements:
Finally, a word about risk allocation. The Fifth Circuit justified, in part, their holding in Diamond. Shamrock by observing that the lessor does not "shoulder the associated risks of exploration, production and development....” The lessee is the exclusive bearer of these risks. [Diamond Shamrock Exploration Co. v. Hodel,] 853 F.2d [1159] at 1167 [(5th Cir.1988)]. This *78statement is only intelligible if risk is equated with out-of-pocket expenditure. Surely the lessor receives diminished royalties if exploration, production and development projections are' not met. Furthermore, mineral exploitation by the lessee of the lessor’s land involves opportunity costs borne exclusively by the lessor. These opportunity costs include foregone profits from alternative uses of the land, including other royalty arrangements that might have been negotiated.
1995 WL 431305, at *12.

. Appellees’ letter to the lessors/royalty owners dated January of 1987 concluded: "If the leases covering these wells remain committed to the gas contract with El Paso, royalty and working interest owners who are affected by this gas contract stand to benefit.” In addition, in the stipulated record before the trial court, one of appellees' representatives also admitted during his deposition that the working interest owners and royalty owners would have benefitted from maintaining the contract with El Paso and not modifying it as it existed at that time.