Chapter 8. Adrift on the Implied Covenant to Market: Regulation By Implication

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1 CITE AS 24 Energy & Min. L. Inst. ch. 8 (2004) Chapter 8 Adrift on the Implied Covenant to Market: Regulation By Implication By David W. Hardymon Vorys, Sater, Seymour and Pease LLP Columbus, Ohio Synopsis Introduction Implied Covenants in Leases [1] Traditional Analysis Three Covenants Implied to Protect the Reversionary Interest [a] Duty to Prevent Waste [b] Duty to Prevent Others from Committing Waste [c] Duty to Repair [2] Oil and Gas Leases Additional Convents Implied [a] Implied Covenant to Protect the Leased Premises Against Drainage [b] The Pro-active Covenants [c] The Implied Covenant to Drill an Exploratory Well [d] The Implied Covenant to Drill Additional Wells [e] The Prudent Operator Standard [f] The Implied Covenant to Market Good Faith and Fair Dealing [1] Historical Perspective [2] Developments in the Uniform Commercial Code [a] Drafting History [b] A Problem of Interpretation [c] Current Definition [d] The UCC Does Not Require Mutual Aid [3] Common Law Good Faith and Fair Dealing

2 8.01 ENERGY & MINERAL LAW INSTITUTE The Expansion of the Implied Duty to Market [1] Market Value [2] Post-Production Cost Deductions [a] At-the-Well Cases [b] Marketable Condition Cases [c] We re Not in Kansas Anymore The Legislative Response Conclusion Introduction. This is an attempt by a practitioner to make sense of the innumerable cases discussing implied covenants in oil and gas leases. It is a premise of this chapter that the law of implied covenants in oil and gas leases has become detached from the bedrock principles of property and contract law upon which it was initially founded. One result is that the force of implied covenants has shifted from the protection, maintenance and development of the leasehold estate to the regulation of the parties conduct. More significantly, the focus has recently moved from the conduct of the parties with respect to their actions on the leasehold premises to the conduct of the lessee with respect to his actions in the marketplace. This drift away from property and contract law principles toward regulation by implication has been accompanied by the abandonment of long-standing rules for construing written instruments. This chapter necessarily includes a survey of trends in property and contract law, any one of which could be discussed in exhaustive fashion. It also necessarily contains citations to numerous cases for general propositions, although it is recognized that many of these cases have already been the subject of extensive analysis by various commentators. It is not my purpose to repeat or take issue with what others have written on the subject of implied covenants in oil and gas leases. I seek only to provoke thought and reflection on three points. First, that the contract concept of good faith and fair dealing is not analogous to the implied covenant to market in an oil and gas lease. Second, by their recent expansion of the implied covenant to market, a distinct minority of jurisdictions has broken new ground by requiring of lessees not simply honesty in fact and reasonable commercial conduct, but also, a subversion 208

3 IMPLIED COVENANTS 8.02 of the lessees own interests to those of the lessor. Third, the invasion of the marketplace by implied covenants derived from instruments of conveyance has brought unpredictability to the law governing the conduct of oil and gas lessees Implied Covenants in Leases. [1] Traditional Analysis Three Covenants Implied to Protect the Reversionary Interest. Historically, leases were conveyances to be construed under principles of property, not contract law. 2 One difference between property and contract law was that a property conveyance could not contain implied covenants, while unexpressed terms and conditions were frequently read into contracts as implied covenants. 3 The rationale for property law s ban on these covenants was based on the idea that the landlord sold to the tenant the exclusive right to possess the demised premises, and that the tenant s primary interest was in the land. Hence the cliché nothing is implied in a conveyance. 4 1 This chapter was written with the assistance of two of my colleagues in the practice of law, Gina R. Russo and Joseph L. Cohen. Their research, drafting, energy and patience made this chapter possible. However, the chapter s premise and conclusions, as well as its errors and omissions, are mine. 2 Robert H. Kelley, Any Reports of the Death of the Property Law Paradigm for Leases Have Been Greatly Exaggerated, 41 Wayne L. Rev. 1563, 1593 (1995). 3 E. Allen Farnsworth, Contracts , 8.2 (2d ed. 1990). 4 Kelley, supra note 2, at 1593 (citing John H. Kennedy, Nothing s Implied in a Lease, Court Finds, Boston Globe, Mar. 12, 1992 at 49, discussing 21 Merch. Row Corp. v. Merch. Row, Inc., 587 N.E.2d 788 (Mass. 1992) where the court reversed the lower court s holding that a commercial lease included an implied covenant that the landlord must act reasonably when withholding consent to an assignment. Cf. According to Robert Kelley, author of Any Reports of the Death of the Property Law Paradigm for Leases Have Been Greatly Exaggerated, this cliché was never true, but was merely an excuse to justify results that arguably might have made sense in England during the High Middle Ages and early Renaissance, but which made no sense in the United States..., Kelley, supra note 2, at After all, implied covenants are said to have existed in both fee and leasehold conveyances even in medieval England. Id. at (providing 209

