Face Challenges Confidently

542 KCM Financial LLC v. Bradshaw

Tuesday, February 2nd, 2016

Richard F. Brown

The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.

KCM Financial LLC v. Bradshaw examines the nature of the duty owed by the executive and the executive’s lessee to the non-executive in an oil and gas leasing transaction. Two deeds executed in 1960 reserved a non-participating royalty interest. The deeds reserved an undivided one-half of any future royalty, but not less than a one-sixteenth share of gross production. The parties to the litigation aligned as successors to the Executive, Non-Executive, Lessee, and Executive’s Assignees. The Executive leased for a 1/8th royalty and a bonus of more than $13 million, and the Executive conveyed part of the Executive’s royalty interest to the Executive’s Assignees. The Non-Executive contended that the terms of the leasing transaction were for a sub-market (1/8th rather than 1/4th) royalty rate (shared by the Executive and the Non-Executive), an above-market bonus (payable only to the Executive), that the Lessee acted in concert with the Executive, and that a constructive trust should be imposed on the royalty payments payable to the Executive’s Assignees. The Executive and the other defendants won on summary judgment in the trial court. The core issue on appeal was the nature of the duty owed by an executive to the non-executive.

The Court reviewed all of its prior holdings, which referred to the duty as one of “utmost fair dealing,” “confidential relationship,” “utmost good faith,” or “a fiduciary relationship,” and which occasionally held that “the executive’s duty is to acquire for the non-executive every benefit that he exacts for himself.” The Court concluded:

If the semantics surrounding the nature of this duty have shifted subtly over the years, this much is clear: An executive owes a non-executive a duty that prohibits self-dealing but does not require the executive to subjugate its interests to those of the non-executive. Thus, in ascertaining whether the executive breached its duty to the non-executive, the controlling inquiry is whether the executive engaged in acts of self-dealing that unfairly diminished the value of the non-executive interest. Although the contours of the duty remain somewhat indistinct, these tenets guide our analysis of the claims before us.

The Court recognized that “[a]s articulated, the executive’s duty is deceptively simple in its explication, but not necessarily straightforward in its application.”

This is because obtaining the same royalty is not necessarily equivalent to obtaining the same benefit. This case is focused on the interplay between royalty and bonus, but the interests and benefits of the executive and the non-executive can also diverge on other issues, such as surface damages, water rights, well locations, easements, drilling commitments, development of other tracts, timing of development, etc. Obviously, the executive will almost never acquire for the non-executive “every” benefit he acquires for himself. For example, a non-participating royalty owner does not share in bonus or delay rentals. “This situation thus presents a conundrum that requires balancing the bundle of rights that comprise a mineral estate.”

The Court then examined the facts of the case and concluded that on the record there was some evidence precluding summary judgment as to whether the Executive breached the Executive’s duty to the Non-Executive. “Although in many cases this will be a fact question, we do not foreclose the possibility that breach of duty may be determined as a matter of law, depending on the evidence in a particular case.” Nevertheless, it is clear that a breach will generally be a fact question, and the Court does not expressly explain how the issue is to be submitted. The opinion does say that “the subject transaction must be viewed as a whole in determining whether the terms of a mineral lease, including the negotiated royalty, reflect the executive’s utmost good faith and fair dealing vis-à-vis the non-executive.”

Our decision today reaffirms a principle that has existed in our jurisprudence for eighty years: An executive owes a duty of utmost good faith and fair dealing to a non-executive and is prohibited from engaging in self-dealing in connection with the formation of a mineral-lease agreement. However, the failure to obtain a market-rate royalty does not, in and of itself, constitute a breach of that duty.

The Court then considered whether any of the derivative claims against the Lessee could be sustained. Regardless of whether the jury ultimately determines the Executive breached the Executive’s duty to the Non-Executive, there was, as a matter of law, no evidence that Lessee breached any duty owed to the Non-Executive. Regardless of the Lessee’s knowledge of the existence of the non-participating royalty interest and regardless of the Lessee’s knowledge of the tension between the Executive and the Non-Executive, “the uncontroverted evidence reflects that [Lessee] merely secured a mineral-lease agreement on mutually acceptable terms.”

The Texas Oil & Gas Association argues in an amicus brief that a lessee should not be tasked—directly or derivatively—with policing the executive’s duty to non-executive interest holders. Nor should a lessee be expected to give weight to a non-participating royalty interest holder’s economic interests; as we have held, that is the executive’s responsibility. We agree with the Association that ‘in negotiating with the executive, a lessee should not fear liability for doing nothing more than getting a good deal closed.’

If there is no existing fiduciary or confidential relationship between the lessee and the non-executive, and if the lessor and lessee are unaffiliated parties except as adverse parties in an arm’s-length leasing transaction, after this decision, it is very unlikely that the lessee will be subjected to some derivative liability or duty to the non-executive.

The Court also rejected the constructive trust claim against the royalty owned by the Executive’s Assignees, because the interest transferred to them was out of the 1/2 interest owned by the Executive, which was not owned by the Non-Executive.

The significance of the case is the effort to clarify the nature of the duty. In the leasing transaction, it is not a traditional fiduciary duty; it is a duty of utmost good faith and fair dealing. Breach of the duty will generally be a fact question, and the pivotal issue will usually be whether the executive obtained some benefit for himself, but not for the nonexecutive, through some “legal contrivance” that unfairly diminishes the value of the non-executive interest. The lessee generally has no duty to protect the non-executive in the leasing transaction and need not fear liability for doing nothing more than getting a good deal closed.