When oil companies transfer oil property among themselves, they frequently do so by an assignment of lease rights. Sometimes they assign all their interest under a lease, but they often assign just a portion of the lease, or reserve some interest in the property. In the event of multiple assignments — such as when party A assigns to party B, who assigns to party C, and so on — there can be confusion about what was assigned, and who is obligated to do what.
This kind of controversy set the stage for the recent decision by the North Dakota Supreme Court captioned Golden v. SM Energy Co., 2013 ND 17, Feb. 1, 2013. The Golden decision presents an interesting discussion about royalty payments, division orders and assigned obligations. Does this case portend what can happen in Ohio? Only for companies that do not learn from mistakes made in other states.
Golden owned oil and gas leases covering property in McKenzie County, N.D. In 1970, Golden sold his “entire interest in the leases” to “B” “subject to my retention of four percent (4%) overriding royalty.”
Golden also designated a “joint area of interest” (“JAI”) in which the parties had further rights and obligations. Specifically, the parties agreed that if Golden purchased additional property in the JAI, he would sell it to B at cost, subject to a 4% overriding royalty. On the other hand, if B acquired additional property in the JAI, it would assign a 4% overriding royalty to Golden at no cost. Finally, the agreement between Golden and B provided that, “any assignment of this Agreement made by [B] shall recite that same is made pursuant and subject to the terms and conditions of this Agreement.”
B did, in fact, acquire new leases in the JAI and assigned the override to Golden. Then in 1993, B assigned its interest in the leases and lands covered by the 1970 agreement to C. The assignment included a provision that B was assigning “all right, title and interest of Assignor in and to … all operating agreements, joint venture agreements, partnership agreements, and other contracts, to the extent that they relate to any of the Assets.” (emphasis added)
C also subsequently acquired additional leases in the JAI before assigning everything to D. The assignment from C to D provided that D “assumes all of Assignor’s duties, liabilities and obligations relating to the Assets to which Assignor was a party or by which it was bound on and after the date hereof.” D ultimately merged into Defendant, SM Energy (“SM”).
All relevant documents in this case were duly recorded.
The dispute arose when, beginning in 2009, SM recognized and paid Golden’s 4% overriding royalty on production from a well located in the JAI, but refused to pay the 4% overriding royalty for earlier periods. The overriding royalty was apparently erroneously overlooked by the parties before 2009. Making matters difficult for Golden, the royalty payments made by SM before 2009 were in conformance with division orders executed by Golden.
The Court’s Analysis of the Assignments
Golden filed a declaratory judgment action to determine the parties’ rights, to quiet title to interests in the land, and for an accounting.
SM argued the lower court erred in granting summary judgment in favor of Golden because, as a matter of law, neither SM nor its predecessors in interest assumed the JAI clause in the 1970 agreement. Specifically, SM argued that the AMI clause did not relate to properties B had previously acquired and assigned to C, but only to properties B might acquire in the future. On the other hand, Golden argued that the assignments leading to SM unambiguously established that SM assumed the AMI clause because the assignments were subject to the terms of “other contracts” that related to the conveyed leases.
The North Dakota Supreme Court began its analysis of the agreement by observing:
The “joint area of interest” clause in the 1970 letter agreement is commonly referred to in the oil and gas industry as an area of mutual interest (AMI) agreement, which has been defined as an “agreement by which the parties attempt to describe a geographical area within which they agree to share certain additional leases or other interests acquired by any of them in the future.” [Citation omitted] The parties in this case agree that the AMI clause is not a covenant that runs with the land, but is a personal covenant that is enforceable only between the original parties to the agreement.
After analyzing general hornbook law on assignments of contracts, the court noted that the same principles apply to AMI clauses:
If an assignee takes an interest in oil and gas leases and the document of conveyance states that it is specifically subject to the terms of a contract wherein the area of mutual interest was created, and the assignee operates under the agreement or attempts to use or enforce the terms of that contract, it is submitted that the assignee has assumed the obligations of the area of mutual interest and it is enforceable against him. Whether or not these obligations were assumed by a party acquiring oil and gas leases subject to an area of mutual interest clause is a question of intent, and all the surrounding circumstances must be evaluated to determine that intent. [Citation omitted]
The Supreme Court concluded that the contested provisions of the 1993 assignment were ambiguous and that a trial would be necessary to discern the intent of the parties. In support of this holding, the court observed that one of the hallmarks of an ambiguous contractual provision is that, as was the case in Golden, each opposing party was able to articulate a rational argument to support its position.
The court also held that even though the agreement between Golden and B was duly recorded and, therefore, gave C constructive notice of its terms, notice to B was not equivalent to an agreement by B to be bound by the terms of the agreement. Of course, if the agreement was deemed to run with the land, the court may have reached a different conclusion.
The Court’s Analysis of the Overriding Royalty
With regard to the override, SM did not contest its obligation to pay Golden royalties on the disputed well, nor did SM deny that Golden was previously underpaid. Rather, SM argued, citing North Dakota precedent, that a well operator is not required to compensate a royalty owner for underpayments if the payments were based on division orders executed by the royalty owner.
The court disagreed and distinguished prior case law by noting that in previous cases the well operator paid out 100% of the proceeds from the well. In prior cases some payees were overpaid and others were underpaid but the well operator realized no benefit from the mistake and was not unjustly enriched, which is different than the present case wherein the operator would benefit from the error. The court instructed:
“Generally, the underpaid royalty owners, however, have a remedy: they can recover from the overpaid royalty owners. … The basis for recovery is unjust enrichment . …
[Prior case law] does not hold that a well operator is automatically insulated from liability for underpayment of royalties simply because the incorrect payments were made in accordance with an executed division order. * * * Here, it is undisputed that SM is the well operator that prepared the division order and SM is also the overpaid working interest owner. Because Golden was underpaid during the relevant time period and SM was overpaid, Golden has suffered harm and SM has been unjustly enriched by retaining the benefits of the erroneous division order and receiving the payments to which Golden was entitled.”
