Pennsylvania Oil and Gas Producers Need to Prepare for New Legislation That Could Give Rise to Disputes with Royalty Owners
Given the undefined parameters of certain of the audit provisions contained in the proposed legislation, producers facing audit requests should undertake a careful review of the proposed legislation and consult with counsel to prepare for the possible enactment of the proposed legislation given the added compliance burdens that the it would create.
On January 30, 2017, the Pennsylvania Senate by a unanimous vote passed two bills—Senate Bill 138 (“SB 138”), which will amend the Oil and Gas Lease Act (the “Act”) and Senate Bill 139 (“SB 139”), which will be a stand-alone law titled the “Natural Gas Lease Anti-Retaliation Act.” Given the overwhelming bipartisan support, many public policy commentators believe the bills could be enacted before the end of the year.
SB 138 will require: (i) that proceeds from production be paid within 90 days of production; (ii) that in the case of a production “joint venture,” information about the “joint venture company” must be disclosed to the interest owners on an annual basis; and (iii) that lessors (or their agents) may conduct an in-person audit of royalty payment information.
SB 139 will prohibit retaliatory action by a lessee against a lessor that has initiated a “good faith action”—whether by “claim, demand or complaint”—that is “intended to secure rights granted under a lease or to determine whether the terms of a lease are being complied with[.]” Thus, under SB 139, a lessor will have a new cause of action where a lessor makes an inquiry or complaint about its royalty payments, and the lessee, in retaliation, ceases production.
If passed, SB 138 will likely have a more immediate impact on oil and gas producers and non-operating joint venture partners. For some producers, it may require payment practices to be changed, and an additional disclosure to be made regarding joint venture partners. Some consideration will also have to be given as to how to comply with SB 138 audit provisions, which appear to contemplate a one-day in-person process but without much direction as to the scope of that process.
Senate Bill 138
The Notable Changes
SB 138 will amend the Oil and Gas Lease Act in a number of different ways. The four most notable changes are described below.
- First, SB 138 adds several new definitions to the Act, including defining “lessor” in a way that appears to be relatively narrow. SB 138 will now define “lessor” as an “owner of oil and gas in place that controls the oil and gas rights and executes a lease granting the right to explore, drill, stimulate, produce, market or sell oil, gas or natural gas liquids.” As noted below, the definition of “lessor” becomes important, as SB 138’s new audit provisions only apply to lessors and their designees.
- Second, SB 138 also now defines “joint venture company” and imposes an additional annual reporting obligation with respect to joint ventures, with the apparent goal of each joint venture member making clear its proportionate share of any production. A “joint venture company” is defined as “an association or other contractual relationship of two or more individuals or companies engaged in the production of an oil or natural gas well for profit without actual partnership or incorporation.” It would appear, therefore, that a “joint venture” could include working-interest owners, non-operator financial investors, and farmout contracting partners.
Under SB 138, “if the joint venture company is separately paying its share of the royalty,” the following information must be provided on an annual basis to each interest owner: (1) joint venture’s name, (2) its address, (3) its telephone number, and (4) the “proportionate share of oil or natural gas that each joint venture markets, expressed as a decimal interest.”
- Third, SB 138 mandates that royalty payments be made within 90 days of production, unless otherwise provided for by contract, and provides for a remedy of interest (at the governing legal rate) for any late payments. Notably, SB 138 makes clear that the parties to an oil and gas lease can contract around the 90-day requirement, and therefore for existing leases that provide for longer lags between production and payment, SB 138 should have no effect on those leases.
- Fourth, and perhaps most significantly, SB 138 creates new audit rights for oil and gas lessors. In Section 4, SB 138 provides authority to “a lessor [or his agent to] inspect the supporting documentation of a lessee for the payment information required under section 3.2.”.
Sections 4(b)(2)(i) and (ii) requires that the lessee shall “designate a location in this Commonwealth for inspection which shall not impose an unreasonable travel burden” on the lessor, and “designate a date for inspection” that is mutually agreeable or is “within 90 days of receipt of the request.”
Additionally, Section 4(b)(2)(v) requires that a “knowledgeable individual [be made available] who is able to answer questions pertaining to accounting issues regarding a well which is the subject of the request.”
And, lastly, Section 4(c) provides that “information provided to a lessor . . . that makes [an inspection] request” must be kept confidential and “may not be disclosed . . . except to an attorney or accountant employed by the lessor.”
Impact of SB 138’s Changes
While SB 138 appears to be relatively straightforward in many respects, several of its changes raise additional questions and have the potential to create confusion and disputes as both oil and gas lessors and lessees attempt to comply with the new changes. For example:
- Who is entitled to request an audit? Under SB 138, only lessors or their agents can make the inspection request. But the definition of “lessor” is narrow, as a lessor is only a person who “executes a lease.” Oftentimes, lessors will assign their oil and gas rights to others. Based on the narrow definition of “lessor,” an assignee of a lessor’s interest seemingly does not have any audit rights under SB 138.
