252 Bowden v. Phillips Petroleum Co.

Richard F. Brown

 
The following is not a legal opinion. You should consult your attorney if the case may be of significance to you.
 
Bowden v. Phillips Petroleum Co., 247 S.W.3d 690, (Tex. 2008), examines whether three subclasses of a class of oil and gas royalty owners were properly certified. The case is focused on dominance and commonality issues in a class action based on royalty clauses. Class members, comprised of Texas royalty interest owners under lease to Phillips Petroleum Company (“Phillips”), initiated suit against Phillips alleging that Phillips’ self-dealing transactions resulted in underpayment of royalties payable to them under their leases. A class action will be precluded if individual issues predominate over common issues. This rule is meant to prevent the jury from being overwhelmed or confused by the complexity and diversity of the individual issues. The court analyzed whether the three subclasses violated this predominance rule.
 
Subclass 1 was comprised of royalty owners with “proceeds” gas royalty clauses and whose gas was sold by Phillips as lessee to a Phillips affiliate. “Proceeds” clauses require that Phillips calculate the royalty as a percentage of the proceeds. Royalty owners asserted that there was a common question for Subclass 1: “whether Phillips failed to reasonably market the gas.” The royalty owners argued that Phillips failed to act as a reasonably prudent operator by selling gas to its wholly-owned affiliate.
 
Many of the leases contained varying express marketing provisions, which were individual issues, and the court of appeals concluded these issues would predominate, thus defeating the class. The Texas Supreme Court did not believe the record was clear enough to support the conclusion that the express duty to market would in practice require different conduct from the duty based on the implied covenant to market. However, the Texas Supreme Court held that even if Phillips owed identical duties to market to all of Subclass 1 royalty owners, Subclass 1 still would not meet the predominance requirement. Whether under an express or implied duty, the jury would have to determine the price a reasonably prudent operator would have received at the wellhead. The varying well locations, quality of the hydrocarbons being produce, field regulations, and other factors would require that the jury conduct a well-by-well analysis. Absent particular evidence that the gas price at the wells can be evaluated classwide, this defeats the predominance requirement. The court noted that in certain circumstances it might be possible to show that a lessee failed to diligently market the gas and obtain a reasonable price for a class of lessors, but royalty owners did not present classwide evidence in this case.
 
Subclass 2 was comprised of royalty interest owners whose royalties were calculated pursuant to the uniform language of Gas Royalty Agreements. The court of appeals decertified Subclass 2 on predominance grounds, holding that the Gas Royalty Agreements were ambiguous. The court of appeals reasoned that because the agreements were ambiguous, the jury would have to hear evidence to determine the intent of thousands of individual royalty owners and then determine whether the parties reached a meeting of the minds on the formula used to calculate royalties.
 
The Texas Supreme Court held that the contracts were not ambiguous and therefore, the subclass did not violate the predominance rule. The royalty owners asserted that Phillips underpaid on royalties because Phillips calculated their royalties based on the dry residue gas instead of the wet gas as produced and as adjusted for the Btu content of the gas. The Gas Royalty Agreements specifically stated how the royalty should be calculated and provided Phillips must pay a royalty on “all sweet gas and sour gas, including all the components thereof, produced from said land and sold or used off the premises” (emphasis by the court). “Liquid products are originally constituent parts of the natural gas produced by Phillips.” The court held this was not ambiguous and that the royalty owners were entitled to be paid based on the value of the natural gas and all of its components.
 
However, the Texas Supreme Court also held that the royalty owners were incorrect in their argument that the royalty should be based on an average of the prices Phillips received for the separate sales of dry residue gas and liquid components. Phillips was required to account based on the volume of natural gas metered at the wells multiplied by a price averaged from sales to third parties, before liquid products were extracted or processed. Similarly, the Gas Royalty Agreements did not have any provision relating to heating content, or an adjustment for heating content, and therefore royalty was payable based on volume and price. “Unless otherwise specified in the mineral lease, generally, the lessee or producer will bear both the cost and benefits for processing and treatment of those minerals after the initial production.”
 
Subclass 3 was comprised of royalty owners whose leases provided for royalties under either an amount-realized/proceeds basis or under a market value basis. Phillips sold the gas under percentage of proceeds (“POP”) contracts. The sales were to Phillips’ affiliate under variable numbers for the POP contract. For example, the POP contract could be 80/20, by which Phillips received 80% of the proceeds from both residue gas and liquids, and Phillips’ affiliate retained the other 20%. Lessors contended the proceeds retained by the affiliate represented a fraudulent post-production fee and that the arrangement was a breach of the implied duty to manage and administer the gas leases. The Texas Supreme Court rejected this concept of the implied covenant and clarified its opinion in Yzaguirre v. KCS Resources, Inc. “Thus, the royalty owners misread our holding in Yzaguirre to suggest we have recognized a ‘duty to manage’ and administer the lease as a reasonably prudent operator distinct from a duty to market as a reasonably prudent operator.” There is a broad duty to manage and administer the lease, and a specific duty to market.
 
The Texas Supreme Court held that by including both proceeds/amounts realized and market value leases, Subclass 3 was improperly certified because it failed to meet the commonality requirement necessary to certification. In reaching its conclusion, the court relied on Union Pac. Res. Group v. Hankins, where it held that even under the commonality requirement’s low threshold, a class with both proceeds leases and market value leases will fail. There is an objective basis for calculating royalties under a market value lease that is independent of the price that lessee actually obtains. Therefore, the court does not recognize the implied covenant to obtain a better price for a market value lease. Because market value leases do not carry with it the implied covenant to obtain a better price, while proceeds leases do, Subclass 3 does not satisfy the commonality requirement necessary to certify.
 
The significance of the case is that it continues the trend toward refusing to certify class claims for royalty, but at least one class did get certified. The Texas Supreme Court also continues to read royalty clauses quite literally, without regard to current marketing complexities, and by drawing a bright line in defining the issues on wellhead sales. “Unless otherwise specified in the mineral lease, generally, the lessee or producer will bear both the cost and benefits for processing and treatment of those minerals after the initial production.” This is a very clear statement of the court’s construction of wellhead sales. The case also clarifies that there is not an independent implied covenant to manage and administer the lease as a reasonably prudent operator distinct from a duty to market as a reasonably prudent operator.