Supreme Court of Texas Issues Three Important Oil and Gas Decisions
June 2015 by Jeffrey A. Schlegel, Omar Samji, Scott W. Cowan, David S. Stringer, Kyle R. Kreshover, and Jeffrey A. Schlegel, June 23, 2015, Jones Day
This month, the Texas Supreme Court decided three cases implicating oil and gas contract interpretation issues with important consequences to the industry. The Court held in all three cases that the plain meaning of a contract will prevail over an interpretation based on the industry’s common views of the intended effect of a provision.
This result can be troublesome for attorneys, landmen, and commercial dealmakers in the industry, as each has felt comfortable in the past relying on a common industry view of how certain key provisions in oil and gas contracts work. Consequently, these cases reinforce the need for a more careful review of key contract terms to ensure that the plain meaning of the text correctly expresses the intended commercial arrangement without the need to rely on what may have been the industry’s customary interpretation. [To decide after the fact, what “interpretation” suits companies best to meet their greed and over ride harms caused?]
Kachina Pipeline Co. Inc. v. Lillis
In Kachina Pipeline Co. Inc. v. Lillis, case number 13-0596, Supreme Court of the State of Texas, the central issue was whether the transporter, a natural gas transportation company, improperly charged a natural gas producer for compression costs associated with compressors located downstream from the transporter’s receipt of the producer’s gas into its gathering system and upstream from a third-party processing facility.
Despite these protests, the Court held that the transporter could not pass these compression costs to the producer. The Court said that although the industry amici made it clear that producers often contract to share in the costs of downstream centralization of compression, “the Agreement does not express an objective intent that the producer would do so, and industry custom cannot impose obligations beyond those within the written Agreement.” The Court interpreted the compression cost provision to be contingent upon the producer failing to overcome the transporter’s working pressure. Based on this, the transporter could deduct only “the costs of compression installed during the term of the Agreement if required to overcome the working pressure in [the transporter’s] system.”
The Court’s decision here demonstrates the consequences of relying on industry custom instead of the plain meaning of the words. The transporter could have easily clarified its intent by expressly providing that “delivery” includes final delivery to a third party.
Chesapeake Exploration LLC and Chesapeake Operating Inc. v. Hyder et al.
In Chesapeake Exploration LLC and Chesapeake Operating Inc. v. Hyder et al., case number 14-0302, Supreme Court of the State of Texas, the Court was presented with the issue of whether an oil and gas lease allowed a producer to deduct postproduction costs from overriding royalty owners, as is typical of an overriding royalty, or whether the lease expressed a different agreement. Of three royalty provisions in the parties’ lease, only one was in dispute. The disputed clause calls for “a perpetual, cost-free (except only its portion of production taxes) overriding royalty of five percent (5.0%) of gross production obtained” from directional wells drilled on the lease but bottomed on neighboring land.
The royalty owners argued that the “cost-free” requirement on the royalty could refer only to postproduction costs, because a royalty, by definition, is free of production costs. The producer, on the other hand, argued that “cost-free overriding royalty” is synonymous with overriding royalty, and that “cost-free” is simply emphasizing that the overriding royalty is free of production costs. The Court noted that leases discussed in previous cases support the producer’s view. However, the Court found that “cost-free” in the overriding royalty provision includes postproduction costs—reasoning that if the royalty owners were to take their gas in kind, as they are entitled to do, they “might or might not incur postproduction costs equal to those charged by [the producer’s marketing company]…” and “[t]he fact that the [royalty owners] might or might not be subject to postproduction costs by taking the gas in kind does not suggest that they must be subject to those costs when the royalty is paid in cash.”
As in the Kachina holding, this case demonstrates the importance of clear, careful drafting in oil and gas agreements.
Plains Exploration & Production Co. v. Torch Energy Advisors Inc.
