OVERRIDING ROYALTY INTERESTS: PITFALLS, PRECEDENT, AND PROTECTION

 

§ 21.01  Introduction

An adversarial relationship, the result of conflicting economic interests, exists between the operating and nonoperating interest owners in an oil and gas lease. Owners of operating interests, the cost-bearing working interest, must bear, in addition to the risks of geological misinterpretations, mechanical failures, environmental obstructionists, and confiscatory taxation, the financial burden of nonoperating interests. Owners of the latter, consisting of overriding royalty interests, production payments, net profits interests, and the like, expect their allotted share of oil and gas free of the expense of exploration, development, and operation-“freeloaders” as perceived by the burdened operating interest owners.

The owners of nonoperating interests, in their simplest form, have no control over the decisions that dictate whether the lease that is burdened by their interest will be drilled or abandoned. Since nonoperating interests, absent contractual protection or special circumstances, expire or terminate at the same time as the lease that they are carved out of, there are thousands of sad stories of landmen and geologists who assigned a lease to an operator in exchange for an overriding royalty interest, then watched helplessly as their lease expired, without any effort on the part of the operator to develop it, only to discover that the operator had taken a new lease from the same lessor, covering the same lands, but free and clear of their overriding royalty interest.

It doesn’t have to be that way. The courts have never hesitated to enforce written provisions in grants and assignments of nonoperating interests which give the owners a say in the operation of a lease. Even in the absence of a written agreement, the courts have been able, with some regularity, to recognize the difference between a shrewd operator and an unscrupulous one, and to construct rules and remedies designed to protect the nonoperating interest owner from the latter.

This paper will highlight the advantages and disadvantages of the nonoperating interest, and summarize recent court decisions that have altered the rights and liabilities traditionally associated with ownership of such interests. Wishing to show no preference for the burden or the burdened, the author will also discuss the protection that current laws afford to both the nonoperating interest owner who seeks to ensure the perpetuation of his or her interest and the operating interest owner who seeks to limit the influence that the nonoperating interest owner can exert over operations.

[1]       The Definition and Nature of an Overriding Royalty Interest

An overriding royalty interest is a nonoperating interest that is carved out of the working interest of an oil and gas lease, rather than the royalty interest. It can be created through a conveyance, but it is more commonly created by a reservation in the assignment or transfer of an oil and gas lease. It is a nonpossessory interest that attaches only when its share of oil and gas is reduced to possession, giving the owner no right, absent an agreement to the contrary, to participate in decisions with regard to the development and operation of the burdened lease.[1] Since an overriding royalty interest is “carved out” of the leasehold interest, it is limited in duration to the term of the burdened lease.[2]

Unless the grant or reservation of the interest provides otherwise, the owner of an overriding royalty interest is entitled to its specified share of oil or gas produced under the terms of the lease free and clear of drilling, completing, and operating costs.[3] However, it is almost universally accepted that the overriding royalty interest owners will bear their proportionate share of production and severance taxes.[4]

Whether a jurisdiction classifies an override as real or personal property will usually depend on how the jurisdiction classifies a landowner’s royalty interest.[5] In most jurisdictions an overriding royalty interest is regarded as real property.[6] The notable exceptions are Kansas and Oklahoma, where an overriding royalty interest is considered personal property before and after it is produced.[7] It is too simplistic to state that a jurisdiction will only classify an overriding royalty interest as either real or personal property. In reality, courts will usually characterize an override as an interest in real property for purposes that affect the land involved, and as a personal property interest for purposes of payments that arise from the interest.[8]

Since an overriding royalty interest is a nonpossessory right that attaches only when the oil and gas is brought to the surface, it cannot be adversely possessed or partitioned,[9] and the owner is not entitled to possessory remedies like trespass to try title (an action to regain possession from a trespasser).[10] Conversely, a lessee cannot bring a partition action in an attempt to extinguish an overriding royalty interest that the lessee claims has overburdened the working interest to the extent that further production, development, or sale of a lease is impossible.[11] The realty/personalty distinction that applies to an override allows the owner to bring a quiet title action to perfect title to the owner’s interest in a lease (real property) but to also maintain a conversion action for revenues due as a result of actual production (personal property).[12]

When the circumstances dictate that the overriding royalty interest is real property: (1) the Statute of Frauds will apply to any instrument creating an override, requiring at minimum a written memorandum signed by the party who bears the override, describing the agreement in enough detail that parol evidence will not be necessary to prove up any substantive terms;[13] (2) specific performance is available as a remedy to compel an assignment or conveyance of the interest[14] assuming that the terms of the contract are clear, and that there has been partial performance of the contract by the party seeking such a remedy;[15] and (3) state recording statutes will apply to the instrument creating the override, and will mandate that the instrument be recorded to ensure priority as against subsequent bona fide purchasers for value without actual notice.[16]

[2]  Other Forms of Nonoperating Interests

Although this chapter focuses primarily on the creation and protection of overriding royalty interests, there are other forms of nonoperating interests that are similar to overrides. With the exceptions noted below, the legal precedents set forth in the cases discussed herein will apply interchangeably to all nonoperating interests.

A production payment (sometimes referred to as an “oil payment,” especially if limited to oil production) is “a share of the oil [or gas] produced from described premises, free of the costs of production at the surface, terminating when a given volume of production has been paid over or when a specified sum from the sale of such oil [or gas] had been realized.”[17]

[T]he only significant difference between an overriding royalty interest and a production payment is that an overriding royalty interest continues for the entire term of the lease, whereas a production payment terminates when the specified amount of production or money has been received by the owner of the production payment. Thus, in any state where an overriding royalty is considered to be realty, a production payment should also be a present interest in land.[18]

The production payment is gaining popularity as a way to finance oil and gas operations and purchases, but it differs from a mortgage secured by production so long as no personal obligation exists on the part of the burdened party to pay the stated amount.[19]

A net profits interest differs from an overriding royalty interest to the extent that the former is to be paid out of net production after specified costs have been recovered by the burdened party.[20] Under the usual net profits arrangement, the burdened party pays all costs of exploration and development, then after recouping these costs from its share of production distributes to the owner of the net profits interest the latter’s agreed share of the “profits.”[21]

Although some commentators have argued that the net profits interest should be viewed as an interest in real property,[22] the nature of a net profits interest is such that many jurisdictions have interpreted it as an interest in the proceeds of production and therefore personal property, rather than an interest carved out of the working interest in a lease, like an override or production payment, which is generally considered real property.[23]

The only thing that can be said with any assurance [with regard to the question whether a net profits interest is real or personal property] is that a net profits interest may or may not be an interest in land and that the nature of the interest and the rights of its owner must be determined from the provisions of the instrument which created it.[24]

Overriding royalty interests, production payments, and net profits interests in an unadulterated form share the following characteristics: (1) they are carved out of the lessee’s working interest in an oil and gas lease and are consequently limited to the term of the burdened lease; (2) the burdened working interest owner has no personal obligation as the interest is only payable out of production; (3) they are nonpossessory interests granting the owner the right to a share in the minerals when produced, but carrying no right to participate in the operation of the burdened lease; and (4) they do not bear any of the costs of developing and operating the lands subject to the interest.[25]

§ 21.02            “Extension or Renewal” Clauses Applicable to Overrides

An “extension or renewal clause” for purposes of this discussion is a provision in an assignment or reservation of an overriding royalty interest or other nonoperating interest that protects the owner against a “washout.”[26] A “washout” is the elimination of the nonoperating interest as a result of the termination or surrender of the burdened lease, and the subsequent reacquisition of a lease on the same lands by the lessee or its agent with the intention of taking the lease free of the burden of that nonoperating interest.[27] An example of an extension or renewal clause is as follows:

The overriding royalty interest reserved by Assignor in the leases subject to this assignment (the “subject leases”) shall apply to every extension, renewal or modification of any of the subject leases, or any portion thereof, taken by Assignee or its successors, assigns, agents or employees (hereinafter referred to as the “Assignee”), and to any new lease taken by Assignee on the lands, or any portion of the lands, covered by the subject leases within one year of the expiration, termination or surrender of any of the subject leases.