4 8.02 ENERGY & MINERAL LAW INSTITUTE Under modern landlord/tenant law, the implied covenants imposed upon a lessee in a typical landlord tenant relationship are few in number. 5 They include: to refrain from waste, to protect against or at least to be responsible for waste by third persons, and to make ordinary repairs. 6 Their existence is substantiated because they protect the landlord s reversionary interest and advance the basic principles of property law. 7 [a] Duty to Prevent Waste. A tenant under a lease has the right to use and enjoy the premises in the condition in which he receives it, but cannot do any act to diminish its as an example of early implied covenants that at a time when the words of general inheritance and his heirs were absolutely necessary to create a fee simple estate in a human being, a conveyance of a remainder to the heirs of a living person was construed to read to the heirs of [the living person] and their heirs, and therefore, a fee simple estate was conveyed). 5 Maurice A. Merrill, The Law Relating to Covenants Implied in Oil and Gas Leases, 223 at 473 (2d ed. 1940). 6 Tiffany, The Law of Landlord and Tenant, Vol. I 109, 110, 115 (1910). Two more covenants have received recognition, including (1) the duty to occupy and use the demised premises and (2) to vacate the premises at the end of the tenancy. Obviously, the latter directly protects the landlord s reversionary interest because it guarantees the return of the property when the lease terminates. See Robert S. Schoshinski, American Law of Landlord and Tenant 5.18 (1980); 1 American Law of Property 3.78, at 347 (A. James Casner, ed. 1952). The former, concededly, protects the landlord s right to receive an appropriate rental value, see Schoshinsk at 5.3 (discussing commercial leases containing percentage rent provisions). However, this implied covenant does not exist unless a percentage rent provision is in place. Id. 7 For an explanation of the reversionary interest, see Watkins v. Restorative Care Center, Inc., 831 P.2d 1085, 1091 (Wash. Ct. App. 1992)(landlord s reversion is estate left in lessor upon completion of lease term); Hueschen v. Stalies, 652 P.2d 246, 248 (N.M. 1982)(at the end of lease period, there is a reversion of the estate back to the grantor); Burnette v. Thomas, 349 So. 2d 1208, 1210 (Fla. Dist. Ct. App. 1977)(landlord and tenant have separate estates in the demised premises during the term of the lease, with tenant s being a possessory interest and landlord s a reversion interest); Miller v. Lemon Tree Inn of Roanoke Rapids, Inc., 233 S.E.2d 69, 72 (N.C. Ct. App. 1977)(leasehold and reversion are separate estates in same property); Ferguson v. District Court of Oklahoma County, 544 P.2d 498, 499 (Okla. 1975)(during the term of the lease, lessee holds outstanding leasehold in premises which for all practical purposes is 210

5 IMPLIED COVENANTS 8.02 value to the injury of the reversion. 8 Put simply, the tenant cannot commit waste. The duty to prevent waste is deeply rooted in case law. In England, holders of a fee simple or fee tail had remedies for injury to real property by tenants who took by operation of law and by tenants at will. 9 At the time, three types of life estates came into being by operation of law: tenant in dower, tenant in courtesy, and guardian in chivalry. Because these life estates arose without the specific volition of any person, the persons to whom the property would pass at the end of these estates needed protection against improper conduct by the life tenants. 10 The law thus safeguarded the inheritance against waste at the hands of the particular tenant where it established the particular estate. 11 It followed that owners of fee interests should be able to maintain a cause of action against such tenants for waste, defined by Blackstone as a spoil or destruction in houses, gardens, trees, or other corporeal hereditaments, to the disherison of him that hath the remainder of reversion 12 Today, the keynote to the definition of waste remains the impingement upon the ultimate estate of the landlord. 13 Inherent in virtually every definition of waste is the notion that the reversionary estate must be protected. For example, waste is defined as an act which affects a vital and substantial portion of the premises, changing its characteristic and appearance, the fundamental purpose of the structure, or the uses contemplated, or a change of such a nature to affect the very realty itself, equivalent to absolute ownership; estate of lessor during such time is limited to his reversionary interest which ripens into perfect title upon the expiration of the lease). 8 Tiffany, supra note 6, 109 at See Vollertsen v. Lamb, 732 P.2d 486 (Or. 1987)(providing an excellent discussion of the history of the law of waste) Powell, The Law of Real Property Camden Trust Co. v. Handle, 26 A.2d 865, 867 (N.J. 1942) Blackstone, Commentaries 281. See also Powell, supra note 10 at Id. See also Wingard v. Lee, 336 S.E.2d 498, 500 (S.C. Ct. App. 1985)(stating that at common law, waste is any permanent injury to lands, houses, gardens, trees or other corporeal hereditaments done or permitted by the tenant of an estate less than a fee to the prejudice of the reversion or remainder). 211

6 8.02 ENERGY & MINERAL LAW INSTITUTE extraordinary in scope and effect or unusual in expenditure. 14 Waste has been further defined as the destruction or material alteration of any part of a tenement by a tenant for life or years, to the injury of the person entitled to the inheritance; 15 an unlawful act or omission of duty on the part of the tenant which results in permanent injury to the inheritance; 16 any act or omission of duty by a tenant of land which does a lasting injury to the freehold, tends toward the owner s permanent loss of the fee, or the destruction or decrease of the value of the inheritance; 17 as any spoil or destruction done or permitted with respect to lands, houses, gardens, trees, or other corporeal hereditaments by the tenant thereof, to his prejudice in reversion or remainder, in other words, to the lasting injury of the inheritance; 18 and finally, as a violation of the obligation of the tenant to treat the premises in such a manner that no harm is done to them and that the estate may revert to those having the reversionary interest without material deterioration. 19 Waste cases typically fall into two categories, voluntary waste, which usually consists of affirmative acts on the part of the tenant causing injury to the premises, and permissive waste, which involves acts of omission 14 Rumiche Corp. v. Eisenreich, 352 N.E.2d 125, 128 (N.Y. 1976). 15 See, e.g., Lustig v. U.M.C. Indus., Inc., 637 S.W.2d 55, 59 (Mo. Ct. App. 1982)( Waste is the failure of a tenant to exercise ordinary care in the use of the leased premises or property that causes material and permanent injury thereto over and above ordinary wear and tear. ). 16 See, e.g., Hardie v. Chew Fish Yuen, 258 Cal. App. 2d 301, 304 (1968). 17 See Bond v. Lockwood, 33 Ill. 212, 214 (Ill. 1864)(any act or omission which diminishes the value of the estate or its income, or increases, the burdens upon it or impairs the evidence of title thereto, is considered waste). 18 See Thomas v. Thomas, 82 S.E. 1032, 1033 (N.C. 1914)(stating that waste is any permanent injury to lands, houses, gardens, trees, or other corporeal hereditaments done or permitted by the tenant of an estate less than a fee to the prejudice of him in reversion or remainder). 19 See, e.g., Three and One Co. v. Geilfuss, 504 N.W.2d 393, 397 (Wis. Ct. App. 1993)( Waste is unreasonable conduct by the owner of a possessory estate that results in physical damage to the real estate and substantial diminution in the value of the estate in which other have an interest. ). 212

