In McCarthy v. Evolution Petroleum Corp., the Louisiana Supreme Court reviewed whether “novel and untested” legal theories relating to alleged fraud in the purchase of a mineral interest aligned with well-established principles of Louisiana mineral law. 2014-2607 (La. 10/14/15), __ So. 3d ___, 2015 WL 5972515. The question was whether a mineral lessee was under duty to disclose information to its lessors. At the time in question, the lessee was negotiating to purchase its lessor’s interest. But the lessee knew, to some extent at least, that the interest could be resold to a third party. The lessee purchased the interest and achieved a higher value on resale. According to the plaintiff lessors, this purchase and resale constituted fraud. The Supreme Court disagreed. It reversed the appellate court’s decision, and dismissed the plaintiff’s claim.
The plaintiffs in the case owned royalty interests to mineral leases within a Delhi Field Unit, located in Richland Parish, Louisiana. They were successors in interest to these mineral rights, which had been held active by production in paying quantities for more than 60 years. Many different entities had managed operations over the years. Evolution Petroleum Corporation eventually took control of operations, and in 2004, sought a purchaser for the property. Evolution agreed to sell the property to Denbury Resources, LLC for $50 million and other compensation. Denbury hoped CO2 enhanced recovery techniques would result in drastically increased production, estimating recovery of an extra 30 to 40 million barrels of oil from the property. Without disclosing the pending deal with Denbury to the plaintiffs, Evolution then made unsolicited offers to the plaintiffs, resulting in the purchase of their royalty interests in the property. The purchases amounted to $15,957 being paid to each of one group of plaintiffs, and $9,859 to another individual. The amounts, however, were valued at 16 years’ worth of previous royalties.
According to their lawsuit, plaintiffs alleged a “relation of confidence” developed between themselves and the operators over the 60 years the leases had been in effect. In response, Evolution moved to dismiss the lawsuit. The trial court granted the motion. On review, the intermediate appellate court, the Louisiana Second Circuit, agreed that the plaintiff’s lawsuit failed to state a legal cause of action. Importantly, however, the Second Circuit allowed the plaintiffs to amend their suit to properly state a legal cause of action. As the Second Circuit explained, although the plaintiff’s approach was novel, it was conceivable that Evolution might have been under a duty to act as a reasonably prudent operator for the mutual benefit of both parties, a duty that would have required disclosure of the Denbury deal.
The plaintiffs then re-filed their lawsuit and added that Evolution failed to act as a good faith operator for the mutual benefit of the parties, in violation of Mineral Code Article 122. Evolution moved to dismiss for a second time, and again, trial court agreed with the operator and dismissed. The case was once again appealed. Reviewing the case a second time, the Louisiana Second Circuit ruled that the plaintiffs’ lawsuit properly stated a legal cause of action. The court focused on the fact that Evolution paid the plaintiffs a purchase price based on previous production, when Evolution knew that enhanced recovery techniques would attribute greatly to future production. The court found that Evolution’s focus on previous production in purchase negotiations, when it knew future production would be greater, amounted to fraud by false assertion.
The court also found that there was fraud by silence. This cause of action derived from Evolution’s status as operator. The court held that it was the duty of a reasonably prudent operator to continue to exercise its lease rights for the mutual advantage and profit of both parties to the lease. In light of Denbury’s impending projects for the property, the court ruled that Evolution might have been under a duty to inform its lessors of the long-planned project for development.
The court did observe that under the law, Evolution was neither the fiduciary nor the trustee of its lessors, and the court conceded that the plaintiffs’ claim was both “novel and untested.” But the bottom line of the Second Circuit’s decision was this: if there was a certain level of ‘closeness’ in the relationship between Evolution and the plaintiffs, then Evolution had a duty to disclose information. The Second Circuit therefore ruled the plaintiffs’ claims could not be dismissed, and the case would have to proceed. Evolution then appealed to the Louisiana Supreme Court.