Because an overriding royalty interest is usually considered an interest in real property, the Statute of Frauds requires that a grant or reservation of an override be in writing. Absent circumstances supporting equitable relief such as reliance and part performance, an oral agreement that an override reserved by an assignor will attach to any extension or renewal of the burdened lease is unenforceable.[28]

An “extension” of an existing oil and gas lease is usually defined as an instrument that prolongs or continues the term of an existing oil and gas lease.[29]

Renewal and extension are concepts closely allied to one another, normally involving a continuation of the relationship on essentially the same terms and conditions as the original contract.[30]

[I]n determining whether a subsequent lease constitutes an “extension or renewal” a court must consider the circumstances surrounding the execution of the leases, the relationship of the parties, whether new consideration was given for the subsequent lease, and the significant similarities and differences in the terms and conditions of the leases.[31]

There appear to be no hard and fast rules to distinguish an “extension or renewal” lease from a “new” lease, primarily because the classification of a lease as one or the other often has more to do with equity than fact. The Tenth Circuit, applying Kansas law, held that five “replacement” leases taken by the lessee at a bonus cost of $130,000, covering (collectively) the same lands included in the single prior lease, each subject to a primary term and landowner royalty that was different from the prior lease, were “new” leases, and not “extensions or renewals.”[32] However, the Kansas Supreme Court has ruled that a lease that covered more land than a prior lease, had a one-year primary term rather than the three-year term of the prior lease, and was taken 13 months after the prior lease expired was an “extension or renewal” of the prior lease.[33] The U.S. District Court for the District of Wyoming recently ruled that leases taken two and one-half months after the prior leases had expired, which covered different formations under less acreage, had a larger landowner royalty, a shorter primary term, a shorter continuous drilling clause, and more rigid pooling requirements, among other variances with the prior leases, were “new” leases not “extensions, renewals or substitute[s].”[34] A new lease entered into one year after the expiration of a prior lease, costing $27,000 in new bonus consideration, which had a different primary term, delay rental obligation, and continuous drilling obligation, was a “new” lease, not a renewal, according to the Texas Supreme Court.[35]

[1]       Washout Protection in the Absence of an “Extension or Renewal” Clause

As a general rule, an overriding royalty interest carved out of the working interest in a lease will be limited in duration to the term of the burdened lease. Absent an “extension or renewal” clause that applies to the override, and absent circumstances of fraud, breach of a fiduciary relationship, or bad faith in the conduct of the lessor or lessee, the expiration, surrender, or termination of an oil and gas lease burdened by an override will result in the extinguishment of the override without recourse by its owner.[36] The reservation of an overriding royalty interest in an assignment of an oil and gas lease, without more, does not create a fiduciary relationship between the assignor and the assignee.[37]

Professor Kuntz writes that “as a matter of theory,” an overriding royalty interest burdening an oil and gas lease should apply to any modifications or extensions of the lease that are made while the original is still in full force and effect, with or without an extension or renewal clause.[38] However, there appears to be little support in the case law for Professor Kuntz’s proposition.

In the absence of an extension or renewal clause in the assignment that reserves the override, or circumstances creating a fiduciary duty between the overriding royalty owner and the lessee, the courts are reluctant to extend an overriding royalty beyond the term of the burdened lease, even when the lessee takes a new lease prior to expiration or surrender of the old. This is especially true when, as is often the case, the burdened lease contains a provision that the lessee can surrender or abandon it at any time.[39] Since most oil and gas leases give the lessee the option during the primary term to drill, pay delay rentals, or surrender the lease, the foregoing rule of law is applied with some frequency.

The courts will grant an assignor/overriding royalty interest owner the same rights in a new lease taken by the assignee when the circumstances of the relationship between the parties creates a fiduciary relationship that requires one to exercise a duty of good faith and fair dealing towards the other. Such was the situation confronting the Oklahoma Supreme Court in the case of Rees v. Briscoe.[40] Rees had assigned his leases to Briscoe in exchange for the reservation of an override and an oral promise by Briscoe to drill each of the leases before they expired. No other consideration was involved. Briscoe drilled one of the three wells promised, then proceeded to obtain “extensions” of two of the leases assigned by Rees, which were executed before the prior leases expired, and which Briscoe proceeded to drill after the prior leases expired, without giving Rees his override. The court held that under the circumstances presented, Rees and Briscoe had a fiduciary relationship and that Briscoe’s failure to grant Rees an override in the extension leases was a breach of the duties that flowed from that relationship, prompting the court to declare that Rees held a constructive trust against the new leases in the amount of his original override.[41]

In Brannan v. Sohio Petroleum Co.,[42] the Tenth Circuit Court of Appeals,[43]having determined that the assignment from Brannan to Sohio which reserved an override was not subject to any drilling commitment, and that Brannan had received a cash bonus as well as the override in exchange for the assignment, ruled that Sohio owed no fiduciary duty to Brannan. Consequently, Brannan was not entitled to apply his override to a “top” lease that Sohio took prior to the expiration of Brannan’s lease covering the same lands as Brannan’s lease, which Sohio successfully drilled after the Brannan lease expired.[44]

The Kansas Supreme Court has ruled that the assignor of a lease who reserved an override was entitled to the same override in a subsequent lease covering the same premises taken by the assignee/lessee when the assignee/lessee and the mineral owner/lessor colluded to fraudulently cancel the original lease in order to eliminate the override.[45]

On bona fide forfeiture or surrender of an oil and gas lease, the overriding royalty created thereunder falls with the lease. But if such forfeiture or surrender is obtained by fraud or collusion between the landowner and the lessee for the purpose of avoiding or cutting out the overriding royalty interest holder and the substitution of a new lease directly to the lessee, then a court of equity may grant relief to the overriding royalty holder against such forfeiture or surrender.[46]

[2]  Washout Protection Under the “Oklahoma Rule”

Anyone who depends on the income generated by an overriding royalty interest should rank the “extension or renewal” clause as second only in importance to the magnitude of one’s interest, especially in Oklahoma. Overriding royalty owners in Oklahoma are the beneficiaries of a generous rule of law, unique to that jurisdiction, which provides that the existence of an “extension or renewal” clause in an assignment creating an overriding royalty interest, by itself, gives rise to a fiduciary duty between the parties to the assignment and their successors.

The “Oklahoma rule” was first established in the case of Probst v. Hughes,[47] which interpreted an assignment of an oil and gas lease from Probst to Hughes that reserved an override and that provided: “[t]his reservation shall likewise apply as to all modifications, renewals of such lease or extensions that the assignee, his successor and assigns, may secure.”[48] It is unclear from the opinion whether Hughes allowed the Probst lease to expire before taking a new lease from the landowner, or whether the new lease was taken four months after the original lease terminated because of a cessation of production. It is clear that the new lease had different terms than the original lease. Although the record contained evidence sufficient to support a determination that Hughes owed a fiduciary duty to Probst (i.e., testimony by Hughes that he believed a deeper, potentially productive sand was located on the leased premises, but did not think the term of the original lease allowed him enough time for further exploration), its ruling focused instead on the “renewal or extension” clause in the assignment:

[u]nder the terms of [Probst’s] assignment, defendants were under the obligation to exercise the utmost good faith to secure a renewal or an extension of the lease if they desired to continue to further prospect the property for oil or gas. . . .[49]

Having determined that Hughes owed Probst a fiduciary duty to obtain a renewal or extension, the variances between the old and new lease were deemed immaterial.

The Tenth Circuit Court of Appeals followed the rule of Probst when it held that a “protection” lease covering lands in Oklahoma, taken three months after the irreparable collapse of the casing in the only producing well holding a proof lease, was subject to the “extension or renewal” clause in an assignment of the original lease from Union Oil Company to Independent Gas & Oil Producers, Inc. wherein Union reserved an override.[50] Earlier testimony established that the only consideration Union received for its assignment was the override and Independent’s commitment to drill the failed well. It was also established that at the time Independent took the protection lease, it still believed the prior lease had value.