7 IMPLIED COVENANTS 8.02 rather than commission on the part of the tenant. 20 A third type has arisen through application of the well-established doctrine that a lessee has no legal right, without landlord consent, to materially change or alter the leased premises even where the change enhances the value of the property. 21 Acts thus constituting this technical waste, though calculated to increase the value of the premises, are know as meliorating waste. 22 The common element in each category is the protection of the landlord s interest in the reversion of the property in an unchanged condition. [b] Duty to Prevent Others from Committing Waste. A tenant may be liable to the landlord for waste committed by a third party under this implied covenant because he, as tenant, is in possession of the demised property and could recover damages from a stranger in a trespass action. A reason for imposing such liability upon the tenant for the acts of strangers, Lord Coke explained, is that otherwise the landlord would be without redress. 23 Again, a covenant is thus implied to protect the landlord s interest in the reversionary estate. [c] Duty to Repair. A landlord may either recover the decrease in rental by reason of the lack of such repairs, or the reasonable cost of repairs that he is required to make to restore the property where the tenant breaches this implied covenant. 24 The age and class of premises let, with their general condition 20 Tiffany, supra note 6, at Am. Jur. 2d Landlord and Tenant 513 (2002). 22 Tiffany, supra note 6, at Tiffany, supra note 6, 110 at Yet, a landlord today can undoubtedly bring suit against a stranger that injures the premises to the damage of the reversion. Id. See Burnette, 349 So. 2d at 1210 (where tortious act of third-party injures interests of both landlord and tenant, each has a right of action for injury to his own interest and each may maintain a separate action, but neither landlord nor tenant can, in his separate action, recover damages to the estate of the other). 24 Id. 213

8 8.02 ENERGY & MINERAL LAW INSTITUTE as to repair at the commencement of the tenancy, are taken into consideration in determining whether a general covenant to repair has been broken. This covenant s importance is once again derived from the landlord s reversionary interest. 25 It guarantees that when the landlord reacquires possession of the demised premise, it will be in the same condition as when the tenant entered lessened of course by normal wear and tear. [2] Oil and Gas Leases Additional Covenants Implied. The typical oil and gas lease is a property arrangement. It is the grant of the exclusive right of exploitation on the property of the lessor for the sole purpose of exploring and producing oil and gas. 26 The traditional covenants of property conveyances apply. 27 However, additional covenants are routinely implied. The early implied covenants focused on the maintenance and development of the leasehold estate and easily relate to the traditional covenants implied in all real property conveyances. Covenants that have been implied in more recent times, however, shift the focus from the maintenance and development of the leasehold estate to the conduct of the parties. They focus not only upon what the lessee must do to maintain the property, but what he must do to further the interests of the lessor. [a] Implied Covenant to Protect the Leased Premises Against Drainage. The implied covenant to protect the leasehold from drainage ensures that the lessor will not suffer a permanent loss of oil or gas due to migration of the hydrocarbons from the leasehold to the neighboring land. 28 It grew out of the law of capture, which allows a landowner to 25 Codman v. Hygrade Food Prod. Corp., 3 N.E.2d 759 (Mass. 1936). 26 See Merrill, supra note 5, 1 at Merrill, supra note 5, 7 at 28; James A. Veasey, The Law of Oil and Gas, 18 Mich. L. Rev. 749, 773 (1920); James W. Simonton, The Nature of the Interest of the Grantee Under an Oil and Gas Lease, 25 W. Va. L. Rev. 295, 322 (1919). 28 Patrick H. Martin & Bruce M. Kramer, Implied Covenants in General, 5 Williams & Meyers Oil and Gas Law 821 at 78.1(Vol ); see also Merrill, supra note 5, 14 at 214

9 IMPLIED COVENANTS 8.02 appropriate all of the oil and gas he may lawfully produce, regardless of whether the oil or gas obtained originated from under his well. 29 However, once a landowner grants a lease, he can no longer protect his own interests in the production. 30 Therefore, the obligation is implied as part of the grant of operating rights to the lessee. 31 The covenant is frequently implied to obligate the lessee to drill an offset well to prevent the drainage. 32 Many courts and commentators equate the duty to protect with the duty to prevent waste implied in ordinary leases. 33 In Finley v. Marathon Oil Co., the court found that the general duty of prudent operation and the subsumed duty to avoid drainage illustrate the office of the common law of property and contracts in interpolating into a contract or conveyance provisions that the parties would almost certainly have agreed to had the need for them been foreseen. 34 Professor Merrill observed that there is a stronger basis for the implied covenant to prevent drainage in the 49; see also 2 E. Brown, The Law of Oil and Gas Leases at pg (2d ed. 1977); see also Eugene Kuntz, A Treatise on the Law of Oil and Gas 57.1 at 53 (Vol ). 29 Brown, supra note 28, 16.02(5) at 16-92; see also Kuntz, supra note 28, 61.1 at Kuntz, supra note 28, 61.1 at Id. at 150; see also Indian Territory Illuminating Oil Co. v. Rosamond, 120 P.2d 349, 352 (Okla. 1941)( The implied covenant of the lease, that the lessee will protect the land from drainage by adjoining wells so long as the drilling of a protection well or wells will, in the judgment of a reasonably prudent operator, be a profitable undertaking, is a continuing covenant the obligation resting upon the lessee during the existence of the lease, or as long as his ownership thereof continues. ); and Kuntz, supra note 28, 61.1 at 149 ( if the landowner has granted an oil and gas lease, the lessor s right to protect against drainage is impaired but such right is included in the operating rights conferred on the lessee for the fundamental purpose of developing the leased premises for their mutual profit and advantage. ). 32 Id. See also Blair v. Clear Creek Oil & Gas Co., 230 S.W. 286, 288 (Ark. 1921); Hartman Ranch Co. v. Assoc. Oil Co., 73 P.2d 1163, 1166 (Cal. 1937); Webb v. Croft, 244 P. 1033, 1035 (Kan. 1933); Union Gas & Oil Co. v. Diles, 254 S.W. 205, 206 (Ky. 1923). 33 Merrill, supra note 5, 219 at ; see also Finley v. Marathon Oil Co., 75 F.3d 1225, 1228 (7th Cir. 1996). 34 Finley, 75 F.3d at 1228 (emphasis added). 215

