Lease Contests in the West Virginia Shale Plays

by Spilman Thomas & Battle, PLLC
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Over the past 18 months, landowners have filed independent actions in West Virginia state courts to invalidate oil and gas leases, some, if not all, of which have been removed to the federal court for the Northern District of West Virginia. See Heller v. TriEnergy, Inc., 877 F.Supp.2d 414 (N.D.W.Va. 2012) (removed from Marshall County); Holmes v. Chesapeake Appalachia, No. 5:11-CV-123, 2012 WL 3647674 (N.D.W.Va. Aug. 23, 2012) (removed from Ohio County); Davis v. EQT Prod. Co., No. 5:12-CV-051, 2012 WL 6111694 (N.D.W.Va. Dec. 10, 2012) (Hancock County). The facts and causes of actions in the plaintiffs’ complaints are substantially similar. In each case, plaintiffs signed leases between 2006-2008 on unfavorable or below-market terms and now wish to void those leases on various theories, including improper acknowledgment and recordation, fraud, and unconscionability.

Until recently, all of these lease contest cases had been referred to arbitration or voluntarily dismissed, leaving these questions largely unsettled. However, Barber v. Magnum Land Services, LLC, a recent cased filed in Preston County, West Virginia, and removed to the Northern District, has the potential to settle many of these outstanding questions. See Complaint, No. 13-cv-00033 [dkt. 1-1] (N.D.W.Va. Feb. 28, 2013).

Improper Acknowledgment

The plaintiffs in Barber allege that their leases should be expunged and voided because they were improperly acknowledged. See Complaint at 11-16. In West Virginia a deed, contract, or other writing must be acknowledged before it can be recorded, and the acknowledgment must be made in the presence of the notary or commissioner. W.Va. Code §§ 39-1-2 and 39-1-4.  Plaintiffs admit they entered into oil and gas leases, and those leases bear their signatures, but they allege those signatures were notarized outside of their presence, and accordingly their leases should be expunged from the records. Complaint at 11-14. Further, the plaintiffs argue that, because the signatures were notarized by defendants’ employee, the leases should be voided for the disqualifying interest of the acknowledging party. Id. at 14-16.

The West Virginia Supreme Court of Appeals has yet to rule on these narrow issues – whether a failure to acknowledge a lease in the presence of the lessors requires its expungement and whether a notary is per se disqualified when he is compensated by an interested party. Nevertheless, the Northern District has considered the issue of improper acknowledgement and held that the plaintiffs failed to state a claim where they freely admitted to having signed the lease. See Heller v. TriEnergy, Inc., 877 F.Supp.2d 414, 426 (N.D.W.Va. 2012). Moreover, West Virginia has a longstanding rule against invalidating records on “narrow and technical” grounds, and it has also abandoned a per se rule of invalidating instruments acknowledged by a notary with a disqualifying interest. Syl. Pt. 3, Janesville Hay Tool Co. v. Boyd, 35 W.Va. 240, 13 S.E. 381 (1891); Galloway v. Cinello, 188 W.Va. 266, 423 S.E.2d 875 (1992).  Indeed, the purpose of an acknowledgment is to (1) authenticate an instrument, (2) permit its admission into evidence, and (3) entitle it to be recorded. Galloway, 188 W.Va. 266, 423 S.E.2d 875.  Notably, West Virginia does not require an acknowledgment for a lease to be enforceable under its statute of frauds. W.Va. Code § 36-1-3.

Fraud

The plaintiffs in Barber have alleged fraud, fraudulent inducement, and fraudulent concealment. See Complaint at 16-19. In support of their fraud claim, plaintiffs allege that landmen told them gas could be removed from underneath their properties with or without their consent, and signing a lease was the sole means of ensuring they would receive compensation. Likely, the landmen were referring to the rule of capture, by which a landowner’s free-flowing oil or gas may be drained by a well on adjacent property, and which has a long history in West Virginia. See Powers v. Union Drilling, Inc., 194 W.Va. 782, 787, 461 S.E.2d 844, 849 (1995). Less clear is the extent to which the rule of capture, as a practical matter, applies to the Marcellus and Utica Shales, where gas is trapped within tight rock formations, rather than free-flowing. Although this question remains unsettled, it should be noted that Judge Bailey recently held that “hydraulic fracturing under the land of a neighboring property without that party’s consent” is not protected by the rule of capture, but is rather an actionable trespass. Stone v. Chesapeake Appalachia, No. 5:12-cv-102 *16 (N.D.W.Va. filed Apr. 10, 2013).

Of plaintiffs’ fraud claims, their claim for fraudulent concealment has the greatest potential to impact lease negotiations in West Virginia. At the heart of plaintiffs’ claim is that landmen knew the market for oil and gas leases was more favorable than the offers tendered to the plaintiffs; that landmen had a duty to inform plaintiffs of the more favorable terms; that landmen nevertheless did not inform plaintiffs of the more favorable terms; and that plaintiffs signed leases with unfavorable terms as a result. West Virginia has long recognized a cause of action for fraudulent concealment, but an essential element of any such action is the duty to disclose. Such a duty exists where there is a fiduciary or confidential relationship between the parties or there is a relative inequality in the parties’ knowledge or circumstances. Pocahontas Mining Co. LP v. Oxy USA, Inc., 2012 W.Va. 169, 175, 503 S.E.2d 258, 265 (1998). However, as a general rule, there is no duty of disclosure as between parties to an arm’s length business transaction.