The facts of this case bring [the protection lease] squarely within the purview of the principles previously outlined [in Probst]. The parties’ lease assignment expressly subjects renewals and extensions of [the original lease] to the overriding royalty interest held by Union and thus triggers operation of the fiduciary rule. The propriety of the rule’s application here is unquestionable inasmuch as the reserved royalty was an important part of the consideration received by Union for the assignment and Independent believed the lease to be lucrative despite temporary cessation.[51]

[3]       Interpretation of the “Extension or Renewal” Clause in Other Jurisdictions

Outside of Oklahoma, there are no cases to be found holding that the “extension or renewal” clause in an assignment or grant of an overriding royalty creates, of its own accord, a fiduciary duty between the parties. The courts in these jurisdictions will still impose fiduciary duties on the assignor and assignee if circumstances of bad faith or illicit conduct exist. How­ever, absent bad acts on the part of the assignee/lessee, most courts are inclined to interpret the extension or renewal clause in an agreement “on the basis of a definitional approach which applies accepted legal distinctions between the terms extension or renewal and new leases.”[52]

Some commentators have opined that the Kansas Supreme Court decision in Reynolds-Rexwinkle Oil, Inc. v. Petex, Inc.[53] adopted the Oklahoma rule with regard to an “extension or renewal” clause, but a close reading of the case has led the author to conclude that the ruling in Reynolds has more to do with the applicability of the extension or renewal clause than its existence. The issue confronted was whether an extension or renewal clause in an assignment of an oil and gas lease from Reynolds to Petex, wherein Reynolds reserved an override, applied to a “substantially similar” “top” lease obtained by Petex prior to the expiration of Reynold’s lease. What appears to have persuaded the court to grant Reynolds an override in the new Petex lease was a finding that the new lease taken by Petex fit the definition of “extensions or renewals” as defined in the assignment and the fact that the relationship between the parties created a duty of “fair dealing:”

[T]he fact [that] Petex took the second lease while the original lease it held was still in full force and effect requires a ruling that the overriding royalty of Reynolds attaches to the later lease. But, this is because of the extension and renewal language in the assignment and not due to any finding of bad faith on Petex’s part.[54]

. . . .

[A] duty of fair dealing exists under the facts of this case. This duty, coupled with the “extension or renewal” wording of the assignment, and the taking of the subsequent lease while the first one was in full force and effect compels a ruling, as a matter of law, that [Rexwinkle’s] overriding royalty interest . . . applies to and burdens the second oil and gas lease upon which production was obtained.[55]

The “confidential relationship” between an assignor/over­riding royalty interest owner and an assignee/lessee was the focus of an earlier decision by the Kansas Supreme Court in Howell v. Cooperative Refinery Ass’n.[56] The case involved an oil company (CRA) and an independent geologist (Howell) who agreed that CRA would provide the financing for Howell to acquire four leases covering a prospect he had generated, and that Howell would subsequently assign the leases to CRA, reserving an overriding royalty interest that would apply to any extension or renewal of the leases. CRA drilled three of the four leases acquired by Howell, but refused (for no apparent reason) to drill on the last lease, which it released upon the expiration of its primary term. CRA then proceeded to take a new lease on the undrilled tract, but refused to assign Howell any override. The court held that the circumstances of the agreement between CRA and Howell created a confidential relationship between the parties that entitled Howell to an override in the new lease:

While . . . “Confidential relation” may be defined as meaning a relationship between business associates that would lead an ordinarily prudent [person] in the management of [his] business to repose that degree of confidence in [another] which results in the substitution of the [other’s] will and judgment for [his] in material matters involved, it has been defined in the law as any relation existing between the parties to a transaction wherein one party [the oil company] is bound to act with utmost good faith for the benefit of the other party [geologist].[57]

Absent a fiduciary or confidential relationship between the assignor and assignee, the courts can be conservative in their evaluation of a lease as an “extension or renewal.” In the case of Lillibridge v. Mesa Petroleum Co.[58] the Tenth Circuit Court of Appeals held that in spite of an “extension or renewal” clause in Lillibridge’s assignment of a lease to Mesa which reserved an override, Lillibridge was not entitled to the same override in five “top” leases taken by Mesa covering the same lands as the original “bottom” lease. Noting that the “top” lease consisted of five separate leases, rather than one lease, that each of the five leases had a different landowner royalty rate than the original lease, and that the assignee/lessee paid an additional bonus of $130,000 for the top leases, the court ruled that they were “new” leases rather than “extensions or renewals.” The commentators have not been impressed:

Lillibridge greatly narrows the scope of protection provided by an express extension or renewal clause, at least in the Tenth Circuit. Unless the terms and conditions of the second lease are essentially the same as those of the original lease, the Tenth Circuit Court of Appeals will not give effect to the extension or renewal clause.[59]

Texas has also declined to adopt the Oklahoma rule. In Sunac Petroleum Corp. v. Parkes[60] the Texas Supreme Court considered whether a party owning an override in a lease (which was thought to be in its secondary term) was entitled to the same override in a “protection” lease taken by the lessee in response to the lessor’s allegation that the prior lease had expired at the end of the primary term. It was ultimately determined that the lessor was correct and that the prior lease had expired more than a year prior to the execution of the protection lease, as a result of an innocent mistake with regard to pooling. The court found no evidence that either party occupied a position of confidence or trust in relation to the other. Noting that the assignment creating the override granted the assignee/lessee the right to surrender the lease without the overriding royalty owner’s permission, the court ruled that the protective lease was a “new” lease to which the override did not extend.[61]

According to the U.S. District Court for the District of Wyoming, interpreting Wyoming law in the case of Sawyer v. Guthrie,[62] the inclusion of a clause reserving an overriding royalty interest, in an assignment made pursuant to a farmout agreement, which states that the override is subject to “any and all extension, renewal and substitute leases” does not, by itself, create a fiduciary relationship between the parties:

This is not to say that there would never be a time where a fiduciary relationship could have been created, but in the present case, the inclusion of boiler plate language [i.e., an “extension or renewal” clause] in a document negotiated at arms’ length between virtual strangers is not such a situation. . . . [T]he Court will not take pity on an experienced, albeit partially unsuccessful oil and gas investor. . . .[63]

The Sawyer v. Guthrie case is worthy of further elaboration regarding Sawyer’s argument that, in spite of the fact that the farmout did not require continuous drilling by the assignee/lessee prior to the end of the primary term (only the requirement that the lessee must release, at the end of the primary term, any of the leased lands not included in a 40-acre producing unit), the duty of good faith and fair dealing that is implied in every Wyoming contract (and every contract in most jurisdictions in the United States) obligated Guthrie and the other working interest owners to establish paying production, or prosecute continuous drilling and reworking operations, on Sawyer’s leases in order to perpetuate all of the acreage under said leases. Sawyer alleged that the penalty for such malfeasance should be the extension of his override to the new leases taken by Guthrie.