The Supreme Court concluded that SM was unjustly enriched and owed Golden retroactive overriding royalty payments regardless of whether the erroneous payments were based on a division order signed by Golden.
- Consider whether an obligation in a contract can be made to “run with the land” so as to obligate future owners who acquire an interest in the land.
- Take care to make your contractual obligations and assignment provisions clear. A carefully drafted contract is still priceless.
- Don’t count on division orders to cure all payment errors.
Provisions in oil and gas leases requiring the lessor’s consent to assignment of the lessee’s interest are common. A lessor may have reasonable concerns about assignment of the lease, especially if the lessor is also the owner of the surface estate of the leased premises. The lessor may have agreed to lease in part because of the reputation and financial condition of the lessee, and he or she may justifiably wish to have control over whether the lease can be assigned to a third party.
Lessees, on the other hand, dislike consent-to-assign provisions in leases. Such provisions may substantially impair the lessee’s perceived value of the leasehold estate it has paid for. Leases are bought and sold like commodities. In the Permian Basin last year, more than $25 billion of transactions took place transferring mineral leasehold interests. Those transactions are made more difficult when lessors’ consents must be obtained to close the transaction.
Before closing a deal to purchase a package of oil and gas leases, the buyer will review the terms of the leases, and included in that review will be identifying leases that require consent to assign. Typically such review will uncover consent-to-assign provisions, in which event the buyer will have to determine whether obtaining such consent will be a condition to closing the deal. In my experience, companies acquiring leases will typically divide the leases containing consent-to-assign provisions into two categories, those with “soft-consent” provisions and those with “hard-consent” provisions. A “hard-consent” provision specifies the consequences of failure to obtain consent — for example, that such a breach is grounds for cancelling the lease, or that specified liquidated damages must be paid for the breach. A “soft consent” is one that prohibits assignment without consent but does not specify a remedy for the breach. Companies may elect to acquire leases with soft-consent provisions without requiring the seller to obtain consent, based on the reasoning that the lessor will have to prove damages for the breach, that damages would be difficult to prove, and that the lessor probably will not sue for the breach. Without a specified remedy for breach in the lease, in particular a right to terminate for the breach, the reasoning is that termination of the lease for breach of the consent-to-assign provision would not be a remedy available to the lessor. The buyer will, however, require the seller to obtain consent for leases containing a hard-consent lease provision, especially if it specifies that breach of the provision would allow the lessor to terminate the lease.
Consent-to-assign provisions may or may not specify any criteria for which the consent may be withheld. A lessee will try to negotiate for inclusion of language saying that the consent may not be “unreasonably withheld,” or may not be “unreasonably withheld, conditioned or delayed.” Without such language, it has been held that a consent-to-assign provision implies no obligation on the lessor to act reasonably in withholding consent. Trinity Prof’l Plaza Assocs. v. Metrocrest Hosp. Auth., 987 S.W.2d 621, 625 (Tex.App.-Eastland 1999, pet. denied); English v. Fischer, 660 S.W.2d 521 (Tex. 1983). So if a lease says simply that assignment may not be made without the lessor’s consent, such consent can be withheld arbitrarily. What constitutes an “unreasonable” refusal to consent may be a subject of dispute. If a lease prohibits “unreasonable” withholding of consent, the lessor may be subject to a claim for substantial damages if his withholding of consent is found to have been unreasonable.
A recent case dealing with a consent-to-assign provision is Carrizo Oil & Gas, Inc. v. Barrow-Shaver Resources Company, 2017 WL 412892 (Tex.App.-Tyler, January 31, 2017). The consent-to-assign provision was contained in a farmout agreement between Carrizo and Barrow-Shaver. (A farmout agreement is an agreement between the owner of a lease and a third party agreeing to assign the lease or portions thereof or interests therein upon satisfaction of certain obligations, typically the drilling of wells on the lease by the third party.) The agreement provided that the rights granted to Barrow-Shaver “may not be assigned, subleased or otherwise transferred in whole or in part, without the express written consent of Carrizo.” Barrow-Shaver negotiated unsuccessfully for inclusion of a provision that Carrizo’s consent would not be unreasonably withheld. But Carrizo orally assured Barrow-Shaver that it would not unreasonably withhold consent.
After spending $22 million drilling wells on the lease with no tangible results, Barrow-Shaver made a deal with another company to purchase Barrow-Shaver’s rights under the farmout agreement for $27.7 million. But Carrizo refused to grant consent to the assignment unless it was paid $5 million – substantially all of the profit that Barrow-Shaver would have made from the transaction. Barrow-Shaver refused Carrizo’s requirement and the deal fell through. Barrow-Shaver then sued Carrizo for $27.7 million, saying it had unreasonably conditioned its consent and had defrauded Barrow-Shaver into entering into the agreement by assuring it that Carrizo would act reasonably.
The case went to trial. The jury awarded Barrow-Shaver $27.7 million in damages, and Carrizo appealed. The court of appeals reversed, concluding that the contract allowed Carrizo to withhold consent and that it had no obligation to act reasonably. One justice dissented. He would have remanded the case for a new trial because of evidence excluded from the jury as to whether “custom and practice” in the industry would require Carrizo to not unreasonably withhold its consent.
A recent excellent article in the Texas Tech University Law Review, Consent to Assignment Provisions in Texas Oil and Gas Leases: Drafting Solutions to Negotiation Impasse, 48 Tex. Tech L.R. 335 (2106), contains discussions on negotiation of consent-to-assign provisions in oil and gas leases.