In an opinion that should give pause to mineral lessors, the Texas Supreme Court revisited the scope of the duty that an executive rights holder owes a non-executive, holding that a lessor’s negotiation of an above-market bonus (for itself) and below-market royalty (shared with the non-executive) may give rise to liability to the non-executive. KCM Financial LLC v. Bradshaw, No. 13-0199, 2015 Tex. LEXIS 220, --- S.W.3d --- (Tex. Mar. 6, 2015).

The Court declined to issue any “bright line rules” regarding the scope of the duty of utmost good faith and fair dealing, emphasizing that its analysis required “balancing the bundle of rights that comprise the mineral estate” and an evaluation of the lease transaction “as a whole.” But the general principles the Court articulated, and the totality of circumstances in this case, were enough to support its holding that fact issues precluded summary judgment for the executive here.

On the other hand, the Court held that the lessee was entitled to summary judgment because the lessor’s alleged breach of its duty to the non-executive could not be imputed to the lessee as a matter of law under any derivative liability theory, noting “the considerable burdens that a contrary holding would impose on the energy industry in Texas.”

Factual Background

The root of the non-executive’s complaint in KCM Financial was that the lease allegedly provided for a higher-than-market lease bonus—to the lessor’s exclusive benefit—and a lower-than-market royalty, which the lessor shared equally with the non-executive. Bradshaw, the non-executive owner, inherited a fifty percent non-participating royalty interest in 1,773 acres of land in Hood County, Texas. The 1960 grant specified that the royalty “be ‘not less than’ one-eighth,” which evidence suggested was the customary royalty rate at the time. By 2005, Bradshaw claimed the prevailing royalty rate in the Barnett Shale area near the property had increased to one-quarter, rather than one-eighth.

The executive rights, which included the power to lease and to receive bonus and delay rentals, were eventually assigned to Steadfast Financial LLC. In 2006, Steadfast leased the mineral rights to Range Production I, L.P., securing a $7,505 per acre, or more than $13 million, bonus and reserving only a one-eighth royalty. Bradshaw’s non-participating royalty interest entitled her to one-sixteenth of gross production from the lease, but none of the lease bonus.

Bradshaw sued Steadfast, Range, and other third parties, alleging that Steadfast engaged in self-dealing and breached its duty by swapping a sub-market royalty rate for an above-market bonus, a trade-off that benefitted Steadfast at Bradshaw’s expense. Bradshaw introduced evidence that the prevailing rate when the lease was signed was a one-quarter royalty and that the bonus was “excessive and many times higher” than customary. Bradshaw also alleged that Steadfast and Range conspired together and that Range aided and abetted the breach.

The Executive Rights Holder Was Not Entitled to Summary Judgment

The trial court granted a take-nothing judgment to the defendants. The Fort Worth Court of Appeals reversed in part and affirmed in part. On appeal to the Supreme Court, Bradshaw argued that the large bonus and the low royalty were “at least some evidence” of Steadfast’s self-dealing at her expense. Steadfast countered that it was under no obligation to secure the highest possible royalty and that it fulfilled its duty as a matter of law because the royalty met the minimum royalty required by the 1960 deed.

Reviewing the substantive law on a lessor’s duty to a non-executive, the Court re-stated “that the executive owe[d] the non-executive a fiduciary duty and . . . defined that duty as an obligation to ‘acquire every benefit’ for the non-executive that the executive ‘would acquire for himself.’” The executive, however, “is not required to wholly subordinate its interests” to those of the non-executive. The executive retains considerable, albeit not “unbridled,” latitude in exercising his duty. The “controlling inquiry” in cases alleging executive malfeasance is whether the executive engaged in self-dealing for his direct, or indirect, benefit at the expense of the non-executive.

The Court noted that many factors govern a mineral lease’s terms, including royalties, delay rentals, bonuses, the number and placement of wells, and other provisions. Each of these factors affects the executive’s and the non-executive’s interests in different ways, and none is necessarily dispositive as to whether the executive discharged his duty. The executive is not obligated to obtain the highest possible royalty or even the market-rate royalty, but that failure may still be a relevant factor in the analysis. The Court stressed the need to review the subject transaction “as a whole” to determine whether the terms of the lease, including the amount of royalty, reflected the executive’s duty of utmost good faith and fair dealing. In this case, fact issues related to the low royalty and the high bonus “preclude[d] summary judgment as to the non-executive’s breach-of-duty claim against the executive.”

Range, the Lessee, Was Not Responsible for the Underlying Tort as a Matter of Law

Separately, the Court dismissed Bradshaw’s derivative-liability claim against Range in light of the absence of any evidence that Range was complicit in the alleged underlying tort. Evidence that Range knew of Bradshaw’s interest, knew of tensions between Bradshaw and Steadfast’s interests, and agreed to the one-eighth royalty and eight-figure bonus was not enough to impute liability onto the lessee as a matter of law. Referring to the amicus brief filed by the Texas Oil and Gas Association, the Court noted that it was “not unmindful of the considerable burdens that a contrary holding would impose on the energy industry in Texas” and “‘in negotiating with the executive, a lessee should not fear liability for doing nothing more than getting a good deal closed.’” (quoting TXOGA’s brief). On these facts, the Court refused to hold a lessee “directly or derivatively” responsible for policing a lessor’s duty to a non-executive.

Summary

Admitting that the contours of the executive’s duty are “imprecise,” the Court held that the key issue remains whether the lessor engaged in acts of self-dealing at the expense of the non-executive. The Court addressed the balancing act between the lessor’s good faith and fair dealing duty to the non-executive, and the reality that “the executive [i.e., the lessor] is not required to grant priority to the non-executive’s interest.”

A proper analysis requires “balancing the bundle of rights that comprise a mineral estate,” not just the amount of royalties. The Texas Supreme Court admonished that courts must analyze a transaction in its totality to decide whether a lessor breached its duty to a non-executive. Specific aspects of a transaction, in this instance the bonus and the royalty interest, even if unusual, are not necessarily dispositive.

Given the Court’s adoption of a fact-based, “totality of the transaction” test, it will likely be very difficult to resolve executive rights disputes by summary judgment. Further, the Court’s opinion should be considered fair warning to any lessee who attempts to negotiate a below-market royalty and an above-market bonus payment that an expensive lawsuit potentially awaits.