The court rejected Sawyer’s argument, stating:

[Sawyer] attempts to imply that it was the duty of Defendants to drill on every section of land covered by the [prior leases] so that the Leases would never expire as long as oil or gas was available in the leased lands. Such a provision does not appear in the Leases or other contracts relating thereto, and the Court will not imply such a provision under the duty of good faith and fair dealing. . . .[64]An implied duty to not let any . . . part of the land covered by the [prior leases] remain undrilled would eviscerate the actual contractual language which only includes a duty to drill one test well. . . . Rather than imposing an absolute duty to drill otherwise, the Express Farm­out states that Defendants “shall continue to have the right to drill additional wells on the acreage.” . . . This language uses the word “right” as opposed to creating a duty to drill ad infinitum.[65]

A breach of the covenant of good faith and fair dealing occurs when a party interferes with or fails to cooperate in the other party’s performance.[66]

The covenant of good faith and fair dealing may not, however, be construed to establish new, independent rights or duties not agreed upon by the parties. In other words, the concept of good faith and fair dealing is not a limitless one. The implied obligation must arise from the language used or it must be indispensable to effectuate the intention of the parties. In the absence of evidence of self-dealing or breach of community standards of decency, fairness or reasonableness, the exercise of contractual rights alone will not be considered a breach of the covenant.[67]

. . . The Court will not contradict the express language of the Agreements by interpreting a duty of good faith and fair dealing on the contracts to mean that Defendants are required to drill on and on, on every portion of the land, until all possible minerals are extracted from the land covered by the [prior leases].[68]

[4]       Miscellaneous “Extension or Renewal” Clause Cases

An assignor who reserves an overriding royalty interest in an assignment that is subject to an “extension or renewal” clause is not entitled to the same override in a subsequent lease taken by a third party who has no previous relationship with the assignee/lessee, even if the third party assigns the new lease to the assignee/lessee, so long as the assignee/lessee is under no obligation to the overriding royalty interest owner to extend the prior lease.[69]

The problem of applying an “inclusive” overriding royalty interest to an extension or renewal lease was addressed by the Texas appellate court in the case of EOG Resources, Inc. v. Hanson Production Co.[70] Hanson and EOG entered into an agreement wherein Hanson agreed to assign six oil and gas leases to EOG in exchange for an overriding royalty interest in each lease equal to the difference between 25% and “existing lease burdens.” However, the actual assignment of the leases from Hanson to EOG, prepared in accordance with the agreement, provided that Hanson would reserve:

[a]n overriding royalty equal to the difference between the aggregate of the basic royalties, overriding royalties and similar burdens chargeable to Assignor’s leases existing on the effective date of this Assignment and twenty five percent (25.00%). The overriding royalty reserved herein shall burden any extensions or renewals taken within one (1) year of termination of the subject leases. . . .[71]

Two of the six leases that Hanson assigned expired prior to drilling. EOG negotiated renewal leases that provided for a landowner royalty (LOR) of 25.0% rather than the 16.67% LOR that burdened Hanson’s leases. After the renewal leases became productive, EOG informed Hanson that because of the 25% LOR, Hanson would not receive any overriding royalty interest. Hanson argued and the court agreed that his override was to be calculated on the basis of the terms of the assignment, i.e., the difference between a 16.67% LOR (the “burdens existing on the effective date of this Assignment”) and 25%, and not on the difference between the new 25.0% LOR and 25%, i.e., 0%.[72]

An extension or renewal clause which provides that an assignor’s reserved overriding royalty interest will apply to other oil and gas leases secured by the assignee/lessee in an area of mutual interest does not apply to fee mineral interests subsequently acquired by the assignee/lessee in such area.[73]

[5]  Application of the Rule Against Perpetuities

The rule against perpetuities prohibits a grant of an interest “unless the interest must vest, if at all, no later than 21 years after the death of some person alive when the interest was created.”[74] “The rule against perpetuities is not a rule of construction, but is a positive mandate of law, to be obeyed irrespective of question of intention.”[75]

The rule does not invalidate a provision that grants the owner of an overriding royalty in a lease the right to receive the same override in “renewals, extensions or modifications” of the lease.[76]

Significantly, the [rule against perpetuities] touches only contingent future interests; a presently vested interest is not subject to the rule. . . .

. . . Union’s property interest in any renewals or extension of [the lease in which it owned an ORI] vested at the time of [the original assignment creating the ORI] and the rule against perpetuities is not operable in such a situation.[77]

The rule does invalidate a provision that grants the owner of an overriding royalty in a lease the right, without a time limitation, to the same override in a “new lease or leases” covering the same lands.[78] In the case of Cities Service Oil Co. v. Sohio Petroleum Co.,[79] Cities assigned an Oklahoma lease to a third party, reserving an override that was to apply to “[a]ny renewal, extension or new lease or leases covering the lands assigned.”79.1 The lease was eventually drilled by George Post, resulting in a dry hole, and was left to expire at the end of its primary term. Two years later, Post obtained a new lease on the same property which was eventually assigned to and drilled by Sohio. Cities sued claiming it was entitled to its override in the new lease. The U.S. District Court for the District of Western Oklahoma ruled against Cities, holding that since the right to apply the override to a new lease, being a future interest, might not vest less than 21 years after some life in being at the creation of the reservation, the “extension or renewal” clause, as it pertained to “new” leases, violated the Oklahoma rule against perpetuities and was void.[80]

A rule against perpetuities “savings” clause, like the one that follows, should ensure that any extension or renewal clause drafted, including one that pertains to new leases, will not be rendered void and unenforceable:

Any other provision hereof to the contrary notwithstanding, any right granted or reserved herein to receive a future interest in a [overriding royalty interest/production payment/net profits interest] shall, in any event, terminate one day prior to the expiration of 21 years after the death of the survivor of all descendants of Joseph P. Kennedy, father of the late President of the United States, who are living on the effective date of this assignment.[81]

§ 21.03  Calculation of Overriding Royalty Interests

An overriding royalty interest is the creation of a contract between an assignor and an assignee, and the language of the contract will determine the nature and quantum of the interest conveyed or reserved.[82] “[N]obody acquires . . . an overriding interest merely by virtue of ownership of mineral rights. It is acquired only by contract, and is payable in the amount and to the person designated by the contract. . . .”[83]

In the absence of ambiguity, courts and title examiners are compelled by the legal canons of construction to determine the intention of the parties to a contract from the “four corners” of the document. The plain meaning of the words that the parties have chosen to describe the nature and magnitude of their interest will control.

Reservations, if made, may be worded as the parties please. If they provide that the grantor shall have a named fraction of the oil produced on all of the described land, that is one thing; if they provide that he shall have a fraction of what is produced from the interest conveyed by the particular lease, it is another thing. The courts will enforce either agreement as made.[84]

The single biggest impediment to the title examiner’s ability to determine the size of the override that the parties intended is the failure of the parties to recognize that there are two ways in which an interest can be proportionately reduced: (1) a reduction proportionate to the mineral interest covered by the oil and gas lease in question (as illustrated in Clause A below); and (2) a reduction proportionate to the amount of working interest that is being assigned (as illustrated in Clause B):

Clause A

The overriding royalty interest (reserved/assigned) in each lease that is the subject of this assignment shall be proportionately reduced in the ratio that the mineral interest covered by the lease bears to the full mineral interest in the lands covered by the lease.

Clause B

The overriding royalty interest (reserved/assigned) in each lease that is the subject of this assignment shall be proportionately reduced in the ratio that the working interest assigned in each lease bears to the full working interest in the lands covered by the lease.

If the only proportionate reduction language included in an assignment is that contained in Clause A, then an assignment conveying a 20% federal operating rights (i.e., working interest) in a federal oil and gas lease, covering all of the minerals under the leased premises, reserving a “5% overriding royalty interest,” cannot be reduced to the 1% of 8/8ths overriding royalty interest that was probably intended. The same problem occurs if the only proportionate reduction language used in an assignment reserving the same override is that appearing in Clause B, and the assignment conveys all of the working interest in a lease that covers only 20% of the minerals under the leased premises.