10 8.02 ENERGY & MINERAL LAW INSTITUTE ordinary principles governing landlord and tenant than the other covenants implied in oil and gas leases: The tenant is always bound to prevent waste. To permit a third person to carry away coal or iron ore from the premises, or to do so himself, except as and under the conditions permitted by the lease, would undoubtedly be a violation of his obligation in this respect. Exactly the same thing is accomplished where the lessee himself drains oil from beneath the leased premises through wells on adjoining land or permits others to do so. The fact that, in the latter case, the injury may be accomplished without the commission of a trespass or giving any right of action against the third party is merely an incident of the peculiar physical characteristics of oil and gas as compared with the solid minerals, and should have no effect upon the application of the general rule. 35 [b] The Pro-active Covenants. Courts recognize three implied covenants that do not fit comfortably within the traditional lease analysis: the implied covenant to explore, the implied covenant to drill additional wells and the implied covenant to market. These covenants can be described as pro-active, meaning that, unlike ordinary covenants, they do not prevent a lessee from acting in a manner contrary to the landlord s interests, they actually compel the lessee to further the lessor s interests. As early as 1940, Professor Merrill acknowledged that the implication of the [oil and gas] covenants... is, in itself, the imposition of an obligation which does not rest upon the lessee under an ordinary lease. Merrill explained: In the ordinary lease, in the absence of an express covenant, the lessee is under no obligation to utilize the premises to any extent. If the lease is of a farm, he is not required to occupy it. If it is of a building, the lessor cannot complaint that he does not use it. This is true, even though the lease restricts the use of the premises to 35 Merrill, supra note 5, 219 at

11 IMPLIED COVENANTS 8.02 specified purposes; failure to use them at all, so long as they are not used for forbidden purposes, does not violate the lease. 36 The pro-active implied covenants arise from the unique relationship of the parties to an oil and gas lease. 37 The lessee is granted the exclusive right to explore and develop the oil and gas potential of the lessor s land in exchange for paying a percentage of the return in the form of a royalty. Under such an arrangement, the lessee is the active party responsible for the operation and production, while the lessor is passive, waiting to receive his royalty. While both parties are primarily interested in deriving an economic benefit from the venture, their interests often conflict with regard to how the desired result is to be achieved. 38 The foremost conflict of interest between a lessor and lessee involves the time and manner of exploring the leased premises, and the extent to which they should be developed and operated. 39 The lessor is generally anxious to realize his royalty and, therefore, hopes that exploration will commence quickly. 40 On the other hand, the lessee, who is more knowledgeable in the industry, might believe that a delay in operation will create a better return. 41 Other sources of conflict arise in deciding how much gas to produce at a time, what constitutes prudent and diligent operation, and how to protect the leasehold from drainage. 42 Moreover, the lessee must expend all of the costs of exploration, development or production, while the lessor s participation is cost free. The disparity 36 Id. at Merrill, supra note 5, 1-3 at 15-22; Jacqueline Lang Weaver, Implied Covenants in Oil and Gas Law Under Federal Energy Price Regulation, 34 Van. L. Rev. 1473, 1485 (1981); A.W. Walker, Jr., The Nature of the Property Interests Created by an Oil and Gas Lease in Texas, 11 Tex. L. Rev. 399, (1933). 38 See Kuntz, supra note 28, 54.2 at 1; Merrill, supra note 5, 1-3 at 15-22; Walker, supra note 37, at See e.g., Hartman Ranch Co. v. Assoc. Oil Co., 73 P.2d 1163 (Cal. 1937). 40 Merrill, supra note 5, 1 at See e.g., Amerada Petroleum Corp. v. Sledge, 3 P.2d 167 (Okla. 1931). 42 Merrill, supra note 5, 1 at

