We sometimes report on recent court decisions that deliver bad news for the oil and gas industry. It thus is a pleasure to report a piece of good news, based on a well-reasoned and, in our view, correct opinion—namely, the Louisiana Supreme Court’s recent decision in McCarthy v. Evolution Petroleum Corp., 2014-C-2607 (La. 10/14/2015), available McCarthy, which reversed a decision of the Louisiana Second Circuit Court of Appeal in favor of a landowner based on a “novel and untested,” overly broad, and ultimately, in our view, incorrect interpretation of Mineral Code article 122.

Mineral Code article 122 is one of the foundational articles of Louisiana mineral law; its importance cannot be overstated. It governs the basic relationship between mineral lessors and lessees and provides in full as follows:

A mineral lessee is not under a fiduciary obligation to his lessor, but he is bound to perform the contract in good faith and to develop and operate the property leased as a reasonably prudent operator for the mutual benefit of himself and his lessor. Parties may stipulate what shall constitute reasonably prudent conduct on the part of the lessee.

In the McCarthy case, the Second Circuit ruled that a lessee’s long-standing relationship with a lessor, while not creating a “fiduciary” relationship between the two, nonetheless could give rise to a duty for the operator “to inform its lessors and not remain silent on its plans to fulfill its obligation as a reasonably prudent operator.”  In support, it pointed to article 122’s requirement that the lessee “operate the property leased as a reasonably prudent operator for the mutual benefit of himself and his lessor.”  The court found that this “duty to inform,” if violated, could give rise to a claim for “fraud by silence” against the lessee, should it remain silent with its lessor(s) regarding its plans when dealing with them.

More specifically, in the McCarthy case, a series of lessees operated the lease under a sixty-plus year old lease that provided for a one-eighth royalty to the lessors.  Production from the lease had decreased recently, but the lessee believed production could be substantially increased through the use of “CO2 enhanced oil recovery technology.”  The lessee thus sought and found a buyer with the willingness and ability to operate the lease through such technology (Denbury Resources, LLC).

In the meantime, the lessee offered to purchase the lessors’ royalty interests for a price equivalent to 16 years’ worth of previous royalties attributable to the lessors’ rights. Two lessors accepted the offer in this suit, selling their rights for approximately $32,000 and $10,000.

But these rights were worth substantially more—allegedly likely millions of dollars—with the increased production from the enhanced oil recovery technology. The lessors sued their former lessee for fraud by silence and fraud by misrepresentation.

The obvious defect with these claims is that a purchaser of a mineral interest has no duty to disclose to the seller its belief about the actual value of the interest. Plaintiffs sought to overcome this defect by alleging a “relation of confidence” had developed between the lessees and the lessors over the previous 60 years of mineral production.  They claimed this relation created a duty to speak to prevent fraud by silence.  They also claimed the lessee committed fraud by misrepresentation by offering the lessors an amount based on prior mineral production.  This “focus” on prior mineral production allegedly misled the lessors by causing them to value their interest based on past production, rather than the future increase in production based on which the operator was valuing the interest.  These arguments put the plaintiffs on a collision course with Mineral Code article 122.

The district court dismissed the case on an exception of no cause of action. After various procedural maneuvers, the appeals court reversed.  It ruled that, while Mineral Code article 122 expressly prohibits lessees from being found their lessors’ fiduciaries, the Supreme Court’s 1937 decision in Emerson v. Shirley, 175 So. 909, had ruled that a duty, and thus a claim, could exist to speak to prevent fraud in the deliberate undervaluing of a mineral interest when the parties to the agreement had a 10-year history of business dealings.  The appellate court found that, if that is the case, then “such measure of the relationship” is a factual determination that “cannot be made through a peremptory exception.”

This opinion relying on a “relation of confidence” between the lessors and lessee ran roughshod over Mineral Code article 122. Thankfully, the Louisiana Supreme Court reversed.

The core of the Supreme Court ruling is that article 122’s imposition of obligations of development on the lessee does not alter that article’s initial statement that the lessee is not a fiduciary of the lessor. As the Court explained:

the default rules of Article 122 are addressed to mineral development operations, not to buying and selling mineral rights. In the transaction at issue, the lessee had no duty to disclose its plans because Article 122 relieves a lessee of fiduciary duties to the lessor, and because the operational portions of Article 122 do not impose disclosure obligations on the lessee.  To hold otherwise, as the appellate court did, that the fact of a lessor/lessee relationship reaching a “certain level” can require disclosures of the facts plaintiffs complain were omitted, is to essentially erase this entire clause from Article 122: “A mineral lessee is not under a fiduciary obligation to his lessor ….”