The “lesser interest” clause of an oil and gas lease operates to reduce the royalty of the lessor if the lessor owns less than all of the minerals under the leased premises, but it cannot be used to reduce an overriding royalty interest that has been reserved in the lease unless (to restate a now familiar mantra) there is an express agreement to do so.[85] This rule has been applied even in situations where the lessor under an oil and gas lease reserves an overriding royalty interest in the lease that is in addition to the landowner’s royalty. In fact, some of the case law available to illustrate how courts have interpreted the quantum of an overriding royalty interest granted or reserved in an instrument pertains to overrides reserved by lessors, for instance:

(1)  The reservation, in an oil and gas lease covering less than 100% of the minerals under the leased premises, of a “1/8th of 8/8ths Overriding Royalty Interest” (without reference to leases or lands) in addition to a 1/8th landowner royalty interest, reserves an undivided 1/8th of 8/8ths override that is not proportionately reduced.[86]

(2)  The reservation, in an oil and gas lease covering ¼ of the minerals under the leased premises, of an “[o]verriding royalty of 1/32nd of 7/8ths of all oil and gas produced and saved under and by virtue of this oil and gas lease in addition to a 1/8th landowner royalty interest, reserved an undivided ¼ of 1/8th of 7/8ths overriding royalty, i.e., proportionately reduced to reflect the mineral interest covered by “this oil and gas lease.”[87]

(3)  The reservation, in an oil and gas lease covering 7/12ths of the minerals under the leased premises, of a production payment of “$15,000.00 out of one-eighth (1/8th) of seven-eighths (7/8ths) of oil, if as and only when produced, saved and marketed from said land under this lease,” in addition to a 1/8th landowner royalty interest, reserved a $15,000 production payment payable out of an undivided 1/8th of 7/8ths of production, without proportionate reduction.[88]

The literal analysis applied in the cases cited above has also been used to determine the quantum of overriding royalty interest reserved in assignments of an oil and gas lease. The Illinois Supreme Court has ruled that the reservation of a “[t]hree sixty-fourths (3/64ths) over-riding royalty out of the Seven-eighths (7/8ths) working interest” in an oil and gas lease that covered only three-quarters of the minerals under the leased premises results in the reservation of an undivided 3/64ths of 7/8ths overriding royalty interest, without proportionate reduction.[89]

In First National Bank v. Kinabrew,[90] the Texas Civil Court of Appeals was asked to construe an assignment transferring “ONE EIGHTH of EIGHT EIGHTS [sic] (1/8 of 8/8) of All the Oil, Gas, and other minerals which may be produced, marketed and saved from the herein described premises.” The assignment did not contain a legal description of any lands, but rather seven oil and gas leases. Each of the oil and gas leases contained a legal description of the same 120.3-acre production unit. These leases combined covered less than 100% of the minerals underlying the unit. The court ruled that the assignment was unambiguous and that the assignee was entitled to a net 1/8 of 8/8ths ORI in production from the lands described in the leases,[91] rejecting the assignor’s argument that the wording of the assignment required that the court look to the leases, determine the combined percentage of minerals that the leases covered, and reduce the 1/8th of 8/8ths ORI accordingly.[92]

Lest the reader come away with the impression that there is a logical consistency to the rules construing grants and reservations of overriding royalty interests, ponder the decision of the Wyoming Supreme Court in Wadi Petroleum, Inc. v. Ultra Resources[93] interpreting the reservation of a “3-1/8% of 8/8ths overriding royalty” in a federal-form assignment of an undivided 20% of 8/8ths working interest in a federal oil and gas lease. The court, without any mention of the decisions discussed above or the legal principles behind them, held that the reservation was ambiguous “due to a lack of clarity and incompleteness of expression”[94] and allowed the admission of extrinsic evidence, in the form of a “more-or-less” contemporaneous agreement and the expert testimony by title attorneys, to persuade it that the parties to the assignment intended that the 3.125% override would be reduced by a fraction of 20/100ths, i.e., a net 0.625% of 8/8ths override. What is mystifying to those who can only evaluate the propriety of the decision from the written opinion is that the “more-or-less” contemporaneous agreement that the court considered specified that Wadi’s predecessor in interest was to reserve (1) an “undivided 1/16th of 8/8ths overriding royalty” in certain leases that were not the subject of the suit, “[w]hich overriding royalty shall not be proportionately reduced if El Paso owns less than the entire leasehold interest [emphasis added];” and (2) a “3-1/8th overriding royalty” in the leases that were the subject of the suit, with no language concerning proportionate reduction.[95] Seizing on the missing proportionate reduction language, the court held that: “at a minimum, the silence creates an ambiguity which requires reference to evidence outside the four corners of the principal documents.”[96]

The court mentions that Wadi “essentially paid nothing”[97] for the leases in question, and that “Wadi did not diligently research exactly what it bought,”[98] but also felt compelled to mention that these matters were not material to its determination, but simply “part of the ‘whole story.’ ”[99] The outsider is left with the impression that the “whole story” has much to do with the fact that before Hondo sold out to Wadi, Hondo had executed division orders certifying that it owned a 0.625% ORI in the subject leases and accepted payments pursuant to those division orders,[100]a fact that the court also felt compelled to explain was “not used to ‘alter or amend’ the terms of the assignments but only to assist the trial court in resolving the inherent ambiguity in the assignments.”[101] Wadi may prove to be a classic example of the right decision for the wrong reasons.

Although the Wadi decision may be an aberration, it is also an effective illustration of the reason why the use of the “8/8ths” suffix to indicate that the interest being assigned is a “net interest,” not to be proportionately reduced is no longer sufficient. For example, if the desired result is that the division credit a party with a 0.03000000 overriding royalty interest, the grant or reservation should refer to a “net 3.0% of 8/8ths” overriding royalty reservation in the “lands covered by the leases which are the subject of the assignment” that is “not to be proportionately reduced in any way, regardless of the working interest in the leases included in this assignment, or the mineral interest covered by said leases.” If the intent of the parties is that the override be proportionately reduced to reflect the mineral interest covered and the working interest assigned, the drafter should avoid any terminology relating to a “net” or “8/8ths” interest, should ensure that the override is reserved in the “production attributable to the leases” that are the subject of the assignment, and should include proportionate reduction language that addresses both the mineral interest and the working interest.

§ 21.04            Enforcement of Express and Implied Covenants by the Overriding Royalty Interest Owner

Implied covenants between lessors and lessees of oil and gas leases have been recognized for over a hundred years. Although there is some disagreement among the commentators as to the reasons for the evolution of these implied covenants,[102] there seems to be a consensus that they arose from the principle of cooperation as defined in contract law, i.e., the requirement that the parties to a contract must cooperate with one another in order to ensure that the purpose of their contract is achieved.

The bare bones of the [oil and gas] leasing transaction are the transfer to the operator of the exclusive privilege of exploring, drilling on, and extracting minerals from the premises. In return for this exclusive privilege, the lessee promises to pay the lessor royalty on minerals produced and saved from the land. Pecuniary return to the landowner depends upon diligent operation of the premises by the lessee. If he permits oil and gas to be drained away from the land, the lessor’s return is diminished or destroyed. If the product is not marketed, there is no return. If the lessee fails to develop known, producing formations, return is delayed indefinitely. In each of these cases, as in others, the principle of cooperation requires that the lessee conduct operations calculated to accomplish the purposes of the lease agreement, namely, the exploitation of the mineral resources of the land.[103]

Generally, the implied covenants that apply to the contemporary oil and gas lease are:

(1)  the implied covenant to drill;

(2)  the implied covenant of reasonable development after discovery;

(3)  the implied covenant to protect the lease from drainage (also known as the offset well covenant or protection covenant); and

(4)  the implied covenant to operate diligently and prudently (which includes the duty of the lessee to market oil and/or gas from the lease).[104]

Recent legal decisions holding that an assignor or assignee of an oil and gas lease who retains an overriding royalty interest has legal standing to enforce implied covenants are still maligned in some jurisdictions as an attempt to rewrite assignments, but embraced in others as a logical extension of the duties that a lessee owes a lessor in order to effectuate the intent behind the lease. The editors of W.L. Summers’s The Law of Oil and Gas have expressed a strong aversion to the idea that an assignor-overriding royalty interest owner can enforce implied covenants, arguing that it violates “the privity concept on which the implied covenants between lessor and lessee sides of the leasing transaction is based.”[105]

Professor Eugene Kuntz has taken a more moderate approach, recognizing that the propriety of allowing overriding royalty interest owners to enforce implied covenants under an oil and gas lease depends on whether the override was created by grant or by reservation:

[T]he grant of an overriding royalty by the owner of the lease as distinguished from an exception or reservation bears no resemblance to a leasing or subleasing transaction. The relation is that of grantor and grantee, and there is no basis for concluding that the parties contemplated that the grantor would owe the grantee any duties regarding development. Accordingly, covenants usually implied in oil and gas leases should not be implied in this instance. . . . In the absence of an express covenant to develop and in the absence of special circumstances which reveal that development is the object of the sale, the covenants implied in oil and gas leases should not be implied in the grant of an overriding royalty interest.

