120 Coastal Oil & Gas v. Roberts

Richard F. Brown

 
The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.
 
Coastal Oil & Gas Corp. v. Roberts, 2000 Tex. App. LEXIS 5974 (Tex. App.—Corpus Christi 2000, n.p.h) construes a provision of an oil and gas lease which permits the lessor to terminate the lease for failure to pay royalties. Payment of royalties under the lease was expressly governed by a clause in the lease which provided:
 

Royalties and other payments for production shall be due and owing to Lessor within 120 days from the date of first production, and thereafter such payments shall be due on or before the end of the second calendar month following the month in which the production for which the royalties or payments are to be made are sold and delivered. If Lessee wrongfully or unreasonably withholds any such payment or payments due to Lessor for a period of thirty (30) days after written demand for payment is made by Lessor on Lessee at the above address (or other such address as made by specified in writing hereafter by Lessee), at the election of Lessor this lease may be terminated. [emphasis added]

 
Coastal drilled a gas well on November 19, 1997. On February 28, 1998, Coastal sent division orders to all interest owners with a letter that stated that Coastal would pay royalties to the interest owners upon receipt of a completed division order. Several of the lessors (“Coates”) did not return a division order to Coastal. Under the terms of the lease, royalties were due March 19, 1998, which was 120 days from the date of first production. Coates sent a written demand for payment on March 24, 1998, stating that royalties were due and owing for the lease and that Coastal had 30 days from receipt of the letter to pay all amounts due and owing. Coastal responded by letter dated April 21, 1998, stating that Coates’ demand for payment was insufficient and deliberately vague because it did not explain the amounts owed or how Coastal had improperly calculated royalties. On May 4, 1998, Coates notified Coastal that Coates elected to terminate the lease. The trial court granted Coates’ motion for summary judgment and terminated the lease.  Coastal appealed.
 
The Corpus Christi Court of Appeals affirmed the judgment of the trial court. Ordinarily, termination of an oil and gas lease can only occur if there is a breach of a special limitation or condition subsequent. Non-payment of royalties is usually considered a breach of a covenant which will subject a party to liability for damages, but not lease termination, unless the lease includes a clause which makes nonpayment of royalties a breach of a special limitation or condition subsequent. The Court of Appeals ruled that the lease included an express condition subsequent that the lessor could terminate the lease if Coates could prove that the following three elements occurred:
 

1. Coastal failed to pay royalties on a timely basis;
2. Coates gave Coastal a written demand for payment; and
3. Coastal wrongfully or unreasonably withheld payment for 30 days following the demand.

 
The evidence was undisputed that Coastal failed to pay royalties on a timely basis. Coastal argued that the written demand was not adequate because the demand letter failed to specify the particulars of any breach. The Court ruled that the lease only required “written demand of payment,” and that the demand letter complied with the terms of the lease.
 
The most interesting part of the case was the Court’s construction of the operation and effect of the Texas division order statute in determining whether Coastal “wrongfully or unreasonably” withheld payment. Because “reasonably” arguably was a fact question not subject to resolution by summary judgment, the Court focused on the meaning of “wrongfully” and the Texas division order statute. Coastal argued that it had withheld payment of royalty pursuant to Section 91.402(c)(1) of the Texas Natural Resources Code, which permits a payor (lessee) to withhold payments of royalties to a lessor pending receipt of a division order. Because Coastal was withholding payment pursuant to a statute, Coastal argued that withholding payment from Coates was not “wrongful or unreasonable,” and because Lease F expressly stated that royalty payments that were withheld pursuant to “any law, order directive or regulation of any governmental or regulatory body having jurisdiction” would not be considered “wrongful or unreasonable.”
 
Under Section 91.402(e) of the Texas Natural Resources Code, if a division order contains provisions in addition to any statutorily permitted provisions, the lessee cannot withhold payment solely because the lessor refused to sign the division order. Coates asserted that it did not sign the division order because it contained an unauthorized provision regarding indemnification. Section 91.402(c)(1) permits lessees to require signed division orders from lessors, but only with certain standard provisions. One of the provisions lessee may include is an agreement that lessor will indemnify lessee for payments made to the lessor, if the lessor does not have merchantable title to the production sold, “unless otherwise agreed.” The lease was expressly made without warranty of title. Therefore, Coates and Coastal had “otherwise agreed” not to indemnify Coastal with respect to title. The Court of Appeals ruled that Coastal’s division  order  did  not  comply  with Section 91.402(c)(1); thus, Coastal could not withhold payments based on that statute.
 
Coastal also argued that it complied with Section 91.402(d) of the Texas Natural Resources Code, which provides an alternative form for division orders. However, the Court of Appeals stated that Section 91.402(d) applied to division orders for “oil payments only,” and because the producing well was a gas well, Section 91.402(d) was inapplicable. Coastal’s division order for gas was required to comply with Section 91.402©)(1). The Court of Appeals noted that Webster’s New Twentieth Century Dictionary defined wrongful as “full of wrong; unjust, unfair or injurious,” and “unlawful.” [emphasis added] Because Coastal’s withholding of royalty was not authorized by Section 91.402(c)(1) of the Texas Natural Resources Code, the withholding was “unlawful”; therefore the withholding was “wrongful.” Coastal also was not entitled to rely on the provision of the lease permitting withholding of royalty if done under “law, order, directive or regulation of any governmental or regulatory body having jurisdiction.”
 
The case is significant for the holding that Tex. Nat. Res. Code § 91.402(d) is applicable only to oil division orders. This case is significant for both lessors and lessees. If a lessor includes such a cancellation clause in his lease, lessor certainly increases lessor’s leverage over lessee to force timely payment of royalties. Termination of a producing lease for failure to timely pay royalty is draconian and fundamentally unfair, but enforceable. Including a provision that the lease is without warranty strips the lessee of any reasonable opportunity to avoid the risk of wrongful payment, because lessee will have to pay every possible claimant. Obviously, lessee should avoid leases with such clauses. Standard oil and gas leases already may be canceled for failure to timely pay delay rentals and shut-in gas payments and failure to produce in paying quantities. Agreeing to a provision canceling a lease for failure to timely pay royalties will only add more obligations and problems for the lessee. For those lessees operating leases containing similar lease cancellation provisions, the lessee should be careful in suspending royalties for any reason. The consequence could be irreversible. It should be noted that in this case Coastal made no payment, which leaves open the question of the effect of a partial payment or incorrect payment.