By Conrad Hester
Thompson & Knight LLP
With oil dipping below the $30 per barrel mark, the continuing profitability of many oil and gas leases may be in jeopardy. The likely result will be a spike in claims that a lease has terminated due to a failure to produce in paying quantities. Whether a marginal well has failed to produce in paying quantities may depend on mountains of accounting data, lengthy expert testimony and numerous technical legal issues. With the total loss of a multi-million dollar lease often at stake, a lease termination battle can take years to finally resolve. But what happens in the meantime? The challenged lease may have several producing wells on it, or perhaps the operator has plans to drill new wells. Should the operator cease all operations or continue business as normal, even when faced with a lease termination dispute and the overlaying issues of repudiation, trespass and receivers?
An operator’s duties following a lease challenge may turn on whether the lease has been repudiated. The doctrine of repudiation applies when the lessor takes the position that the lessor is the owner of the property to the exclusion of lessee. It is doubtful that the actions of a lessor merely raising questions about the validity of a lease or requesting operating expense data to verify profitability constitutes a repudiation. A repudiation only occurs when the lessor gives unequivocal notice that it believes the lease has terminated or files suit challenging title. The lessee must show it had notice of the repudiation and relied on it, for instance, by suspending operations.
Repudiation relieves the lease holder from any obligation to conduct operations or produce minerals in order to maintain the lease while the litigation is pending. If the lessor repudiates a lease that is valid and in effect at the time, courts may extend the lessee’s time to perform under the lease by the amount of time the lessee was prevented from conducting operations.
Many operators may choose to shut-in wells when faced with a lease challenge. However, shutting-in is not without its own complications. First, if the dispute involves marginal wells, shutting-in may not hold the lease, as it must be capable of producing in paying quantities at the time it is shut-in. Further, if the lease limits the number of years that the wells may be consecutively shut-in, a lengthy termination battle may extend beyond this period. Repudiation relieves the lessee of both problems, as it suspends obligations to maintain the lease until the suit is resolved.
Additionally, a lease challenge allows the lessee to suspend royalty payments. The Texas Natural Resources Code permits payors to withhold payment without interest when there is a dispute concerning title that would affect distribution of payments.
In short, if the lessor repudiates the lease, the lessee may cease all operations. It may shut-in or stop operating its wells and put future development on hold until the issue is resolved. Repudiation will not resolve the issues that gave rise to the lease challenge in the first place, but it does suspend the lessee’s obligations going forward.
Parties to a challenged lease should also be aware of trespass issues, as the lessor may have asserted a trespass action in addition to lease termination. If the court determines that the lease is valid, trespass claims are unfounded, as the lessee had the right to develop the minerals. However, if the lease is found to have terminated, then the lessee may have to compensate the lessor for the minerals produced after the lease expired.
Texas follows the “Good Faith Improver” doctrine which states that one who improves real estate under the erroneous but good faith belief that it owns the land may recover from the true owner the cost of improvements that enhanced the value of the property. A trespasser acts in good faith when it has an honest and reasonable belief that it has superior title. Therefore, if a lessee drills a well before it is aware the lease has terminated, it can offset its capital costs from the value of the minerals it must pay.
If the lessee chooses to move forward with operations, there is support in Texas law for enjoining a lessor from interfering with its continued operations. The lessee must demonstrate both a probable right and a probable injury in order to obtain the injunction. On the flip side, lessors have repeatedly lost their attempts to enjoin lessees from continuing to operate during a lease challenge.
However, an operator who conducts operations such as drilling with knowledge of a pending lease challenge takes a significant risk. If the challenge ultimately succeeds, the operator’s actions would not only be a trespass, it would probably legally constitute a “bad faith” trespass. Parties that trespass in bad faith must reimburse the trespassed party in full for the value of all minerals removed, without making any deductions for incurred expenses. If the lessor has encouraged or requested the lessee to continue operating while the litigation is ongoing, the court may restrict a bad faith claim. Otherwise, a lessee that chooses to move forward with development in the face of a lease challenge might spend millions of dollars drilling a well, only to hand the keys over to a successful lessor.
The consequences of trespass can put both parties to a lease challenge in a tough position. If prices are high, the lessee will want to drill soon, and the lessor will want the benefit of higher royalty payments. If there are offset wells, the leased land may be getting drained. The parties to the suit can enter into an agreement allowing for production under specific conditions while the suit lasts. However, if the parties cannot reach an agreement, appointment of a receiver may be an option.
A receiver is a person appointed by the court to preserve property during pending litigation. Receivers serve temporarily, are disinterested, and represent both the court and the parties interested in the litigation. Like trustees, receivers stand in the place of the owner of property.
A receiver is tasked with receiving and preserving property and protecting it for the benefit of all interested parties, so the receiver will administer and manage the lease pending the litigation’s final resolution. Subject to a court’s control and authorization, a receiver may take charge of the property, receive rents, collect and settle demands, make transfers, and perform other acts on the property, such as operating wells. The land the receiver takes charge of must generally belong to a party to the proceeding.
The Texas Civil Practice and Remedies Code contains a chapter allowing for the appointment of a receiver for mineral interests owned by nonresident or absentee individuals, contingent interests in minerals, and royalty interests owned by nonresident or absentee individuals. However, the code does not explicitly address the need for a receiver where the parties are in litigation to determine the true owner of the land. Without an applicable statutory provision, a receiver for property subject to a lease challenge could only be appointed under what are called the rules of equity.
Equity may require appointment of a receiver if the leasehold is at risk of drainage or inaction may otherwise lead to waste. In title disputes a receiver may be appointed to drill and hold proceeds until a final judgment on the title issue. The appointment procedure begins with a party to the litigation filing an application for appointment, or the court itself may appoint a receiver. After the application is filed, the court will hold a hearing where it considers the application and any objections. Appointment of receivers is within the discretion of the court, but it is generally considered a drastic remedy to be used sparingly. If a receiver is appointed, the party seeking appointment must post a bond sufficient to pay all damages and costs, in case of wrongful appointment. The receiver’s fees are included as part of the court costs and are generally paid out of the proceeds of the receivership. The receivership cannot extend past the time the suit is pending, but otherwise is within the court’s discretion. Although an operator may prefer to operate the leased premises itself, a receiver may be a good compromise option, where the operator is unwilling to take on the risk of spending money it may not recoup.
Clearly, a lease challenge raises a host of issues about the proper approach for operating the land until the challenge is resolved. However, Texas law has established some mechanisms to assist with the process. To sum up, if the lessor repudiates the lease, the lessee may suspend its operations; if the lessee develops during the lease challenge, it may have to pay the lessor for the value of the extracted minerals without reimbursement for expenses; and if the lease must be developed in the interim, a third party may be appointed as receiver.
Conrad Hester is a Trial Associate in the Fort Worth office of Thompson & Knight LLP where he focuses his practice on oil, gas, and energy law. His oil and gas expertise includes contract disputes, royalty litigation, lease termination suits, trespass to try title claims, surface access and damages disputes, and drafting and negotiating agreements regarding acquisition, exploration and production, and operations. He also represents energy clients in a variety of bankruptcy and commercial litigation matters.