Where an overriding royalty is reserved on the transfer of an oil and gas lease, the transaction bears a certain resemblance to a leasing transaction. The grantor has granted full operating rights and has retained a nonoperating interest that can only be enjoyed if the operating rights are exercised by the grantee.[106]

In Professor Kuntz’s opinion, the principles described above also apply to the grant or the reservation of a production payment.[107]

The weight of authority is to the effect that a covenant to drill a well is not to be implied from the severance of an overriding royalty or oil payment.[108] In the absence of an express provision in an assignment of a lease requiring the assignee/lessee to commence a well prior to expiration of the primary term, an assignor who reserves a production payment cannot enforce an implied drilling covenant against the assignee/lessee if the latter has the contractual choice, during the primary term of a lease, to either drill or pay delay rentals and has chosen to pay rentals.[109] If the assignor of a lease reserves an override and the assignment does not, by its express terms, require the lessee to drill on the lease during the primary term, the assignor cannot force the lessee to drill by asserting the implied covenant to protect the lease from drainage.[110]

Generally, covenants will be implied with respect to a nonoperating interest if the transaction giving rise to such interest creates a continuing relationship between the parties and the benefits of one party are dependent upon the development or operations of another. The covenants primarily recognized are the covenants of protection against drainage, of reasonable development, and of fair dealing and good faith.[111]

[1]       Enforcement of Implied Covenants as “Running With the Land”

The decision by the Fifth Circuit, in the case of Phillips Petroleum Co. v. Taylor,[112] was one of the first to recognize that the owner of a reserved overriding royalty interest in a lease has standing to enforce the lessee’s implied covenant to protect the lease from drainage. Applying Texas law, the court held that:

an overriding royalty, created by assignment, is an interest in real estate regarded as a covenant running with the land as between the assignor and assignee, and enforceable by the assignor against the assignee.[113]

Under the facts of this case, the only interest to be enforced by [the assignor-override owner] was the overriding royalty. The oil having been drained, the only recourse by which his injury could be compensated lay in a suit for damages. His interest being a covenant running with the land, and enforceable as such, it certainly follows that his protection and the administration of justice require that the right to sue be awarded to him. . . . [114] [A] contract which requires the assignee to advance money for drilling implies a covenant to develop. The same reasoning . . . raises an implied covenant in this case where the duty [to protect from drainage] was owed to the lessor and where the only consideration moving to the assignor for a conveyance of minerals . . . was an overriding royalty from the first oil produced. Unless such an obligation be imposed, the conveyance is wholly without consideration.[115]

The Texas Supreme Court has since ruled that the assignor of an oil and gas lease who retains an overriding royalty has the right to enforce the implied covenant to protect its lease from drainage. In Bolton v. Coats[116] the court held that: “[u]nless the assignment provides to the contrary, the assignee of an oil and gas lease impliedly covenants to protect the premises against drainage when the assignor reserves an overriding royalty.”[117]

In the case of Garman v. Conoco, Inc.,[118] the Colorado Supreme Court held that an implied covenant to market gas (i.e., “to engage in marketing efforts which ‘would be reasonably expected of all operators of ordinary prudence, having regard to the interests of both lessor and lessee’ ”[119]) extends to a Colorado overriding royalty interest owner, thereby excusing that owner from paying any share of post-production costs necessary to make that owner’s share of gas marketable. The rationale behind the ruling is obscure:

Implied lease covenants related to operations typically impose a duty on the oil and gas lessee. Accordingly, the lessee bears the costs of ensuring compliance with these promises. . . . The purpose of an oil and gas lease could hardly be effected if the implied covenant to drill obligated the lessor to pay for his proportionate share of drilling costs. In our view the implied covenant to market obligates the lessee to incur those post-production costs necessary to place gas in a condition acceptable for market. Overriding royalty interest owners are not obligated to share in these costs.[120] [121]

The mystery of the Garman decision dwells in footnote 23 where­in the court acknowledges that “[s]ome question exists whether the implied covenants under an oil and gas lease extend to overriding royalty owners. However, the rationale for application of the covenants to protect the lessor similarly extends to the interest of an overriding royalty owner.”[122] Whether this footnote is tantamount to a ruling that Colorado overriding royalty interest owners can enforce any and all implied covenants against a lessee remains to be established.

The Tenth Circuit has ruled that the assignor of a federal oil and gas lease located in New Mexico, who retained an overriding royalty interest in an assignment of that lease, has the right to enforce an implied covenant to protect against drainage against the assignee-lessee.[123]

[2]       Enforcement of Implied Covenants Arising Out of Express Covenants in the Assignment

The Oklahoma courts will extend the protection of implied covenants in an oil and gas lease to an assignor who retains an override, but only when the instrument creating the override contains an express provision that gives rise to an implied covenant. In Kile v. Amerada Petroleum Corp.,[124] Kile took a lease on 20 acres of land which provided, among other terms, that the lessee could extend the lease through the primary term by either drilling or paying annual delay rentals. Kile assigned the lease to Amerada, reserving a 1/8th overriding royalty interest. The assignment did not contain any requirements concerning drilling or development. Kile subsequently sued Amerada for damages resulting from the alleged drainage of his lease by offsetting production. The court, ruling in favor of Amerada, held that “[t]he relationship thus created between [Kile] and [Amerada] was purely contractual . . . [and] . . . the rights of the parties hereto must be governed entirely by the provisions of the contract of assignment [of the override].”[125] The court specifically rejected Kile’s argument that the obligation to drill an offset well was implied from the obligation to pay him an override.

The implied obligation is to diligently develop where there is some express obligation to drill assumed by the lessee, and, in such case, to protect the [lease] lines from drainage by offset wells. . . .[126]There must be some express covenant entered into upon which to base the implied obligation, and, if the court should undertake to supply the primary framework of the agreement which the parties themselves have omitted, it would constitute an invasion of the domain of private contract reserved to individuals under the law. . .

The contract involved here was an ordinary assignment of an oil and gas lease, reserving to the assignor a certain interest out of the working interest assigned, but without any specific agreement or covenant on the part of the assignee to drill on the premises covered by the assignment.[127]

In a subsequent opinion,[128] the Oklahoma Supreme Court confronted the same issue decided by the Colorado Supreme Court in Garman concerning an overriding royalty owner’s right to assert that its assignee-lessee had breached the implied covenant to market oil and gas by deducting from the revenues generated by the override the “post-production” costs incurred by the lessee to render the gas “marketable.” The court discussed in detail the evolution of the laws in Colorado[129] and Texas[130] granting overriding royalty interest owners the right to enforce selective implied covenants in an oil and gas lease. Unfortunately for SMR, the override owner, its interest was created pursuant to a grant, not a reservation.[131] Citing the above-quoted statement of Professor Kuntz that an override created by a grant, as opposed to a reservation, should not reap the benefit of implied covenants in a lease,[132] the court reaffirmed its ruling in Kile[133] that the right to enforce the implied covenants of an oil and gas lease does not extend to an overriding royalty interest owner absent an express provision in the instrument creating the override giving rise to the implied covenant.[134]

Like its neighbor to the west, Arkansas does not permit the owner of an overriding royalty interest or a production payment to enforce implied covenants against a lessee.[135] The Arkansas Supreme Court refused to accept “as a matter law” an implied duty of the assignee-lessee to reasonably develop an oil and gas lease and protect it against drainage when the only consideration for the assignment of the lease was the reservation of an override. Instead, it followed its earlier ruling in Henderson Co. v. Murphy,[136] which involved an oil payment, and held that Arkansas does not recognize the right of an overriding royalty interest owner to enforce the implied covenants under a lease.[137] “In assignments, such as these in the instant case, the assignor and assignee are usually experienced in the oil business and knowledgeable enough to make certain any uncertainty by inserting provisions which protect the assignor’s interest if he deems it necessary.”[138]

