Recently, the Texas Supreme Court clarified the duty owed by an executive rights holder to a non-participating royalty owner when negotiating an oil and gas lease.  KCM Financial LLC v. Bradshaw is an important opinion as it makes clear what obligations the executive rights holder has, and does not have when negotiating and signing mineral leases.  [Read full opinion here.]

Basic Legal Background

Generally, if not severed, a mineral owner possesses certain rights as part of mineral ownership.  These rights include the executive right, which is the right to negotiate and enter into an oil and gas lease, the right to receive royalty payments, and the right to bonus payments.  Sometimes, however, these rights can be severed such that one person holds the executive right for all mineral owners in the tract who will receive the royalty negotiated by that executive rights holder.

For example, assume that A, B, and C each own a 1/3 undivided interest in 100 acres of mineral rights.  The general rule is that each A, B, and C hold their own executive rights and can lease their portion to an oil or gas company as they wish.  If, however, A was granted all executive rights for the 100 acres in addition to his 1/3 interest, it would be up to A to negotiate and enter into any oil and gas leases for the property.  B and C would be “non-participating royalty owners” and essentially be left at A’s mercy.

Realizing this, Texas courts have long recognized that an executive rights holder owes a duty of “utmost good faith and fair dealing” when negotiating or signing a lease agreement.

Factual Background

In this case, involving 1,773 acres of mineral rights in Hood County, Texas, a non-participating royalty owner filed suit against an executive rights holder claiming that the executive holder breached his duty of good faith and fair dealing.  There was a non-participating royalty interest owner as well as a second royalty owner who held all executive rights and the right to bonus payments.

Specifically, the non-participating royalty owner alleged that the executive had entered into a lease with a sub-market royalty rate, which the non-participating royalty owner and executive rights holder would share equally, in exchange for an above-market bonus payment, which was to be paid solely to the executive rights holder.  She offered some evidence that a 1/4 royalty was available and common in the area at the time the lease was signed, despite the executive agreeing to a 1/8 royalty.  The non-participating royalty owner argued that by securing a below market royalty rate, the executive right holder breached his duty to her.  The executive rights holder argued that he did not act improperly when the contractual terms and facts were considered as a whole and that a court could not look at a single factor like royalty in a vacuum in making that decision.

The trial court sided with the executive rights holder, finding no wrongdoing and granting summary judgment.  The court of appeals reversed, finding that factual issues precluded summary judgment and that the case should be tried.  The executive rights holder appealed.

Supreme Court Opinion

The Supreme Court reaffirmed that an executive rights holder owes a duty of utmost good faith and fair dealing.  They made clear, however, that the executive is “not required to wholly subordinate its interests in favor of the non-executive if their interests conflict.”  So, exactly what is the rule applied to executive rights holders?

Unfortunately, the court stated that “no bright line rule can comprehensively or completely delineate the boundaries of the executive’s duty.”  Instead, in each case, the facts must be carefully considered, including the lease and circumstances of its execution.

The Court offered further guidance, explaining that a lease includes a below-market rate royalty is only one factor to consider in determining if the duty was met, and is not, alone, an indication that the executive rights holder breached his duty.  To require an executive to always accept the highest royalty would improperly impinge his or her right to consider all facts when negotiating a lease.

Further, an executive is not required to place the interest of a non-participating royalty owner above the executive’s own interest.  On the other hand, the Court made clear that the executive may not engage in acts of self-dealing that unfairly diminish the value of the non-participating royalty interest.

In summary, the court held that an “executive owes a non-executive a duty that prohibits self dealing but does not require the executive to subjugate its interests to those of the non-executive.  Thus, in ascertaining whether the executive breached its duty to the non-executive, the controlling inquiry is whether the executive engaged in acts of self-dealing that unfairly diminished the value of the non-executive interest.

So, what about the facts in this case?  The court found that there were factual issues that required the case be tried.

Why Should We Care?

First, this case is an important reminder that the rights incident to mineral ownership can be severed and divided in various ways, including granting a single person the right to negotiate and sign oil and gas lease for others.

Second, this case further clarifies the duty of an executive rights holder when negotiating mineral leases.  It is important for executive rights holders to take care to understand the duty imposed on them.  Likewise, non-participating royalty owners should be aware of the scope and limitations on the duty of an executive rights holder.