ACCOUNTING TO THE UNLEASED COTENANT:

Challenges in an Altered Leasing Landscape

Right of Cotenant to Explore and Produce

Joint tenant in the fee may explore for and produce oil and gas without consent of his cotenants•Peculiar nature of oil and gas estate is that use is consumption; not considered to be destruction or waste•Fugitive nature requires development to avoid loss•Permitted unless other cotenants are denied rights or gratuitous injury occurs => Trespass•Right extends to lessee of cotenant

Accounting for Profits

• A leasing cotenant must account for the proportional share of the profits

• SOL likely does not run until accounting is demanded and refused

• But, what is the basis for the calculation of the accounting?

McIntosh v. Ropp

• Life tenant executed oil & gas lease, one remainderman ratified, & other sought accounting without offset for costs of development

• Court determined that fair accounting is based on royalty, which is the fair market value of the mineral in place, when such royalty can be ascertained by expert testimony in view of all of the circumstances

Cases Supporting Royalty Basis of Accounting

• Petition of Baily, 76 A.2d 645, 647 (Pa. 1950) (holding that in the absence of malice, damages to cotenants was fairly measured by value of royalties paid, which were the usual customary royalties for oil and gas)

• Everly v. Shannopin Coal Co., 11 A.2d 700, 702 (Pa. Super. 1940) (coal)

• Mercur v. State Line & S. R., 32 A. 1126, 1127 (Pa. 1895) (basing the royalty to be paid to unleased cotenant in coal on evidence furnished by both sides)

• Appeal of Fulmer, 18 A. 493 (Pa. 1889) (slate)

Cases Supporting Net Profits Calculation

Several courts have based an accounting on the "value of the ore at the mine's mouth, after deducting the expenses of putting it there. . . ."

• Kelley v. Kelley, 115 A.2d 202, 204 (Pa. 1955)• Bell v. Johnston, 126 A. 187, 188 (Pa. 1924)• McGowan v. Bailey, 36 A. 325, 326 (Pa. 1897)• Coleman's Appeal, 62 Pa. at 279 (Pa. 1869) (ore)

How to Account, Then?

Established law would indicate that a royalty accounting is appropriate, except where no evidence of fair royalty value exists, in which case a net profits accounting is appropriate

Impact of Fraud

Where fraudulent inducement or misrepresentation is involved, defrauding cotenant will not be permitted to deduct development costs when accounting for the production. Foster v. Weaver, 12 A. 313 (Pa. 1888).

What is a “Fair Royalty Value” post-2006?

• Traditional royalty for oil and gas was easy to ascertain• Vast fluctuations in bonus and royalty payments • Is the fair royalty…

a. That which the cotenant negotiated? Issue regarding poorly negotiated lease

b. That which was prevailing in the location of the leasehold at the time of the leasing of the cotenant?

c. That which is prevailing at the time the unleased cotenant is located?

Incentive not to locate cotenant • The product of a weighted average of all lease

compensation in a unit? • Same considerations for bonus

Enterprise Oil & Gas Co. v. National Transit Co.• Dicta indicates that the unleased tenant may choose

remedy• Lessee assigned oil leases, retaining 1/8 royalty; assignee

refused to pay after claimant averred he owned 1/16 of the leases and wasn’t party to assignment

• Claimant was permitted to defend suit & trial court awarded him all the oil royalty

• Court reversed, holding that claimant failed to present sufficient proof in the assumpsit action that cotenants took more than fair share

• Either ratify the lease and seek an accounting or repudiate the lease and proceed as an unleased cotenant

Expenses of Development

1. Unleased Cotenant ratifies lease and thus is not responsible for expenses

2. Unleased Cotenant is working interest owners who shares in operating costs

3. Unleased Cotenant is treated as a carried working interest owner: no liability for dry hole, entitled to fractional share of net profits, no out of pocket operating expenses

4. “Back-in after Payout“ treats Unleased Cotenant as a royalty interest owner until payout, at which time interest is converted to a working interest. Operator bears all the costs.

Who Accounts?

Traditionally, cotenant accounts, but…•Proportionate reduction clause•Financial responsibility of leasing cotenant•Choice of unleased cotenant to be working interest owner, rather than lessor

Questions?