Another of the objections raised in W.L. Summers’s The Law of Oil and Gas with regard to the enforcement of implied covenants in an oil and gas lease by an overriding royalty owner was the advantage that the owner would have in any determination of the economic viability of development:

It [permits] an interest owner who has further diminished the production entitlement of the leasehold working interest to enforce his claims in terms of a standard of paying quantities in the case of the drainage and development covenants, which was larger than the working interest entitlement after its diminishment by retention of an overriding royalty.[139]

A solution to this potential inequity has been suggested by Williams & Meyers:

Both the lessor and the owner of an override, suing on an implied covenant to protect against drainage, may be required to prove that an offset well, if drilled, would have been profitable. In proving profitability, the lessor would need [to] prove only that the return from production after deducting landowner royalty would have been sufficient to yield a profit to the lessee; the owner of the override would be required to deduct the override as well as the landowner royalty in determining whether an offset well would have been profitable.[140]

For obvious reasons, any instrument creating an overriding royalty interest should include a provision stating that any and all implied covenants in the lease will run to the owners, successors, and assigns of operating or nonoperating interests in the lease.[141] A provision in an assignment such as that which follows, prohibiting the owner of an override or production payment from asserting any rights arising out of implied covenants, is also enforceable.[142]

Development of, and operations on the premises, if any, and the extent and character thereof, as well as the preservation or forfeiture of the leasehold, shall be solely at the will of said [operator] or its successors or assigns, and, upon termination of the leases covering the lands above described, for any cause whatsoever, there shall be no further liability hereunder.[143]

§ 21.05  Pooling and Unitization

The formation of voluntary units, federal exploratory units in particular, is tedious and time consuming. Once the operator has obtained the necessary percentage of committed working interest ownership in a proposed unit area required by the authorizing governmental agency, the tendency is to pull back on efforts to ensure the commitment of the remaining owners, especially owners of royalty and overriding royalty interests. Unfortunately, once the unit has been approved, sophisticated overriding royalty interest owners may not consider subsequent joinder to be in their best economic interest. By failing to secure the commitment of nonoperating interests in the unit area, the operator runs the risk of becoming obligated to pay uncommitted overriding royalty interest owners on a “lease” basis (i.e., based upon their ownership in the drillsite lease), while paying committed owners on a “unit” basis (i.e., according to their proportionate interest in a spacing unit or a participating area). As a result, the working interests may find themselves forced to bear out of their share of production a disproportionately large burden of landowner and overriding royalties.

“Unilateral” pooling and unitization provisions in an oil and gas lease give the lessee the right to pool or unitize the royalty interest in the lease without the necessity of the lessor’s consent. There is a common belief that the nonoperating interests in a lease that contains a unilateral pooling and/or unitization provision, including overriding royalty interests, are also subject to the provision, obviating the need for their consent.

Even in Texas, we think a persuasive argument can be made that the owner of a working interest burdened by a nonoperating interest does have the power to pool the nonoperating interest if the oil and gas lease contains a pooling clause, unless the assignment or other instrument creating the nonoperating interest clearly negates the [working interest owner’s] ability to do so.[144]

A decision by the Texas Court of Appeals in Union Pacific Resources Co. v. Hutchison[145] supports the proposition that a lessee can pool or unitize the royalty interest in an oil and gas lease pursuant to a unilateral pooling or unitization clause, and thereby pool or unitize any overriding royalty interests burdening that lease without the necessity of the owner’s consent.[146]

In an assignment dated one day after the lease, [the assignor] assigned the leasehold in its entirety . . . except for her overriding royalty, vesting in [assignee-lessee] by her own act all executive rights.

. . . .

Nothing in the assignment purports to reserve in [assignor] any executive rights and nothing purports expressly to prohibit pooling of the mineral estate without [assignee’s] consent.”[147]

. . . .

[Assignor] assigned the leasehold in its entirety to [assignee], except for her overriding royalty. . . . The legal effect of her unqualified assignment was to vest in [assignee] . . . the identical rights, privileges and benefits [assignor] possessed under the . . . Lease.[148]

Unfortunately, the Wyoming Supreme Court has turned conventional thinking on its ear with its decision in Moncrief v. Harvey[149] concerning the calculation of an overriding royalty interest in a State of Wyoming oil and gas lease within a federal exploratory unit. Harvey, the original lessee under the state lease which covered 560 acres, assigned the lease to Texaco, reserving a 5% of 8/8ths overriding royalty interest. There was no applicable language in the assignment from Harvey to Texaco with regard to unitization, but a provision in the lease gave the state the right “with consent of the lessee, to commit the [lease] in a unit . . . and to establish, alter, change or revoke the drilling, producing, and royalty requirements of the lease to conform therewith.”149.1 Texaco and the State of Wyoming voluntarily committed their interests in the lease to the unit, but Harvey refused. A producing well was drilled on the subject lease resulting in the creation of a participating area (PA) covering 1,440 acres, including the 560 acres in the subject lease. Moncrief and Texaco, the working interest owners of the well, argued that under the terms of Harvey’s lease, the fact that the State and Texaco had committed their interests to the unit resulted in the commitment of Harvey’s override, with or without his express consent. Consequently, Harvey’s override should be paid on the basis of the PA, meaning that his 5% overriding royalty interest would be proportionately reduced by a fraction of 560/1440ths. Harvey countered with the allegation that his override could not be committed without his express consent, and claimed that he was entitled to a full 5% of 8/8ths override, payable on a “lease” basis.

Citing the fact that “[c]ommitment of a tract to unitization obviously involves a calculated weighing of the benefits and detriments involved in unitizing the subject lands,”[150] the Wyoming Supreme Court ruled in favor of Harvey, holding that:

[T]he word “lessee” as used in the unitization clause was intended to cover lessee/assignors who retain an interest in the lease. A lessee/assignor who retains an interest is subject to many of the same risks as the assignee if the leasehold is unitized without his consent. . . . We hold that the unitization clause could not unitize Harvey’s overriding royalty interest without his consent, and his consent was never given.[151]

In another decision,[152] the Wyoming Supreme Court held that an overriding royalty interest in a lease with no unitization clause that had been committed to the unit by the lessor but not by the owner of the overriding royalty will still be deemed “committed” to the unit when the override is to be “computed and paid on the same basis, in the same manner, at the same time and on the same products, substances and elements, as is the royalty payable to the Lessor.”[153] According to the court, the language concerning the payment of the override was clear and unambiguous. Since the lessor had joined the unit, and the landowner royalty was being paid on a prorated unit basis, the same method of payment should apply to the override.[154]

§ 21.06  The Nonoperating Interest and Bankruptcy

Section 541(a)(1) of the U.S. Bankruptcy Code defines a bankrupt’s estate as “all legal or equitable interests of the debtor in property as of the commencement of the case.”[155] This provision has protected owners of overriding royalty interests whenever the working interest owner who bears the override files bankruptcy (assuming that the conveyance creating or reserving the override has been properly executed and recorded). Section 541(b)(4)(B)(i) of the Bankruptcy Code specifically excludes an interest that the debtor has conveyed “pursuant to a written conveyance of a production payment to an entity that does not participate in the operation of the property from which such production payment is transferred.”[156]

The case of Boyd v. Martin Exploration Co.,[157] a U.S. district court decision applying Louisiana law, illustrates the Bankruptcy Court’s traditional approach towards overriding royalty interests created prior to a bankruptcy filing. Martin Exploration Co. (MECO) had an incentive program, embodied in an “Employee ORI Agreement,” which provided that key employees would receive overriding royalty interests in all nonproducing oil and gas leases that the company acquired. Initially, assignments of these overrides were made to the key employees as soon as the leases were acquired, but as the business grew and the demands on the employees’ time increased, the assignments were neglected. In an effort to fix the problem, the company started transferring the overrides due key employees to a nominee, pursuant to a nominee agreement, to be administered on the employees’ behalf. Nevertheless, some overrides were never assigned to the employees or the nominee. When the company filed for Chapter 11 bankruptcy protection, the key employees initiated an adversary proceeding seeking assignment of the overrides that had never been conveyed.