Unconscionability

Finally, the plaintiffs in Barber seek to avoid their leases on the basis of unconscionability . See Complaint at 19-21. Traditionally, unconscionability was defined as a bargain that would neither be made by a man in his senses and without delusion, nor be accepted by a fair man. The modern rule, as applied in West Virginia, defines unconscionability by both its procedural and substantive elements. Brown v. Genesis Healthcare Corp., 229 W.Va. 382, 729 S.E.2d 217 (2012). Procedural unconscionability may exist where the lessor and lessee have unequal bargaining power or the party claiming unconscionability lacks meaningful alternatives. Substantive unconscionability considers whether the terms of the lease are fair. For a lease agreement to be unconscionable, both the procedural and substantive elements must be met. However, a court will apply a sliding scale, whereby greater evidence of procedural unconscionability will require less evidence of substantive unconscionability, and vice versa.

The plaintiffs in Barber have claimed that their leases are procedurally unconscionable because they were not represented by counsel and the terms were not negotiated. See Complaint 16 ¶ 112, 20 ¶ 132. As evidence of substantive unconscionability, plaintiffs cite to $50/acre bonus payments and 12.5% royalty rates, both of which they allege were below-market. Id. at 20 ¶¶ 132-33.

Although the absence of counsel during lease negotiations may be evidence of unconscionability, it does not render an agreement per se unconscionable. Likewise, contracts of adhesion are not per se unconscionable. It is also unlikely that a court will find unequal bargaining power or lack of meaningful alternatives in the vast majority of lease contest cases. Landmen and industry are more experienced in negotiating leases, but a lessor will have sufficient time in almost every instance to inform himself about oil and gas leases or obtain counsel prior to signing a lease. Most importantly, lessors ultimately possess rights to the natural gas beneath their properties, and this provides the lessor with leverage over landmen, particularly in a state like West Virginia without forced pooling.  But see J. Zach Burt, Comment, Playing the “Wild Card” In the High-Stakes Game of Urban Drilling: Unconscionability in the Early Barnett Shale Gas Leases, 15 TEX. WESLEYAN L. REV. 1 (2008).

As to substantive unconscionability, the general rule is that a court will not test the adequacy of consideration, and a party will be bound to his bargain, even if he later regrets its terms. But, a court may void or reform a contractual provision if it shocks the conscience. Nevertheless, this is a difficult burden for plaintiffs to meet, and substantive unconscionability generally is determined in light of circumstances as they existed when the lease was made. But see Kansas Baptist Conv. v. Mesa Operating Ltd. P’ship, 253 Kan. 717, 864 P.2d 204 (1993) (considering changed circumstances).

Plaintiffs face a significant burden, perhaps even an impossible burden, in arguing that a 12.5% royalty is unconscionable, because 12.5% is the state minimum royalty in West Virginia. Additionally, plaintiffs’ argument for unconscionability is, at least in part, premised on the higher bonuses and royalty rates obtained by other landowners, but there is no indication that plaintiffs’ properties are comparable to those other properties. For instance, bonus payments and royalties often increase proportionate to the acreage and potential of the tract being leased.

Nevertheless, a fact-finder might determine that either a low bonus payment or a low royalty would be permissible alone, but that together they are unconscionable. A property that is high-risk for an oil and gas company might justify a low bonus payment, but a higher royalty if the well is productive. On the other hand, at least one court has reflected on the inherently speculative nature of the oil and gas industry to hold that a bonus payment was not unconscionable. Thompson v. Kiddings, 276 P.2d 229 (Okla. 1954); see also Heyward v. Bradley, 179 F. 325 (4th Cir. 1910) (ordering specific conveyance of property containing phosphate rock despite contention by seller that increase in value of property justified rescission.); Moore v. Sawyer, 167 F. 826 (C.C.E.D. Okla. 1909) (refusing to find 10% royalty and bonus payment unconscionable where there was no fraud and royalty rate was usual).

Conclusion

Landmen and operators should follow Barber closely because of its potential to create precedent in West Virginia regarding duties of disclosure in lease negotiations and unconscionability of terms. Landmen and operators may also choose to take the following steps to limit their potential liability. First, advise landowners of their right to review the lease before signing. At the same time, inform landowners that an offer is of limited duration and may be withdrawn as circumstances require. Second, avoid potentially misleading references to the rule of capture or, at a minimum, accurately define the rule. Third, ensure that the landowner is aware that the landmen or operator is not his or her representative, but rather represents the lessee. Fourth, avoid absolute statements regarding bonus payments and royalties, as these may be difficult to verify. Instead, counsel landowners that bonus payments and royalties may vary according to the market and the acreage and prospects of the tract to be leased. Fifth, have an attorney review oil and gas leases for potentially troublesome terms. Finally, ensure that any signed lease is properly acknowledged. Although an improperly acknowledged lease should be enforceable against the lessor and lessee, it will not provide constructive notice to subsequent bona fide purchasers. By taking the foregoing steps, landmen and operators will be in a position to avoid lease contests or at least establish a strong defense.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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