In Plains Exploration & Production Co. v. Torch Energy Advisors Inc., case number 13-0597, Supreme Court of the State of Texas, the Court was asked to determine whether the excluded-assets provision of a purchase and sale agreement for certain oil and gas leases excluded a particular claim relating to reimbursement of bonus payments made by the seller to secure the leases. The seller under the purchase and sale agreement at issue argued that a particular claim for restitution of lease-bonus payments was excluded from the sale and that it was entitled to a portion of the related $83 million judgment that the new owner of the interests was awarded. The Court noted that this case was a “conventional contract-interpretation dispute” as to whether the seller was entitled to a portion of that judgment.
The Court determined that because the terms “arising from,” “arising under or with respect to,” and “attributable to” were used in reference to claims, a “pre-effective date causal nexus” was required for the seller to retain such claims. Because this claim arose after the effective date, the seller was not entitled to any of the judgment as a matter of law.
As with the previous two cases, the Court’s decision demonstrates that unambiguous, explicit drafting is required in order for the intent of the parties to be respected, and that drafters must be meticulous in including exceptions, explanations, and standards for complicated subjects in order for the parties’ agreed commercial expectations be respected by the courts.
These recent decisions by the Texas Supreme Court should put practitioners and industry members on notice that attention to specific language in a contract is crucial, and that even if certain language has a common understanding in the industry, the court will defer to the plain meaning of that language over industry custom and practice in the event of a dispute as to interpretation. [Emphasis added]
COMPARE TO CANADA:
Honesty isn’t just the best policy, it’s (now) the law, Canada’s Supreme Court rules with respect to contract performance by Samaneh Hosseini and Andrew S. Cunningham, November 18, 2014, Stikeman
Let’s be honest: SCC finds all contracting parties owe each other a duty of honesty by Dalton W. McGrath, Q.C., Michael O’Brien and Joshua Sealy-Harrington, November 17, 2014, Blake Cassels & Graydon LLP
The Supreme Court of Canada (SCC) has just released its decision in Bhasin v. Hrynew, which recognizes for the first time in common law Canada that every party to a contract has a legal duty to perform its contractual obligations honestly and with regard to the legitimate interests of the other party. This duty cannot even be avoided by express agreement between the parties. [Are oil and gas companies like Encana exempt?] It is difficult to overstate the importance of this decision in terms of bringing some measure of coherence and clarity regarding what is expected of contracting parties in the performance of their contractual obligations.
Beginning in 1989, the appellant, Mr. Harish Bhasin, worked for Canadian American Financial Corp. (Can-Am), which markets education savings plans to investors through retail dealers known as enrolment directors—the position held by Mr. Bhasin. In effect, the enrolment directors acted as small business owners with their success depending on building a sales force. Between 1989 and 1999, Mr. Bhasin expanded his sales force and business.
Mr. Bhasin’s relationship with Can-Am during the material time was governed by a commercial dealership agreement (Agreement). In particular, the Agreement, which took effect in 1998, had a term of three years and provided that the contract would automatically renew at the end of the three-year term unless one of the parties gave six months’ written notice to the contrary.
In the end, Can-Am decided not to renew the Agreement. However, Mr. Bhasin alleged that decision was as a result of pressure from Mr. Larry Hrynew, another enrolment director and a competitor of Mr. Bhasin, who wanted to capture Mr. Bhasin’s alleged lucrative niche market. Mr. Bhasin claimed that he was ultimately obliged to take less remunerative work with one of Can-Am’s competitors, and sued Can-Am for breach of an implied term of good faith in the Agreement. The trial judge found liability against the defendants.
The Alberta Court of Appeal reversed the decision of the Alberta Court of Queen’s Bench stating that the issue of good faith was not properly pled and that the lower court erred by implying a term of good faith in the context of an unambiguous contract containing an entire agreement clause. The SCC reversed the decision of the Alberta Court of Appeal and, in so doing, provided its analysis regarding the imposition of good faith in contracts and imposed a new common law duty to act honestly in the performance of contractual obligations.
The SCC began by noting that Canadian common law in relation to good faith performance of contracts was piecemeal, unsettled and unclear. It stated that two incremental steps were in order to make the common law more coherent and just. The first step was to acknowledge that good faith contractual performance is a general organizing principle of the common law of contract which underpins and informs the various rules in which the common law recognizes obligations of good faith contractual performance. The second step dictated by the court was to recognize, as a further manifestation of that organizing principle of good faith, that there is a common law duty which applies to all contracts to act honestly in the performance of contractual obligations.