12 8.02 ENERGY & MINERAL LAW INSTITUTE between the amounts invested accounts for many conflicts in decisions to be made regarding the operation and production of the oil and gas. 43 In the early years of the industry, most oil and gas leases did not contain express terms addressing these issues. 44 One reason the leases were silent was that the parties could not contemplate how the lessee should conduct operations because neither of them knew whether the well would be productive or profitable. 45 However, because the lessee was often considered the more knowledgeable and experienced party, the implied covenants were directed toward one end: the protection of the royalty interest of the lessor. 46 In other words: Because the interests of the lessee may frequently be in conflict with the interests of the lessor in the various stages of exploration, development, and operation of the leased premises, the self-interest of the lessee in establishing and maintaining production provides no reliable basis for protection of the interests of the lessor. If any protection is afforded the lessor when the lessor s interests come in conflict with that of the lessee, it must be predicated upon an agreement of the parties or upon recognized rights and duties which arise by virtue of the relation of the parties. 47 [c] The Implied Covenant to Drill an Exploratory Well. While it has been said that in construing oil and gas leases, courts have drawn upon the principles of the law of landlord and tenant so far as they could be made applicable, 48 they have also recognized that oil and gas leases have the character of contracts as much as instruments of conveyance and must be treated differently. For example, one court stated 43 Kuntz, supra note 28, 54.2 at Merrill, supra note 5, 2 at 19; Weaver, supra note 37, at Weaver, supra note 37, at Walker, supra note 37, at Kuntz, supra note 28, 54.2 at Merrill, supra note 5, 7 at 28 n

13 IMPLIED COVENANTS 8.02 that the purpose of the lease was not to make a grant of the land or to transfer any estate therein and instead, characterized its function as follows: It only gave the right to the lessee to search for minerals and an interest in the minerals when so found and taken out. The consideration moving to the lessor for the execution of the lease... was obviously the royalties upon the minerals which should be discovered and taken from the land. 49 Accordingly, the court found an implied covenant in every oil and gas lease that the lessee must commence a diligent search and operation of the leasehold with reasonable promptness so that the landowner may realize the benefits of his bargain. It follows that No such lease should be construed as to enable the lessee who has paid no consideration to hold it merely for speculative purposes, without doing what he stipulated to do, and what was clearly in the contemplation of the lessor when he entered into the agreement. 50 This covenant to explore obligates the lessee to begin drilling an initial well on the leasehold within a reasonable time after execution of the lease, and to continue such with due diligence until operation of the well is complete. 51 The covenant originally developed in response to oil and gas leases created during the formative years of the industry, which were usually either perpetual in time, or contained long fixed-terms. 52 The courts rationalized that the main purpose of the lease was the exploration for gas and oil and that the real considerations moving the contracting parties was the prospective benefits and profits from gas or oil if discovered. Therefore, it was reasonable to infer that the real intention 49 Mansfield Gas Co. v. Alexander, 133 S.W. 837, 838 (Ark. 1911). 50 Id. at , citing Huggins v. Daley, 99 Fed. 606 (4th Cir. 1900). 51 Williams & Meyers, supra note 28, 811 at 59, citing Mansfield Gas. Co. v. Alexander, 133 S.W. 837 (Ark. 1911); see also Merrill, supra note 5, 14 at 49-51; see also Brown, supra note 28, at 16-7,8; see also Kuntz, supra note 28, 57.1 at Kuntz, supra note 28, 57.1 at

14 8.02 ENERGY & MINERAL LAW INSTITUTE of the parties was that the gas company... should, with diligence, and within a reasonable time, enter upon the premises and drill a well, to test the existence or nonexistence of gas. 53 Essentially, this covenant served as the catalyst to ensure that the lessee would do what he agreed to do. This covenant has lost significance due to developments in leasing practices. 54 The modern oil and gas lease usually contains express provisions regarding the time in which the drilling of an initial well will commence. 55 Even leases that do not contain such express provisions will usually either terminate automatically or excuse performance by the payment of delay rentals within a fixed period of time. 56 [d] The Implied Covenant to Drill Additional Wells. Williams & Meyers suggests that this covenant should be split into two: (1) the covenant of reasonable development and (2) the covenant of further exploration. 57 The covenant of reasonable development is concerned with further drilling in known producing formations, whereas the covenant of further exploration requires the lessee to drill potentially productive but as yet untested... formations. Essentially, a lessee may breach the implied covenant of reasonable development if he fails to produce oil from a known producing formation, or produce it with the proper rapidity. On the other hand, a lessee may breach the implied covenant for further exploration if he fails to test the land for the purpose of discovering oil or gas Consumers Gas Trust Co. v. Littler, 70 N.E. 363, (Ind. 1904). 54 Kuntz, supra note 28, 57.1 at 53; Williams & Meyers, supra note 28, 812 at 63; see also Patrick H. Martin, A Modern Look at Implied Covenants to Explore, Develop, and Market Under Mineral Leases, Inst. on Oil & Gas L. & Tax n 177, 179 (1976). 55 Williams & Meyers, supra note 28, 812 at See Martin, supra note 54, at Williams & Meyers, supra note 28, 841 at 267; Kuntz, supra note 28, 58.1 at Williams & Meyers, supra note 28, 831 at 214.3,

15 IMPLIED COVENANTS 8.02 The justification for these implied covenants is that the operating rights are in the lessee; so long as he refused to drill exploratory wells or surrender the land, the lessor is deprived of the use of his mineral estate and of the opportunity for further exploration of the land. 59 To comply with the covenant, the lessee must maintain an active interest in developing the lease, in determining whether or not further development is feasible, and in drilling further development wells if drilling is feasible. 60 [e] The Prudent Operator Standard. It is generally recognized that the prudent operator standard had its origins in the landmark case of Brewster v. Lanyon Zinc. 61 In Brewster, the Court of Appeals for the Eighth Circuit considered a lessors equitable claim for forfeiture when the lessee failed to develop the leasehold premises after drilling a single well and obtaining production. The lease called for the lessee to either drill a well during the first two years of the lease or pay an annual delay rental until a well was drilled. If no well were drilled within five years, the property would revert to the lessor. The lessee drilled a single well during the fifth year of the lease and in all other respects complied with its obligations to pay rents and royalties. However, many oil and gas wells were drilled on adjacent properties and it was undisputed that oil and gas was being drained from the leasehold, although the extent of the drainage could not be ascertained with certainty. Accordingly, the lessor brought an equitable action in forfeiture to regain possession of the leasehold before further drainage could occur. The lessor contended that the lessee was required to either develop the leasehold or give up its claims to it, while the lessee contended that it had strictly complied with the letter of the lease and was permitted to hold the lease either for speculative purposes or to prevent its acquisition by a business rival. 59 Id. at Kuntz, supra note 28, 58.1 at Brewster v. Lanyon Zinc, 140 F. 801 (8th Cir. 1905). 221

