Operators take note – the Texas Supreme Court has agreed to hear the petition for review of an operator sued in 2002 for breach of contract for underpaying royalties between 1988 and 1997. The case is captioned: Shell Oil Company, SWEPI L.P. d/b/a Shell Western E7P, successor in interest to Shell Western E&P, Inc., v. Ralph Ross. The Court of Appeals in Houston, First District, released its opinion on February 25, 2010, ruling a royalty owner is able to recoup monies that were not paid to it for many years beyond the typical time bar of four years prior to filing suit. This Houston opinion is not yet controlling in West Texas, but the Supreme Court’s upcoming decision will certainly affect the Permian Basin oil and gas industry.

In a traditional suit for breach of contract in Texas (the appropriate claim a royalty owner can bring against an operator for underpayment of royalties), the royalty owner would be limited to collecting for underpayment for only four years prior to the royalty owner filing suit. This is due to the ‘statute of limitations’ for a breach of contract suit. Statute of limitations are in place to fairly and efficiently try lawsuits in a timely fashion. After the passage of time, memories of witnesses and parties are not as fresh and relevant documents may no longer exist, so a plaintiff must bring only timely claims in a suit.

An exception to the statute of limitation for a breach of contract claim, however, is the allegation that a defendant ‘fraudulently concealed’ the facts that would give a plaintiff knowledge of his claim. In order to show fraudulent concealment, the Texas Supreme Court has held that a plaintiff must show the following: (1) that the defendant acted with fraudulent intent and concealed a wrong known to it; and, (2) that the plaintiff used reasonable diligence to protect its interests prior to the expiration of the statute of simitations. For operators, even a finding that a breach of contract occurred does not automatically prove that the operator engaged in fraudulent concealment. Or at least this has been the long-understood state of the law.

In the case now before the Supreme Court, the Houston Court of Appeals found there was sufficient evidence to prove fraudulent concealment because Shell committed several contractual breaches, or “systematic breaches”. This finding is contrary to previous Texas Supreme Court rulings that “mere breach of contract is not fraud and may not be evidence of fraud.” What’s more, despite the requirement that the plaintiff use reasonable diligence to investigate any potential shortages, the Court of Appeals accepted the plaintiff’s claim that he did not request information from Shell, or research his concerns, because “it would not have mattered”. This is not only not reasonable diligence, it is complete inactivity, which should not allow the plaintiff to claim fraudulent concealment allows him the additional time to bring his claims against the defendant. A puzzling decision, to be sure.

The startling effect on Texas operators is that any royalty check can be challenged, regardless of how long ago it was sent, and despite a claim being brought well after the four year statute of limitations. If this becomes Texas law, then even if the royalty owners sit on potential underpayment of royalty claims for decades, they will be allowed to collect underpayments and damages decades after the checks were received by them. Further, we will almost certainly see an increase in lawsuits by royalty owners who were previously barred from attempting to collect alleged unpaid royalties. Costs for operators and other interest owners will rise as involvement in litigation is required. If the Texas Supreme Court agrees with the Houston Court of Appeals, every breach of contract case against an operator becomes a case for fraud as well, eradicating the four year time bar found in the statute of limitations. Operators across Texas will have to be on guard, and retain records, indefinitely, out of fear of being sued for a royalty payment sent in the early eighties! Operators need to follow the briefing in this suit with concern. The briefs filed in this case, and the notification of oral argument, when granted, can be found at http://www.supreme.courts.state.tx.us.