The court noted that the organizing principle of good faith recognized that, in carrying out the performance of the contract, a contracting party should have appropriate regard to the legitimate contractual interests of the opposing party. Further, the court recognized that “appropriate regard” for the opposing party’s interests will vary depending on the context of the contractual relationship. It does not require acting to serve those interests in all cases—it merely requires that a party not seek to undermine those interests in bad faith. [Like the AER and oil and gas companies do to land and or water well owners?] The SCC was clear to state that this general principle has strong conceptual differences from the much higher obligations of a fiduciary and that good faith performance does not engage duties of loyalty to the opposing party or a duty to put the interests of the opposing party first.
The SCC was also clear that good faith, which may be invoked in widely varying contracts, calls for a highly context-specific understanding of what honesty and reasonableness in performance require so as to give appropriate consideration to the legitimate interests of both contracting parties. [Including land and water well owners?] Additionally, the court made clear that the development of the principle of good faith is not an invitation to veer into a form of ad hoc judicial moralism or “palm tree” justice. Rather, the court held that the principle of good faith must be applied in a manner that is consistent with the fundamental commitments of the common law of contract which places substantial weight on the freedom of contracting parties to pursue their individual self interests. [So not just the AER, Harper and provincial governments and oil and gas company’s interests and profit?] …
The court was clear that under the new general duty of honesty, parties must not lie or otherwise knowingly mislead each other about matters directly linked to the performance of the contract. …
The SCC stated that the new duty of honest performance is a general doctrine of contract law which imposes, as a contractual duty, a minimum standard of honesty in contractual performance and operates irrespective of the intention of the parties—it is analogous to equitable doctrines which impose limits on the freedom of contract, such as the doctrine of unconscionability. …
While it is clear that this new general duty will vary based upon the circumstances of each case, this decision provides much needed clarification on this area of the law and represents an important development in Canadian contract law. [Emphasis added]
Supreme Court of Canada recognizes a general principle of good faith in contractual performance by Neil Finkelstein and Brandon Kain, November 14, 2014, McCarthy Tétrault LLP
The Supreme Court of Canada has released a precedent-setting judgment in the area of contract law. In Bhasin v. Hrynew, 2014 SCC 71, the Court recognized for the first time that there is a general organizing principle of good faith in the performance of contracts throughout Canada. The appeal was successfully argued by Neil Finkelstein and Brandon Kain of McCarthy Tétrault’s Toronto litigation group.
The Bhasin case will now become very important for Canadian businesses. All contracts throughout Canada are now subject to the duty of, at a bare minimum, honest performance, which the Court held cannot be excluded by the terms of an agreement. Businesses will need to consider whether they are discharging this duty when carrying out a contract. If a given course of action could be construed as deceptive, businesses should avoid pursuing it unless they are willing to assume the risk of litigation. Businesses should also be aware that under the general principle of good faith, new obligations beyond the duty of honest performance could be recognized in the future.
In a unanimous judgment written by Justice Cromwell, the Court held that good faith contractual performance is an overarching organizing principle of the common law of contract that underpins and informs the various rules in which the common law currently recognizes obligations of good faith. The organizing principle means that parties must perform their contractual duties honestly and reasonably and not capriciously or arbitrarily, and they must have appropriate regard to the legitimate contractual interests of the contracting partner. [How will oil and gas companies and land agents cope with honesty and fairness? Do they have any ability to operate in good faith, honestly? How will the AER now conduct Synergy Alberta lies and Appropriate Dispute Resolution Contracts (gag orders) as enabling agent to rights and law violating oil and gas companies? And how will the Alberta Surface Rights Board continue forcing on landowners (unwanted, lying, in “bad faith” lease contracts) with lying, rights violating, health harmful oil and gas and frac operations?] …
As a specific manifestation of this organizing principle of good faith, the Court recognized a new common law duty that applies to all contracts to act honestly in the performance of contractual obligations. This duty of honest performance does not impose a duty of loyalty or disclosure, but it prohibits parties from lying or otherwise knowingly misleading each other about matters directly linked to the performance of the contract. In Bhasin, the corporate defendant was found to have breached the duty of honest performance and was therefore held liable in damages to the plaintiff. [Emphasis added]
Supreme Court of Canada ruling makes honesty the law for businesses by Jacquie McNish, November 14, 2014, The Globe and Mail
Lying in business will be a lot more expensive after a Supreme Court of Canada ruling that establishes a ground-breaking new doctrine in contract law.