The Supreme Court granted review and overturned the Second Circuit’s decision, holding that the operator Evolution was not under a duty to disclose the impending Denbury deal to its lessors. The first matter of law that the court turned to was whether Mineral Code Article 122 recognizes a cause of action for fraud by silence. The case therefore “significantly hinged” upon Article 122, which states:
A mineral lessee is not under a fiduciary obligation to his lessor, but he is bound to perform the contract in good faith and to develop and operate the property leased as a reasonably prudent operator for the mutual benefit of himself and his lessor. Parties may stipulate what shall constitute reasonably prudent conduct on the part of the lessee.
La. R. S. 31:122.
The Court first observed that although Louisiana law recognized that fraud may result from silence or an action, the law also required that, for fraud to result from a silence or suppression of the truth, there must also existed duty speak or to disclose information. The plaintiffs’ petition was devoid of any allegation of any relationship of confidence, the
Court noted. Did Mineral Code Article 122 create that duty? The Court reasoned that under Mineral Code Article 122, the duty of the mineral lessee did not include disclosure of information. For example, it was well known that certain information gained through geological data and technical developments remains proprietary. In contrast, however, the Court stated that contractually imposing a duty to disclose information could be permissible, if that is what the parties agreed. But in reviewing the record, the Supreme Court recognized there was no allegation that the parties agreed to such disclosure. Further, Article 122 itself did not impose such an obligation. The Court reasoned that the obligations under Article 122 are addressed to “mineral development” operations, not “buying and selling” properties. Citing the Louisiana Mineral Law Treatise, the Court reasoned further that the mineral lessee was “not required to place the interests of the lessor ahead of [its] own, nor was [it] bound by the traditional fiduciary restraints of full disclosure, lack of self-dealing, or prohibition against profiting from the affairs of one’s principle.” Patrick Martin, Louisiana Mineral Law Treatise § 1003 (2012). To hold, as the Second Circuit did, that the relationship between lessor and lessee could rise to a “certain level” which would require disclosure was against the plain language of Article 122: “A mineral lessee is not under a fiduciary obligation to his lessor….” La. R. S. 31:122.
The Court then turned to the question of fraud by affirmative misrepresentation. In this allegation, plaintiffs stated that Evolution ‘misdirected’ their attention to prior production. Prior production was largely irrelevant to the assessment of the present value of the interest. But the Court observed that the Louisiana Mineral Code expressly prohibits the rescission of sales premised on what it is called in Louisiana “lesion beyond moiety,” a rule that allows the seller to rescind a sale of property when the sale made for an amount less than one-half the fair market value of the property. Louisiana Civil Code Article 2589. Thus the Louisiana Mineral Code, in Article 17, specifically states that lesion beyond moiety does not apply to a sale of minerals. La. R.S. 31:17. The Louisiana Supreme Court seized upon this point. It noted the Second Circuit’s ruling essentially allowed the plaintiffs to circumvent this prohibition. Even if Evolution’s representations to plaintiffs were misleading by focusing on past values of production, the plaintiffs still did not have a claim on which they could recover. Since the plaintiffs complained about the fairness of the price compared to market value, the Court ruled that the plaintiffs’ allegations were “a disguised – but prohibited” claim of lesion beyond moiety. The Court concluded that the plaintiffs’ claims for fraud by misrepresentation were prohibited by Mineral Code Article 17.
The Second Circuit’s allowance of a “novel and untested” legal claim to proceed against the operator was based on its conclusion that the lessee was under a duty to disclose more information than a normal purchaser. As the Louisiana Supreme Court held, this holding was incorrect because the mineral lessee is, by law, not a fiduciary of its lessor. Louisiana law has long recognized (as the Supreme Court expressly pointed out) that mineral exploration is both costly and inherently speculative. The recent McCarthy decision recognizes those well-worn principles and ensures uniformity of Louisiana’s mineral law, by reaffirming two established points of law: 1) a mineral lessee is not under a fiduciary obligation to its lessor, La. R. S. 31:122, and 2) a sale of mineral rights cannot be rescinded simply because it is made for less than ½ of its fair market value, unlike a standard transaction of real property in Louisiana. La. R. S. 31:17.