Back v. Chesapeake Energy Corp. et al

Filing 76

OPINION AND ORDER: Chesapeake's motion to dismiss (DE 70 ) this action is DENIED. Signed by Judge Karen K. Caldwell on 2/18/2020. (RCB)cc: COR

UNITED STATES DISTRICT COURT
EASTERN DISTRICT OF KENTUCKY
SOUTHERN DIVISION
PIKEVILLE
THOMAS R. BACK, Individually and on
behalf of all other similarly situated states,

CIVIL ACTION NO. 7:16-192-KKC

Plaintiff,
V.

OPINION AND ORDER

CHESAPEAKE OPERATING, LLC and
CHESAPEAKE APPALACHIA, LLC,
Defendant.

*** *** ***
The defendants move (DE 70) to dismiss the plaintiff’s complaint. For the
following reasons, the motion will be denied.
I. Background
According to the complaint, the plaintiff, Thomas Back, owns an interest in the oil
and gas estate of property located in Knott County, Kentucky. (DE 51, Complaint ¶ 2.)
He leased that estate to the defendants (collectively, “Chesapeake”), granting Chesapeake
the right to produce and sell the oil and gas. In return, Chesapeake agreed to pay royalties
to Back.
Pursuant to the written lease agreement between Chesapeake’s predecessor in
interest and Back’s ancestors, Chesapeake’s predecessor was required to pay the lessors a
royalty for 1/8 of the natural gas extracted from the land at issue at a fixed rate of
$0.12/mcf (thousand cubic feet) for as long as the land produced gas. (DE 51, Complaint
¶ 13; DE 54-2, Lease.) However, Back alleges, “Long ago, before Chesapeake acquired

an interest in Mr. Back’s natural gas estate, Chesapeake’s predecessors determined and
agreed to pay Mr. Back or his ancestors not on the basis of the fixed per-mcf rate set forth
in the written contract.” Instead, Chesapeake’s predecessors “determined and agreed” to
pay the lessors “1/8 of the price a[t] which Chesapeake sells the gas (typically the market
price), less actual and reasonable expenses incurred in making the gas marketable.” (DE
51, Complaint ¶ 14.) Back alleges that, under this agreement, Chesapeake was required to
pay royalties based on the sales price of gas at the time it is sold. (DE 51, Complaint ¶
15.)
Back asserts Chesapeake paid him fewer royalties than the parties agreed to. More
specifically, Back asserts that, in late 2007, Chesapeake sold a large amount of natural
gas (208 billion cubic feet) to affiliates of certain investment banks at a sales price of
approximately $1.1 billion or $5.27/mcf. (DE 51, Complaint ¶¶ 16, 17, 18.) Back alleges
that the sale consisted of gas from wells located on the property of thousands of lessors,
including Back. He alleges that Chesapeake agreed to give the banks scheduled quantities
of gas until 2022. (DE 51, Complaint ¶¶ 16, 17.) The parties have referred to this $1.1
billion transaction as a Volumetric Production Payment (“VPP”).
Back alleges that, after the sale, Chesapeake calculated the royalties it paid to him
and other lessees “as if no such sale had ever occurred.” (DE 51, Complaint ¶ 18.) Later,
Back alleges, Chesapeake paid him royalties on the gas sold to the banks but calculated
the royalties based on a lower sales price than what the banks paid it. (DE 51, Complaint
¶ 19.)

2

Back also alleges that Chesapeake sent him regular royalty statements that
contained intentional and knowing misrepresentations because they “reflect improperly
inflated expenses and improperly deflated royalty payments.” (DE 51, Complaint ¶ 23.)
Back asserts claims of breach of contract, breach of the implied covenant of good
faith and fair dealing, and fraud. In addition, he seeks an accounting from Chesapeake of
the manner by which his royalty payments were calculated.
By prior opinion (DE 50), the Court dismissed the claim for breach of the implied
covenant of good faith and fair dealing. Chesapeake now moves for dismissal of the
remaining claims.
II. Analysis
A.