“The tide has come in,” said veteran Toronto litigator Paul Pape, who frequently represents shareholders and other parties against businesses in class-action lawsuits. “If you lie, it’s going to cost you now.”
In a unanimous ruling, a panel of seven Supreme Court justices rewrote centuries-old common law to clarify bewildering Canadian case law about the legal duty of businesses to act in good faith with companies and people with whom they have contracts. Some areas of contractual law, such as employment, franchise and insurance agreements, already require a duty of good faith, but no such standard exists in the broader arena of commercial contracts. [Will Harper’s China trade deal make the oil and gas industry exempt from Canada’s Supreme Court rulings?]
“Enunciating a general organizing principle of good faith and recognizing a duty to perform contracts honestly will help bring certainty and coherence to this area of the law,” Supreme Court Justice Thomas Cromwell wrote in the decision released on Thursday. One of the legal pillars of acting in good faith, Justice Cromwell wrote, is a duty to be honest about business conducted under a contract.
[What about the AER? Can it continue to lie in Synergy Alberta and Appropriate Dispute Resolution contracts, since Alberta Courts ruled it’s legally immune from anything and everything?]
“It is a simple requirement not to lie or mislead the party about one’s contractual performance,” he said.
With the exception of Quebec, which imposed a duty of good faith years ago in contract law, Canadian courts have trailed other countries such as the United States in defining the legal standard. The courts have historically been reluctant to handicap businesses with rules that might interrupt the progress of commerce.
The Supreme Court’s decision marks a bold shift from that tradition.
In their ruling, the justices said an Alberta financial company now known as Heritage Education Funds Inc. breached its contract with Edmonton-based dealer Harish Bhasin when it “acted dishonestly,” “misled” and withheld information about its reasons for ending a contract with Mr. Bhasin in 2001. The lost contract cost Mr. Bhasin his business and set off a 13-year legal odyssey that included a five-week trial and appeals that culminated in Thursday’s decision.
“This is a very significant case,” said Neil Finkelstein, a McCarthy Tétrault lawyer in Toronto who argued for Mr. Bhasin before the Supreme Court in February. It has been difficult to hold businesses accountable for acting in bad faith, he added, unless contracts contain specific language requiring parties to act and communicate honestly. Language in contracts that do require a duty of good faith typically is inconsistent.
Mark Gelowitz, a litigator with Osler Hoskin & Harcourt [Firm representing Encana in Ernst versus Encana], said that, in light of the decision, he is advising clients to be more mindful of what they say. “Parties are going to have to be dramatically more careful in how they communicate with other parties to a contract.” [Is that code for “dramatically more honest?”]
In Mr. Bhasin’s case, an Alberta trial judge ruled Heritage Education Funds improperly breached its contract by acting dishonestly. The decision was overturned by an Alberta appeal court, which ruled no specific language in Mr. Bhasin’s contract required Heritage Education to act in good faith.
Mr. Bhasin was an independent dealer who sold education savings plans on behalf of Heritage Education. According to the Supreme Court, the Edmonton company was untruthful about its dealings with one of Mr. Bhasin’s competitors, which later hired away the dealer’s sales team. The Supreme Court upheld the trial judge’s award of $87,000, plus interest, and legal costs.
In an interview Mr. Bhasin, now retired, said he was determined to fight his case to right a wrong. “I felt that something wrong was being done to me. I had to fight it to make sure that justice was done and that this won’t happen to others.”
A spokesman for Heritage Education could not be reached for comment. [Emphasis added]