16 8.02 ENERGY & MINERAL LAW INSTITUTE The court forfeited the lease, noting that the difficulty of determining the extent of the drainage prevented the lessor from pursuing a remedy at law for money damages. Although the court acknowledged that there was no express provision mandating subsequent operations after the initial term of the lease, it concluded: [I]t does not follow from this that the lease was silent on the subject, or that the matter is left absolutely to the will of the lessee. Whatever is implied in the contract is as effective as what is expressed. Implication is but another name for intention, and if it arises from the language of the contract when considered in its entirety, and is not gathered from the mere expectation of one or both of the parties, it is controlling The implication necessarily arising from these [lease] provisions... is that... the work of exploration, development, and production should proceed with reasonable diligence for the common benefit of the parties, or the premises be surrendered to the lessor Considering the migratory nature of oil and gas and the danger of their being drawn off through wells on other lands if the fields should become fully developed, all of which must have been in the minds of the parties, it is manifest that the terms of the lease contemplated action and diligence on the part of the lessee. 62 From this language, the prudent operator standard was born. It is noteworthy that the Brewster court did not posit an independent cause of action based upon the lessee s failure to diligently develop the property. The implied obligation to develop the property was invoked by the court to support the equitable remedy of lease forfeiture. It is also noteworthy that the court found the remedy of forfeiture to be appropriate as a means of protecting the leasehold estate against drainage; that is, to protect the landowner s reversionary interest in the property. Finally, the Brewster 62 Id. at (emphasis supplied). 222

17 IMPLIED COVENANTS 8.02 court implied an obligation in fact (as opposed to in law ) by which it filled a perceived gap in the lease language with an obligation which must have been in the minds of the parties. The reasonable prudent operator standard has evolved into the standard by which all actions taken by the lessee in the production and operation of the wells on the leasehold are judged. 63 In this respect, it may not be an implied covenant per se, but an overreaching standard of performance with which the lessee must comply in fulfilling all of his obligations, express or implied. 64 The implied duty of diligent and proper operations is a catch-all obligation, and another formulation of the general duty of the lessee to act as a reasonably prudent operator. 65 In cases regarding the duty of diligent and proper operation, the standard of good faith and sound discretion and the prudent operator standard have been applied interchangeably. 66 The covenant governs two concepts: what must be done by the lessee in serving the often-conflicting interests of the lessor; and the manner in which all operations must be conducted. 67 [f] The Implied Covenant to Market. Historically, the duty to market was one aspect of the implied covenant of diligent operation or reasonable prudent operator standard. 68 The earlier 63 Williams & Meyers, supra note 28, at Id. at 36, 37 and 41 (the prudent operator standard is a general standard applicable in different types of disputes), and ( The prudent operator is a reasonable man engaged in oil and gas operations. He is a hypothetical oil operator who does what he ought to do not what he ought not to do with respect to operations on the leasehold. ). 65 Williams & Meyers, supra note 28, 861 at 424.1; Kuntz, supra note 28, 59.1, 59.3 at 106, 121 ( In some instances regarding what must be done and in most instances regarding the manner in which operations must be conducted, the duty of diligent and proper operation imposed upon the lessee by virtue of the lease is no different from the general duty imposed on all persons to exercise that degree of care which a prudent person would exercise under the circumstances. ). 66 Kuntz, supra note 28, 59.3 at See e.g., Warfield Natural Gas Co. v. Allen, 59 S.W.2d 534 (Ky. 1933). 68 See Merrill, supra note 5, 4, 72 at 23 and 183; Walker, supra note 37, at

18 8.02 ENERGY & MINERAL LAW INSTITUTE academics, including Professors Merrill and Walker, combined the implied covenant of diligent operation with the duty to market because, at its origin, the lessee was only required to act as a reasonable prudent operator in producing and marketing the product. 69 Often, the covenant was equated with the covenants for exploration and development, because like them, the implied duties to properly operate and market the product were based upon the same consideration the notion that the lessor s main consideration for the venture was the expectation of royalties. 70 Therefore, it was implied that the wells [would] be operated and the product sold. 71 Over time, the implied covenant to market the product emerged as an obligation separate and distinct from the implied covenant of diligent operation. 72 Once the duty to market was recognized as an independent covenant, it too began to evolve. The duty to market was used initially as a bridge between the conflicting interests of the lessee, who often delayed marketing the oil or gas found for various reasons, and the interests of the lessor, who was often interested in an immediate return on his royalty. 73 The early focus was to ensure that the product was marketed within a reasonable time after production, thereby requiring the lessee to avoid an 69 See e.g., Iams v. Carnegie Natural Gas Co., 45 A. 54 (Pa. 1899); People s Gas Co. v. Dean, 193 F. 938 (10th Cir. 1911); Wolfe v. Texas Co., 83 F.2d 425 (10th Cir. 1936); Wolfe v. Prairie Oil & Gas Co., 83 F.2d 434 (10th Cir. 1936); Daughetee v. Ohio Oil Co., 105 N.E. 308 (Ill. 1914); Hails v. Johnson, 263 S.W. 679 (Ky. 1924); Brimmer v. Union Oil Co. of Cal., 81 F.2d 437 (10th Cir. 1936); Berthelote v. Loy Oil Co., 28 P.2d 187 (Mont. 1933). 70 Walker, supra note 37, at 404; Weaver, supra note 37 at 1486; Kuntz, supra note 28, 54.2 at 3; Merrill, supra note 5, 73 at Merrill, supra note 5, 73 at , citing Brewster, 140 F. at 801; People s Gas Co. v. Dean, 193 F. 938 (10th Cir. 1911); Benedum-Grees Oil Co. v. Davis, 107 F.2d 981 (6th Cir. 1939); Acme O. & Min. Co. v. Williams, 74 P. 296 (Cal. 1903); Gadbury v. Ohio & Indiana Consol. Nat. & Illuminating Gas Co., 67 N.E. 259 (Ind. 1903). 72 Brown, supra note 28, at 16-6; Williams & Meyers, supra note 28, at Merrill, supra note 5, 72 at 182; Williams & Meyers, supra note 28, 853 at