Motion to Dismiss for Failure to State a Claim

On a motion to dismiss pursuant to Federal Rule of Civil Procedure 12(b)(6), like
the one filed by the defendants here, the Afactual allegations in the complaint must be
regarded as true.@ Scheid v. Fanny Farms Candy Shops, Inc., 859 F.2d 434, 436 (6th Cir.
1988) (quoting Windsor v. The Tennessean, 719 F.2d 155, 158 (6th Cir. 1983)).
Chesapeake argues that Back’s breach-of-contract claim must be dismissed for
several reasons. First, it argues that the claim must be dismissed because Back does not
allege that Chesapeake breached any provision of the original written lease agreement
between the parties. Again, the written lease agreement provides that Chesapeake must
pay Back the flat royalty rate of 12 cents/mcf. Back does not allege that Chesapeake
breached that provision of the lease.
Back argues, however, that the parties “modified” the written lease agreement to
require that Chesapeake pay Back “1/8 of the price a[t] which Chesapeake sells the gas

3

(typically the market price), less actual and reasonable expenses incurred in making the
gas marketable.” (DE 51, Complaint ¶ 14.) It is this obligation that Back claims that
Chesapeake breached.
Second, Chesapeake argues that the breach-of-contract claim must be dismissed
because Kentucky law forbids any such “side agreement” from amending a “written,
integrated contract[].” (DE 70-1, Mem. at 7.) The lease’s integration clause provides,
“this instrument embraces the entire understanding and contract between the parties and
any agreements or representations verbal or written, made by any person on behalf of
either the Lessor or the Lessee not contained in this lease are unauthorized and do not
bind the parties.” (DE 54-2, Lease.)
“The purpose of an integration clause stating that there are no agreements or
understandings between the parties other than those reflected in the written contract is, of
course, to prevent either party from relying upon statements or representations made
during negotiations that were not included in the final agreement.” Coal Res., Inc. v. Gulf
& W. Indus., Inc., 756 F.2d 443, 447 (6th Cir. 1985) (emphasis added). Thus, in O’Bryan
v. Massey-Ferguson, Inc., 413 S.W.2d 891 (Ky. 1966), the case that Chesapeake cites in
support of its argument, the court determined that the integration clause at issue there
“utterly” forbade the enforcement of agreements that were made prior to the written
agreement but not incorporated into it. Id. at 893.
The Kentucky Supreme Court has, however, explicitly rejected the argument that
an integration clause prohibits parties from modifying an agreement after they have
executed it. Energy Home, Div. of S. Energy Homes, Inc. v. Peay, 406 S.W.3d 828, 834
(Ky. 2013). “In general, a ‘merger clause’ is a contractual provision to the effect that the

4

written terms of the contract may not be varied by prior agreements because all such
agreements have been merged into the written document.” Id. (quoting 17A C.J.S.
Contracts § 577 (2013)). Such a clause means that the parties to the agreement are not
“contractually bound to any prior expressions or representations or understandings that
may have arisen between them.” Id. The clause operates to prevent a party from
disavowing the written contract by claiming that the true agreement between the parties
included other, unwritten terms or conditions.” Id. But an integration clause “does not
prohibit the parties from future agreements to modify or even to rescind the contract.” Id.
Third, Chesapeake argues that Back’s breach-of-contract claim must be dismissed
because he has failed to make sufficient allegations in the complaint to state such a claim.
Chesapeake argues that Back has not alleged “when the Lease was supposedly modified,
by whom, or the manner of modification” and that he has not alleged any consideration
for the alleged modification.
Federal Rule of Civil Procedure 8(a)(2) requires only a short and plain statement
of the claim showing that the pleader is entitled to relief, in order to give the defendant
fair notice of what the claim is and the grounds upon which it rests. Bell Atlantic Corp. v.
Twombly, 550 U.S.544, 555 (2007). “While a complaint attacked by a Rule 12(b)(6)
motion to dismiss does not need detailed factual allegations, a plaintiff's obligation to
provide the ‘grounds’ of his ‘entitle[ment] to relief’ requires more than labels and
conclusions, and a formulaic recitation of the elements of a cause of action will not do.”
Id. (internal citations omitted). In order to survive a motion to dismiss, the factual
allegations in the complaint “must be enough to raise a right to relief above the
speculative level.” Id. The plaintiff must plead “enough facts to state a claim to relief that

