The Consequences of “Self-Dealing” for the Executive Right Holder

Previously, we have discussed the holding in Lesley, et al. v. Veterans Land Board of the State of Texas, et al. and its implications for executive right holders. Recently, the Texas Supreme Court revisited the duties of an executive right holder in KCM Financial LLC, et al. v. Bradshaw. “Executive rights” are one of the attributes of the mineral estate, and the executive right holder is vested with the right to execute oil, gas and mineral leases. It has long been established that an executive right holder has a fiduciary duty of utmost good faith and fair dealing to the non-executive interest owner. In its discussion of such duty, the Court in KCM Financial LLC, et al. focused on the presence of self-dealing, which can be “pivotal” in determining whether the executive has breached his duty to the non-executive. Self-dealing occurs when the executive obtains a benefit for himself without obtaining a similar benefit for the non-executive. In particular, the Court concentrated on how the executive’s negotiation of certain terms of an oil and gas lease may be evidence of self-dealing if such lease terms reflect that the executive “engaged in acts of self-dealing that unfairly diminished the value of the non-executive interest.”

In KCM Financial LLC, et al., Betty Lou Bradshaw owned a nonparticipating royalty interest in 1,773 acres. A nonparticipating royalty interest is a cost-free interest in the production of oil, gas and other minerals that does not carry with it the executive right. Steadfast Financial, LLC was vested with the executive rights attributable to Bradshaw’s nonparticipating royalty interest. In 2006, Steadfast, the predecessor to KCM Financial LLC, executed an oil and gas lease in favor of Range Production I, L.P., covering the interests of Steadfast and Bradshaw in the 1,773 acre tract (the “Lease”). The Lease provided for a 1/8 royalty interest, and Steadfast agreed to a lease bonus in the amount of $7,505 per acre, for a total of more than $13,000,000. As a nonparticipating royalty interest owner, Bradshaw was entitled to her share of the royalty provided for under the Lease, but she was not entitled to any portion of the lease bonus.

Historically, courts have held that an executive must “acquire for the non-executive every benefit that he exacts for himself” in order to uphold his duty to the non-executive. In other words, the executive must not engage in self-dealing. At the outset, it appears that Steadfast upheld its duty by obtaining the same royalty for Bradshaw as it obtained for itself. However, obtaining the same royalty does not equate to obtaining the same “benefit”. Instead, the Court in KCM Financial LLC, et al. suggests that all of the terms of an oil and gas lease must be considered in determining whether the executive obtained the same “benefits” for himself and the non-executive, including delay rentals, bonus amounts, royalty, and other such provisions.

Bradshaw presented evidence that (i) the 1/8 royalty interest negotiated by Steadfast was lower than the market rate royalty interest in the area at the time the Lease was executed, and (ii) the bonus paid to Steadfast was much higher than the customary lease bonus in the area at that time. Because Bradshaw had no right to any portion of the bonus, Bradshaw argued that Steadfast engaged in self-dealing by agreeing to an unusually low royalty, a benefit shared by both parties, in order to obtain an extraordinarily high lease bonus, a benefit enjoyed only by Steadfast. As such, Bradshaw claimed that Steadfast had breached its duty to her. In its discussion of the facts above, the Court commented that if “[Steadfast Financial] has misappropriated what would have been a shared benefit (a market-rate royalty interest) and converted it into a benefit reserved only unto itself (an enhanced bonus), with the intent to diminish the value of Bradshaw’s royalty interest . . . such conduct is the essence of self-dealing.” Although the Court alluded to the possibility that Steadfast’s conduct amounted to a breach of its duty to Bradshaw, the case was ultimately remanded back to the trial court without a final determination.

As such, what can we deduce from KCM Financial LLC, et al.? For holders of the executive right, it is clear that an executive right holder should, at the very least, obtain a market-rate royalty in the negotiation of an oil and gas lease. As recognized in KCM Financial LLC, et al., a court will likely consider all of the lease terms negotiated by the executive in determining whether the executive has upheld his duty to the non-executive. A non-executive interest owner is often only entitled to share in the royalty attributable to an oil and gas lease and thus will not share in any of the other benefits attributable to such lease (i.e. bonus and delay rentals). By obtaining a market-rate royalty, the executive has seemingly obtained a fair value for the benefit commonly shared by the executive and non-executive, which may shield the executive from a claim of self-dealing.

Although KCM Financial LLC, et al. may have shed some light on yet another factor to be considered when establishing whether an executive has upheld his duty to the non-executive, there is still no bright-line rule for executive right holders to follow. As a result, an executive should carefully consider the impact of all lease terms on the non-executive when negotiating an oil and gas lease.

Of course, this is not an exhaustive discussion of the law applicable to these issues. For more information on this topic, please email Megan Knell, Oil, Gas & Energy Lawyer with BRANSCOMB|PC. Her contact information is mknell@branscomblaw.com or (512) 735-7800.