19 IMPLIED COVENANTS 8.03 unreasonable delay. 74 Lessees were required to make diligent efforts to ensure that the lessor realized the benefit of his royalty interest Good Faith and Fair Dealing. The pro-active covenants, unlike the duty to prevent drainage, focus on the conduct of the parties instead of the condition of the leasehold. In order to imply these covenants, which have no basis in property law, courts have leaned heavily upon the contract law precept of good faith and fair dealing, or more precisely, upon its inherent principle of cooperation. 76 [1] Historical Perspective. The concept of good faith has enjoyed a long history in the law. 77 However, the concept was virtually eliminated from contract doctrine during the late nineteenth century with the advent of the pure theory of contracts attributed to Christopher Columbus Langdell. 78 This period was characterized by notions of freedom to contract, judicial nonintervention, caveat emptor, and bargained-for exchange. Contracting parties were seen as equals, free from social duties and at liberty to strike the best possible deal for themselves See e.g., Brimmer, 81 F.2d at 437; Wolfe, 83 F.2d at 425; U.S. v. Brown, 15 F.2d 565 (N.D. Okla. 1926); Carroll Oil & Gas Co. v. Skaggs, 21 S.W.2d 455 (Ky. 1929); Hails, 263 S.W. at 679; Pittsburgh-Columbia O. & G. Co. v. Broyles, 91 N.E. 754 (Ind. 1910); Howerton v. Kansas Natural Gas Co., 106 P. 47 (Kan. 1910); Hails v. Johnson, 263 S.W. 679 (Ky. 1924); Cole v. Taylor, 8 Pa. Super. 19 (1898); Glasgow v. Chartiers Oil Co., 25 A. 232 (Pa. 1892). 75 See Wolfe, 83 F.2d at Williams & Meyers, supra note 28, at 8. For a further discussion of the principle of cooperation, see Meyers, The Effect of Express Provisions in an Oil and Gas Lease on Implied Obligations, 14 L.S.U. Min. L. Inst. 90 (1967). 77 Jason Randal Erb, Note, The Implied Covenant of Good Faith and Fair Dealing in Alaska: One Court s License To Override Contractual Expectations, 11 Alaska L. Rev. 35, 38 (1994)(citing Friedrich Kessler & Edith Fine, Culpa in Contrahendo, Bargaining in Good Faith, and Freedom of Contract: A Comparative Study, 77 Harv. L. Rev. 401 (1964) tracing the concept of good faith and fair dealing through various doctrines in American contract law). 78 Eric M. Holmes, A Contextual Study of Commercial Good Faith: Good-Faith Disclosure in Contract Formation, 39 U. Pitt. L. Rev. 381 at 385 (1978). 79 Erb, supra note 77, at 39 citing Holmes, supra note 78, at

20 8.03 ENERGY & MINERAL LAW INSTITUTE Professor Arthur Corbin contributed to the rejuvenation of the covenant in the twentieth century. In his treatise on contracts, Corbin asserted that when parties have themselves so far satisfied the legal requirements that the court is willing to hold that a contract has been made, it will compel performance in accordance with what it believes to be required by good faith and fair dealing. That is: When unforeseen contingencies occur, not provided for in the contract, the courts require performance as men who deal fairly and in good faith with each other would perform without a law suit. It is thus that unanticipated risks are fairly distributed and a party is prevented from making unreasonable gains at the expense of the other. This is not making a contract for the parties; it is declaring what the legal operation of their own contract shall be, in view of the actual course of events, in accordance with those business mores known as good faith and fair dealing. 80 With the promulgation of the Uniform Commercial Code in 1958, the covenant of good faith and fair dealing gained greater prominence. 81 [2] Developments in the Uniform Commercial Code. [a] Drafting History. The drafting history of the Uniform Commercial Code does not reveal an intended interpretation of the good faith provision. At an early stage of the process, the drafters defined the obligation of good faith to include both: (1) honesty in fact and (2) observance of reasonable commercial standards in an actor s business or trade. 82 The comment provided: This 80 3 Corbin 541 at 95, Erb, supra note 77, at The 1949 version of the section read: Good faith means honesty in fact in the conduct or transaction concerned. Good faith included good faith toward all prior parties and observance by a person of the reasonable commercial standards of any business or trade in which he is engaged. U.C.C (18)(May 1949 Draft). See Clayton P. Gillette, Limitations on the Obligations of Good Faith, 1981 Duke L.J. 619, 622 (1981)(providing an in-depth analysis of the earlier drafts of the Uniform Commercial Code); Robert S. Summers, Good Faith in General Contract Law and the Sales Provisions of the Uniform Commercial Code, 54 Va. L. Rev. 195, 207 (1968). 226

