KENTUCKY ROYALTY LITIGATION

UPDATE

Karen J. Greenwell

Wyatt, Tarrant & Combs, LLP

250 West Main Street

Suite 1600

Lexington, Kentucky 40507

Royalties

Royalty Calculation Issue Created When Product is Sold

Away From The Well

Mostly a Gas Issue

Common Lease Terms:

“Market Price at the Well”

“Proceeds at the Well”

How do you Determine the Price or Proceeds “at the

well”?

Royalties

Can You Deduct Post-production Costs From

The Sales Price To “Net-back” To “Market Price”

Or “Proceeds” “At The Well”?

Can gas severance taxes be deducted in that

calculation?

ROYALTY LITIGATION

Appalachian Land Company v. EQT

Production Company (Federal Ct.)

Baker v. Magnum Hunter Production,

Inc. (Ky State Ct.)(Pending)

Court SystemsKentucky State Courts

Kentucky Supreme

Court

Kentucky Court of

Appeals

County Circuit Courts

County District Courts

Federal Courts for KY

U.S. Supreme Court

6th Circuit Court of Appeals

US District Court, Eastern

and Western Districts of

Kentucky

Federal Court

Federal Courts Apply The Substantive

Law Of The Applicable State On State

Issues

If The State Appellate Courts Have Not

Decided A Point Of Law, The Federal

Courts Must “Guess” What The State

Courts Will Do

Or

Federal Court

The Federal Court Can Ask The State Court By

“Certifying” The Question To The State Court.

The Federal Court’s “Guess” Is Not Binding On

Kentucky State Courts, And They The State

Courts Are Free To Come To The Opposite

Conclusion.

POPLAR CREEK

In Poplar Creek, The Federal Courts Made Their Own Guess About What Kentucky Law Would Be On The Deductibility Of Post-Production Costs

Trial Court – July 2, 2009

KY Courts Would Interpret “At The Well” To Mean Producer Pays On Value Of Gas “Before It Has Been Gathered, Treated Or Compressed”

Appellate Court (6th Circuit)

Affirmed

“We Hold That Kentucky Follows The “At-the-well” Rule, Which Allows For The Deduction Of Post-production Costs Before Paying Appropriate Royalties.”

Severance Taxes Were Not An Issue

APPALACHIAN LAND (Federal Ct.)

Addressed Deductibility Of Post Production Costs And

Gas Severance Taxes In Calculating Gas Royalty.

Held In Abeyance Until 6TH Circuit Ruled In Poplar Creek

Trial Court – Judgment On The Pleadings:

Adopted 6TH Circuit’s Poplar Creek Ruling That Costs

Are Deductible

Ruled That Severance Taxes Are Deductible As Post-

production Costs

6TH Circuit

Certified Deductibility Of Severance Taxes To The

Kentucky Supreme Court

APPALACHIAN LAND (Ky Sup. Ct.)

6TH Circuit

Certified Deductibility Of Severance Taxes To The

Kentucky Supreme Court

The Kentucky Supreme Court answered saying:

“[W]e conclude that in the absence of a specific lease

provision apportioning severance taxes, lessees may not

deduct severance taxes or any portion thereof prior to

calculating a royalty value.”

APPALACHIAN LAND (Ky Sup. Ct.)

The Kentucky Supreme Court Found That:

The Gas Severance Tax (KRS 143A.060) Is Imposed

For The Privilege Of Producing Gas.

The Tax Is Not A Post-Production Cost.

The Opinion Does Not Specifically Address The Oil

Severance Tax. (KRS 137.120)

APPALACHIAN LAND (Ky. Sup Ct.)

Although The Ky. Sup. Ct. Opinion Was A

Response To A Certified Question, It Is Now A

Published, Final Declaration Of Kentucky Law

And Will Be Binding On All Kentucky Courts.

What Now?

APPALACHIAN LAND (Ky. Sup Ct.)Severance Taxes Should Not Be Deducted In

Calculating Gas Royalties At The Well, Unless The

Lease Permits It.

The 6th Circuit Will Send The Case Back To The

District Court To Decide Damages For Improperly

Deducted Severance Taxes.