Based on this reasoning, the Court dismissed the fraud by silence claim, ruling that, in transacting business with its lessors, a lessee owes no duty not imposed on any other potential purchaser and thus that a lessee has no duty to disclose to a lessor information regarding an interest’s potential value or any other matter.

This conclusion also generally disposed of the fraud by misrepresentation claim that the price offered by the lessee misled the lessors by causing them to focus on past production; as the Court observed, “in this context, as a matter of law, an offer to purchase is not a guarantee of value.” Otherwise, the Court addressed the remainder of that claim by observing that, ultimately, the lessor’s claim is that the lessee knowingly offered a lower price for the lessor’s interest than its actual value.  The Court correctly surmised that this actually was a claim for lesion beyond moiety, which Mineral Code article 17 provides does not apply to a sale of mineral interests.

In explaining this position, the Court adopted the reasoning of various federal courts, most notably Thomas v. Pride Oil & Gas Properties, Inc., 633 F.Supp.2d 238, which had made similar rulings favorable to the oil and gas industry.  It is welcome that this reasoning has been adopted as part of Louisiana law by the State’s highest court.  Quoting Thomas, the Court reasoned:

Recalling our earlier determination in this case that the claims relating to an offer being insufficient are essentially fraud claims, we approve of the following observation: “To pursue a claim for purported deficiency in the value of these lease rights …, be it in error or fraud, is to pursue a claim for lesion beyond moiety.”

Based on this reasoning, the Supreme Court reversed the Second Circuit and reinstated the trial court’s dismissal of the lessors’ claims.

Given the treatment that the industry sometimes received in Louisiana’s courts—and received in the Second Circuit here—the Louisiana Supreme Court’s decision, including its express reliance on, and learned interpretation of, the Mineral Code, is welcome. While bad cases make bad law and courts’ application of “widow’s justice” sometimes is understandable, it is heartening that the Louisiana Supreme Court here did not allow such considerations to prevail over the express provisions of the Mineral Code and ultimately the principle that lessors are not children and that lessees are not their lessors’ fiduciaries when the parties engage in arms-length business transactions.

We trust that the Louisiana Supreme Court’s reasoning will put an end to the pernicious “relation of confidence” doctrine, which had been developing in the Second Circuit in express contradiction to the dictates of Mineral Code article 122. The Court’s decision contains two lessons going forward for the industry.

First, the Court noted the exception to article 122’s default rule that a lessee is not a lessor’s fiduciary; the article’s final sentence provides that “Parties may stipulate what shall constitute reasonably prudent conduct on the part of the lessee.” The Court noted that, pursuant to this provision, “parties to mineral leases may contractually impose a duty for a lessee to disclose information, such as the information plaintiffs complain was not provided to them when defendants negotiated to purchase plaintiffs’ royalty interests.”  [It was this contractual possibility, not merely a long course of interaction, that may create a duty to speak such as in Emerson.]

This observation is important because, as one client recounted to us recently, oil and gas operators frequently purchase large blocks of leases without bothering to examine the provisions of every lease. As an economic decision this is understandable.  However, the Court’s decision here emphasizes that the default rules of the Mineral Code cannot always be relied on, because they almost always may be altered by a provision in a lease.  Thus, a lessee who purchases a lease without examining each of its provisions could find itself liable to its lessor for not disclosing certain information, even though such a cause of action does not otherwise lie under the Louisiana Civil or Mineral Code.

Therefore, when purchasing leasehold assets, parties should consider erring on the side of due diligence, even if it may raise the transaction costs of a particular transaction. Where that is not economically feasible, then at the least lessees who acquire leases should conduct a thorough legal analysis as to any governing lease before transacting business, or engaging in communications, with a specific lessor.

Second, this case is a caution to everyone in the industry to avoid what may be termed sharp practices. While it is thankful that “widow’s justice” did not prevail here, as everyone in the industry knows, that often is not the case.  The former lessee here incurred real and substantial costs and uncertainty as a result of this litigation, and risked creating a precedent that could have hurt the industry as a whole for the future.  Wherever practicable, you should conduct your business and structure your transactions to avoid such costs and exposure.