21 IMPLIED COVENANTS 8.03 Act adopts the principles of those cases which see a commercial contract not as an arm s length adversary venture, but as a venture of material interest, when successful, and as involving due regard for commercial decencies when the expected favorable outcome fails. 83 If this Comment had survived, an expansive interpretation of the obligation could be defended on the ground that among the decencies observed by parties to a contract is the recognition of affirmative duties toward one another that would not otherwise exist. In light of the comment, the commercial decencies prong appear[ed] to exact an additional and extraordinary degree of concern for others. 84 In response, the 1950 Committee on the Proposed Commercial Code of the Section on Corporation, Banking, and Business Law of the American Bar Association lobbied to have the definition changed to mean honesty in fact in the conduct or transaction concerned and the absence of trickery, deceit or improper purpose. Although the Code draftsmen did not adopt the committee s proposed definition, they did delete all but the honesty in fact portion in The commercial reasonableness prong, however, reappeared in the 2002 version, but without the prior comment about regard for commercial decencies U.C.C cmt. (May 1949 Draft)(emphasis supplied). 84 See Gillette, supra note 82, at Summers, supra note 82, at 209 citing Malcolm, The Proposed Commercial Code, 6 Bus. Law. 113, 128 (1951). See also G. Gilmore, The Ages of American Law (1977)(suggesting that the limitation in the 1952 version was a clear rejection of commercial decencies as an unreasonably broad, moralistic imperative and that only the deliberate lie was outlawed). 86 The comment provides: Former section 1-201(19) defined good faith simply as honesty in fact; the definition contained no element of commercial reasonableness. Initially, that definition applied throughout the Code with only one exception. Former Section 2-103(1)(b) provided that in this Article... good faith in the case of a merchant means honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade. This alternative definition was limited in applicability in three ways. First, it applied only to transactions within the scope of Article 2. Second, it applied only to merchants. Third, 227

22 8.03 ENERGY & MINERAL LAW INSTITUTE However, even after the acceptance of the honesty in fact definition, the Code s drafters and sponsors could not define the phrase with unanimity. Gillette describes the turmoil as centering on the question of whether a commercial relationship creates obligations of cooperation and diligent concern for the other party s position, notwithstanding a contract s failure to address the allocation of the risks that create that concern. Patterson concludes that good faith s intended interpretation would not be clear even had the drafters been in agreement because [t]he drafters did not adopt the Code; legislatures did, and we have virtually no evidence of what the legislatures thought of the obligation. 87 [b] A Problem of Interpretation. The UCC has become an active laboratory of experiments on good faith, as evidenced by the good faith provision in the Restatement strictly construed it applied only to uses of the phrase good faith in Article 2; thus, so construed it would not define good faith for its most important use-the obligation of good faith imposed by former Section Over time, however, amendments to the Uniform Commercial Code brought the Article 2 merchant concept of good faith (subjective honesty and objective commercial reasonableness) into other Articles. First, Article 2A explicitly incorporated the Article 2 standard. See Section 2A-103(7). Then, other Articles broadened the applicability of that standard by adopting it for all parties rather than just for merchants. See, e.g., Sections 3-103(a)(4), 4A- 105(a)(6), 8-102(a)(10), and 9-102(a)(43). All of these definitions are comprised of two elements-honesty in fact and the observance of reasonable commercial standards of fair dealing. Only revised Article 5 defines good faith solely in terms of subjective honesty, and only Article 6 and Article 7 are without definitions of good faith. (It should be noted that, while revised Article 6 did not define good faith, Comment 2 to revised Section states that this Article adopts the definition of good faith in Article 1 in all cases, even when the buyer is a merchant. ) Given these developments, it is appropriate to move the broader definition of good faith to Article 1. Of course, this definition is subject to the applicability of the narrower definition in revised Article 5. U.C.C (20) cmt. 20 (2002). 87 See Gillette, supra note 82, at (internal citations omitted). 228

23 IMPLIED COVENANTS 8.03 (Second) of Contracts, which grew out of this laboratory. Even within the UCC, however, the courts and commentators have been in a quandary as to how to define good faith because the statutory definition lacks precision and specificity. 88 As for approaches, many courts and scholars have advocated an expansive interpretation of good faith, which would prevent commercial actors from taking advantage of changed circumstances that adversely affect other contracting parties. 89 Others believe good faith exists to prevent commercial actors from declaring technical breaches. 90 Yet another approach proposes that good faith requires disclosure of advantageous information withheld to attain a superior bargain rather than to deceive or cheat. 91 In these instances, the obligation becomes less of a duty not to create undue risks to others and more of a duty to assist others confronted with risks not created by the obligor. 92 Finally, one commentator sees good faith as a prophylactic measure that permits judges to impose liability for condemnable behavior not otherwise fitting within traditional categories of actionable conduct. 93 [c] Current Definition. Section of the UCC provides, Every contract or duty within [the Uniform Commercial Code] imposes an obligation of good faith in its performance. 94 Good faith, except as otherwise provided in Article 5, 88 Christina L. Kuntz, Frontspiece on Good Faith: A Functional Approach Within the UCC, 16 Wm. Mitchell L. Rev. 1105, (1990)(citing Restatement (Second) of Contracts 205 comments a, c, d, and e (1979); Corbin on Contracts 654A-I (Supp. 1990)). 89 Gillette, supra note 82, at 619 (citing Baker v. Ratzlaff, 564 P.2d 153, 156 (Kan. 1977)). 90 See Summers, supra note 82, at 202 ( Good faith, as judges generally use the term in matters contractual, is best understood as an excluder a phrase with not general meaning or meaning of its own. Instead, it functions to rule out many different forms of bad faith. ). 91 See Holmes, supra note 78, at See Gillette, supra note 82, at See Richard Danzig, A Comment on the Jurisprudence of the Uniform Commercial Code, 27 Stan. L. Rev. 621, 631 (1975). 94 U.C.C (2003). 229