The District Court Will Have To Address The Practical

Questions Of Who Is Entitled To Recover, For What

Periods, From Whom, And How Much.

APPALACHIAN LAND (Ky. Sup Ct.)

What Is The Period Of Possible Recovery?

If The Ruling Is Viewed As Purely Prospective, There

Might Be No Recovery Allowed For Periods Prior To

The Ruling.

KRS 413.120 (4) Establishes A 5-year Statute Of

Limitations For An Actions For Profits Or Damages

For Withholding Real Or Personal Property.

APPALACHIAN LAND (Ky. Sup Ct.)

KRS 413.120(11) establishes a 5-year statute of

limitations for an action based on fraud or mistake.

Punitive damages may be available on a fraud

claim.

KRS 413.090(2) establishes a 15-year statute of

limitations for an action on a written contract executed

before July 15, 2014. The statute of limitations is 10

years for those later contracts (KRS 413.160).

APPALACHIAN LAND (Ky. Sup Ct.)

Who Can Recover? That Will Depend On

Circumstances Of Each Lease.

Generally, The Claim Belongs To The Lessor At The

Time The Claim Accrued, As It Accrued, And Does Not

Go To A Successor Lessor.

Has A Lessor Died During The Damages Period?

With A Will: The Claim May Have Been Expressly Conveyed Or

It May Have Passed In The Residuary.

Without A Will: The Claim Will Pass As Personal Property Under

The Laws Of Descent And Distribution.

APPALACHIAN LAND (Ky. Sup Ct.)

Has the lessor assigned the lease or transferred

the property?

Did the assignment or deed specifically

include accrued claims?

If not, those claims may still belong to the

assignor/grantor.

APPALACHIAN LAND (Ky. Sup Ct.)

Did Claims Accrue During The Tenure Of A Prior

Lessee?

Did The Successor Lessee Specifically

Assume Any Accrued Claims?

Are There Contractual Rights Of Indemnity

Against The Prior Lessee?

APPALACHIAN LAND (Ky. Sup Ct.)

Does App. Land Apply To Oil Severance Taxes?

Possibly/Probably Not.

KRS 137.120 says: “The tax … shall be imposed

ratably upon all persons owning any interest in such

oil.”

If The Oil Is Deemed To Have Been Taken In Kind

And Sold By The Lessor At The Wellhead, Then The

Lessor Would Be An “Owner” And Subject To The

Tax.

This Would Be Particularly Applicable If The Jobber

Pays The Lessor Directly.

APPALACHIAN LAND (Ky. Sup Ct.)

Regardless Of What The Federal District Court

Decides, There Will Likely Be Appeals.

When These Issues Are Taken Up By The State

Courts, They May Have Different Answers.

BAKER (Pending)

State Court Case

Addressed the Deductibility Of Post-Production

Costs To Arrive at Price “at-the-well”

Severance Taxes Not An Issue

Harlan Circuit Court

“Kentucky follows the “at-the-well” rule that

permits a lessee to deduct its post-production

costs before the royalty payment to the lessor

is calculated.”

Ky Court of Appeals agreed.

BAKER

Kentucky Supreme Court

“[U]nder standard ‘market price (value) at the

well’ royalty clauses, the lessee is solely

responsible for the costs of production – of

bringing the gas to the well – but post-

production costs for such marketing-related

enhancements as accumulating,

compressing, processing, and transporting

the gas may be deducted from gross receipts

before the calculation of the royalty share.”

BAKER

The landowners filed a petition for rehearing on

9/9/15.

MHP Has 20 days to respond.

Since the Ky Supreme Court’s opinion was

unanimous, it seems unlikely there will be a

substantial change in response to the petition.

BAKER

Once Baker Becomes Final And We Know That

Post-production Costs Are Deductible, The

Focus, In State And Federal Court, Will Turn To

Questions About The Amount, Nature,

Reasonableness And Proof Of The Deductible

Costs.

KENTUCKY ROYALTY LITIGATION

UPDATE

Karen J. Greenwell

Wyatt, Tarrant & Combs, LLP

250 West Main Street

Suite 1600

Lexington, Kentucky 40507