The overriding royalty interests that had actually been assigned to the employees were never an issue since MECO had no legal or equitable claim to them. With regard to the overrides that had been assigned to the nominee, or were earned under the Employee ORI Agreement but never assigned to the employee or nominee, the district court held that: (1) the Employee ORI Agreement was sufficient to transfer title to the overrides provided for in the agreement from the company to the employees, citing Louisiana law holding that “[a]ll sales, contracts and judgments affecting immovable property, which shall not be recorded, shall be utterly null and void, except between the parties thereto”;[158] and (2) MECO did not have any beneficial interest in the overrides assigned to the nominee since the overrides were being held “in trust” for the employees, and both MECO and the nominee were under a fiduciary duty to assign those interests to the employees.[159]

The antithesis of Boyd is an opinion by the Colorado Court of Appeals in the case of Grynberg v. Waltman,[160] which upheld a Bankruptcy Court’s decision discharging not only a debt owing for unpaid production revenues attributable to an overriding royalty interest, but the overriding royalty interest itself. The case was originally filed by Grynberg in the Denver district court, subsequent to the approval of this Chapter 11 reorganization plan by the U.S. Bankruptcy Court, seeking a declaratory judgment that overriding royalty interests previously assigned to Waltman while he was employed as exploration manager for Grynberg were extinguished as a result of confirmation of the plan. Waltman had left Grynberg’s employ sometime prior to the bankruptcy filing, whereupon Grynberg stopped paying Waltman the overrides he had been assigned, and informed Waltman that no further overrides would be paid. After his filing for Chapter 11 protection, Grynberg named Waltman as a creditor with a disputed claim. Waltman knew about the bankruptcy proceeding, and even testified in hearings related to the case, but failed to file a proof of claim with regard to the disputed override in spite of an order from the court instructing every creditor to do so. Grynberg’s plan was eventually approved free of any further obligation to Waltman.

Waltman acknowledged that payments due on production prior to the bankruptcy petition were personal property, and dischargeable as a debt, but argued that the overriding royalty interests that had been assigned to him were his own real property interests not subject to discharge in Grynberg’s bankruptcy. The district court and the Colorado Court of Appeals disagreed, holding that “according to 11 U.S.C. §1141(b)(1994), upon confirmation of a bankruptcy plan, all property of a debtor’s estate is vested in the debtor free and clear of any claim or interests of the creditors . . . [and that] [u]nder 11 U.S.C. §1141(d)(1)(B) (1994), confirmation of such plan terminates all disputed rights and interests of equity security holders. . . .”[161]

Here, [Waltman] has acknowledged in his motion for summary judgment that both parties were aware that the ownership of the overriding royalty interests was in dispute at the time of plaintiff’s bankruptcy proceedings. [Grynberg’s] bankruptcy estate included the oil and gas leaseholds and necessarily dealt with the overriding royalty interests connected with them.

Once the claim to royalty payments based on the overriding royalty interests was disputed, the ownership of that interest was called into question and was, therefore, before the bankruptcy court. . . . Subsequently, by operation [of] 11 U.S.C. §1141(b) (1994), plaintiff’s estate, including the oil and gas leases, vested in him free of defendant’s contested royalty interests when the bankruptcy plan was confirmed.[162]

The downfall of Waltman appears to have been his failure to file a proof of claim.

A proof of claim is a written statement that apprises the court of the existence, nature, and amount of the claim. . . . A creditor whose claim is not listed on the [debtor’s] schedules or whose claim is listed as disputed, contingent or unliquidated must file a proof of claim by the claims “bar date” or he may not vote on a plan of reorganization or share in any distribution of property of the debtor’s estate. . . .

By filing a claim against a bankruptcy estate, a creditor triggers the process of allowance and disallowance of claims, thereby subjecting himself to the bankruptcy court’s equitable power. Thus, once the creditor files a proof of claim, neither the debtor nor the creditor is entitled to a jury trial.[163]

A production payment, like an overriding royalty interest, is usually classified as an interest in real property. But a “hybrid” production payment, created under a “Production Payment Loan Agreement,” secured by a lien on the assignor’s mineral interest and classified as a “loan” for federal tax purposes, can be deemed a secured loan in a bankruptcy proceeding. If so, the owner of the “hybrid” will be deemed a “secured creditor” by the Bankruptcy Court, and can be held liable for administrative expenses incurred by the bankrupt’s estate that are necessary to maintain the secured creditor’s collateral. The foregoing set of facts was behind the ruling in the Fifth Circuit case captioned In re Senior-G & A Operating Co. v. Aguillard,[164][165]wherein the court held that under the terms of the Production Payment Loan Agreement between Senior-G & A Operating Co. (the assignor of the production payment) and PSI, Inc. (the holder of the production payment), “Senior mortgaged—it did not transfer—its mineral interest in the well to PSI (and also pledged its production), and under Louisiana law, PSI must be classified as a secured creditor as opposed to a royalty owner.”[166]

When PSI asserted rights against Senior’s interest in the well pursuant to the loan agreement it became part of the “ ‘process of allowance and disallowance of claims’ [or] the restructuring of debtor-creditor relations” under the jurisdiction of the bankruptcy court, and was liable for its proportionate share of “administrative expenses” under 11 U.S.C. § 506(c).[167]

§ 21.07            Matters to Be Considered in Drafting an Assignment or Reservation of an Overriding Royalty Interest

Honorable people will abide by commercially reasonable provisions included in a grant or reservation of an overriding royalty interest or other form of nonoperating interest. In the absence of honor, commercially reasonable terms written in clear, concise, and unambiguous language usually can be enforced in a court of law, assuming money is no object. In the absence of honor or money, the parties to a grant or reservation of a nonoperating interest have nothing to lose by defining their respective rights and obligations. The following is a checklist of items to be considered in conjunction with grants or assignments of overrides, production payments, and net profits interests:[168]

(1)       How is the nonoperating interest to be calculated?

(2)       What expenses, if any, are to be borne by the interest?

(3)       How should the interest that the parties intend to reserve or convey be expressed to allow for, or avoid, proportionate reduction?

(4)       Will the interest attach to: (a) extensions, renewals, and/or modifications of the original lease and/or (b) new leases taken by the assignee, its agents, or assigns within a specified time after the expiration of the original lease? Is a rule of perpetuities savings clause necessary with regard to future rights in “new” leases?

(5)       Should the instrument creating or reserving the interest give the owner the right to enforce all implied covenants under the burdened lease?

(6)       Should the instrument creating or reserving the interest contain express drilling and development obligations, especially with regard to the primary term, that go beyond those implied in an oil and gas lease?

(7)       Is the interest entitled to share in advance payments or “take-or-pay” payments received by the lessee under gas purchase and processing agreements?

(8)       Is the owner of the interest entitled to take production in kind and, if so, how will revenues be calculated on (a) the share of the owner’s oil and gas that is used to produce the well, (b) the share of the owner’s oil and gas that is lost in the course of production, and (c) the share of the owner’s oil and gas that may be reinjected into the well for pressure maintenance and other purposes?

(9)       Can the assignee/lessee pool or unitize the interest without the owner’s consent and, if so, how?

(10)     Should any dispute with regard to the interests be subject to binding arbitration, mediation, or other methods of alternative dispute resolution?

(11)     Should attorneys’ fees and costs be recoverable in the event of a dispute or litigation concerning the interest and, if so, from whom?

(12)     Should the instrument creating the interest contain a provision binding the burdened party and its successors from disputing the interest or claiming a right to the interest in a bankruptcy or insolvency proceeding affecting the burdened party?

In the event all efforts to include special provisions in an instrument creating an override or other form of nonoperating interest are rebuffed, just remember the words of Professor Kuntz, paraphrased for the proper effect, who said that “It is better to reserve than to receive.”