- What is the scope of the audit? SB 138 permits an audit of “supporting documentation,” but what that consists of is not clear. One limitation is that for midstream services provided by unaffiliated third parties, only invoices for those services need to be provided, and a “composition of the fees” need not be provided. While unclear, this appears to suggest that where an unaffiliated midstream company provides bundled gathering services, a producer need not unbundle those fees for purposes of the audit. SB 138 also does not expressly limit how far back in time the available “supporting documentation” must reach. A request can be made by the same lessor only once in a 12-month period, and thus the intent of SB 138 may be to limit the time parameters for an audit to only a 12-month payment period.
- What will the audit look like? SB 138 appears to contemplate a one-day in-person audit, where the supporting documentation can be inspected and where the lessor can ask a “knowledgeable individual” questions about the information. The producer must designate a location for the audit within Pennsylvania that will not impose an “unreasonable travel burden” on the lessor. SB 138 only provides for a lessor to have the right to inspect documents at the audit, not to copy them, and therefore there does not appear to be any duty by a producer to furnish copies of any supporting documents to a lessor (if copies of documents are voluntarily copied and produced, then SB 138 requires that they be treated as confidential). At the audit, the producer must “[m]ake available a knowledgeable individual who is able to answer questions pertaining to accounting issues regarding a well which is the subject of the request.” SB 138’s “make available” language appears to be intentionally broad, and could be interpreted to mean that such a person need only be available by telephone or be on call.
- What if an existing lease already has audit provisions? Some leases already provide for audit rights and an audit process. SB 138 does not expressly address this scenario, or create an exception to its audit provisions in the event that an oil and gas lease already has audit provisions. For existing leases that provide for different inspection procedures, the audit provision of SB 138 may be subject to constitutional challenges under the Contracts Clause of the U.S. Constitution.
- What are the penalties or remedies for non-compliance with SB 138’s audit provision? SB 138 does not provide for any remedies in the event that one or both sides do not comply with the audit provisions. If disputes arise, this may necessitate judicial intervention and potentially injunctive relief.
- When does the new joint venture disclosure apply? SB 138 requires a new annual disclosure, largely aimed at identifying all joint venture entities and describing their proportionate share of the gas that they sell. But the annual disclosure of SB 138 only applies “if the joint venture company is separately paying its share of the royalty.” Unfortunately, this language is unclear. On one hand, this seems to suggest that the new disclosure only applies when the royalty payment is made by the joint venture entity itself (i.e., “the joint venture company”). On the other hand, the language could be interpreted to mean that it applies when each member of a joint venture separately pays its share of royalties. SB 138 also does not specify who needs to make the disclosure. Operators and non-operators who are involved in joint ventures will need to carefully examine SB 138 and coordinate how any disclosures should be made. Even if some joint ventures believe that they are exempt or fall outside of SB 138, given the lack of clarity in SB 138, it may be prudent to make an annual disclosure of all proportionate shares of production.
Senate Bill 139
SB 139 creates a new cause of action for lessors. Specifically, if a lessor can show that a lessee has retaliated against it for making a good faith complaint, the lessor can bring a civil lawsuit, seeking “reasonable damage.” SB 139 appears to be targeted at the situation where a lessor makes an inquiry or complaint about its royalty payments, and the lessee, in retaliation, ceases production.
Notably, under SB 139, a lessee can defend its conduct on the basis of the lease—that is, if conduct is authorized under the lease, then that is one defense to such a retaliation claim. Because most leases give producers the ability to shut in wells or surrender the lease, it remains to be seen whether claims under SB 139 will be brought or be successful in surviving past the pleading stage in litigation.
SB 138 and SB 139 are important changes to the existing legislative landscape. With respect to SB 138, companies involved in joint ventures and companies that are responsible for the payment of oil and gas royalties will need to ensure compliance with SB 138’s new disclosure and audit provisions. With respect to SB 139, oil and gas companies should monitor how these claims are being treated through the courts and how courts interpret the parameters of this new statute.
More broadly, SB 138 and SB 139 appear to be part of a broader package of new legislative initiatives on issues of oil and gas leases and royalties. A variety of additional legislative initiatives have been proposed that would attempt to regulate, modify, or otherwise affect the terms of parties’ existing oil and gas leases in spite of constitutional prohibitions on legislation that impairs existing contracts. Those initiatives should be closely watched given the potential effect of legislation on the relationship between production companies and landowners.
 The “supporting documentation” relates to information that is already required to be disclosed on check stubs under current Section 3.2 of the Act—specifically: total barrels of oil or Mcf of gas sold; price received per barrel or Mcf; total amount of severance and other taxes and deductions permitted under the lease; net value of total sales from the property less taxes and deductions; interest owner’s interest in production, expressed as a fraction; interest owner’s share of total value of sales prior to deductions; and interest owner’s share of the sales value less the interest owner’s share of taxes and deductions.
 The Supreme Court of the United States has stated that a Contracts Clause challenge to a state law may be successful where that law “operate[s] as a substantial impairment of a contractual relationship” and where that “impairment is substantial.” General Motors Corp. v. Romein, 503 U.S. 181, 186 (1992) (citing Allied Structural Steel Co. v. Spannaus, 438 U.S. 234, 244 (1978)).