5

is plausible on its face” and to nudge his claim “across the line from conceivable to
plausible.” Id. at 570.
A claim for breach of contract under Kentucky law requires that the plaintiff
establish: “1) existence of a contract; 2) breach of that contract; and 3) damages flowing
from the breach of contract.” Fifth Third Bank v. Lincoln Fin. Sec. Corp., 453 F. App’x
589, 601 (6th Cir.2011) (quoting Metro Louisville/Jefferson Cnty. Gov't v. Abma, 326
S.W.3d 1, 8 (Ky.Ct.App.2009)).
Back’s amended complaint pleads the existence of a contract. He alleges that
Chesapeake’s predecessors in interest entered into thousands of written lease agreements
with the owners of oil and gas estates, including Back’s ancestors. He further alleges that
those agreements provided for various methods of determining the amount of royalties to
be paid to the landowners. (DE 51, Complaint, ¶ 13.) Back alleges that “long ago,”
however, the parties “modified” the lease agreements to provide that the lessee would pay
all of the landowners the same royalty rate, which was 1/8 of the price at which the lessee
sold the gas less expenses. (DE 51, Complaint, ¶ 14.) He further alleges that Chesapeake
breached this amended portion of the lease agreement by failing to pay him the royalties
due after Chesapeake sold gas to banks pursuant to the 2007 VPP. Finally, he alleges
damages consisting of the royalties due.
It is true that the complaint does not state who modified the leases, when they
were modified, or how. Nor does it state whether there was any consideration for the
modified royalty rate or what that consideration was. Back will have to prove all of these
facts at some point in this litigation. Nevertheless, this additional information is not

6

necessary to simply state a breach-of-contract claim. Nor does Chesapeake need that
additional information to formulate a response to the allegations.
Further, the Sixth Circuit’s decision in this matter sheds some light on the issue
of when and how the lease agreements were modified. That court agreed that any
amendment to the lease agreements must be in writing. Unlike this Court, however, the
Sixth Circuit determined that the writing requirement was satisfied by two instruments:
the royalty statements issued by the lessee that reflected the modified royalty rate and the
corresponding royalty checks signed by Back. Back v. Chesapeake Appalachia, L.L.C.,
773 F. App'x 294, 296 (6th Cir. 2019).
Fourth, Chesapeake argues that Back’s breach-of-contract claim must be
dismissed because, even if the royalty provision of the lease has been amended, Back is
not entitled to 1/8 of the price that Chesapeake actually sold the gas less expenses.
Instead, Chesapeake argues, Back is only entitled to 1/8 of the “market price” less
expenses. And Chesapeake argues that the market price cannot be set by one transaction
like the VPP.
The Sixth Circuit has determined that the terms of the amended royalty rate are
set forth in the royalty statements issued by Chesapeake and the royalty checks signed by
Back. The Court is unable to determine from the royalty statements in the record whether
the amended royalty rate is based on actual sales prices or the market rate. (DE 42-1,
Royalty Statements.)
Finally, Chesapeake argues that the breach-of-contract claim must be dismissed
because the VPP did not sell the investment banks gas, which would trigger
Chesapeake’s obligation to pay Back royalties. Instead, Chesapeake argues that, with the

7

VPP, it sold the banks its rights to revenue from the gas produced from the wells, which
did not trigger any obligation to pay Back royalties.
For this argument, Chesapeake recognizes that Back and his co-lessors have a
right to 1/8 (12.5 percent) of the price at which Chesapeake sells the gas (the revenue
from the wells). (DE 70-1, Mem. at 13, n.6.) Chesapeake explains that this agreement
leaves it with the right to 87.5% of the revenue from the wells. (DE 70-1, Mem. at 13,
n.6.) It argues that, with the VPP, it sold to the banks only its 87.5 percent revenue
interest in the gas produced from the wells.
In support of this argument, Chesapeake relies on a ruling by the Southern District
of New York in McCall v. Chesapeake Energy Corp., 817 F. Supp. 2d 307 (S.D.N.Y.
2011), aff'd, 509 F. App'x 62 (2d Cir. 2013). In that case, the plaintiff McCall co-owned a
“working interest” in several wells pursuant to a joint operating agreement (JOA) with
various entities named as defendants in the action. The court referred to these defendants
as the “Chesapeake Defendants.”
As working interest owners, McCall and the defendants were joint owners of the
oil and gas while they were in the ground. Id. at 311. Pursuant to the JOA, after the oil
and gas were produced from the ground, however, each working interest owner became
the owner of its proportionate share of the minerals. Id. at 315. The working interest
owners were free to dispose of their share of the oil and gas through a variety of means
including by selling an “overriding royalty interest” in them. Id.
The Chesapeake Defendants entered into ten VPPs with certain banks. Plaintiff
McCall asserted that the VPPs conveyed oil and gas in the ground. She alleged that, as
joint owner of the mineral in the ground, she was entitled to proceeds from the sale. All

8

parties agreed that the critical issue in the case was “whether the McCall Well VPPs sell
oil and gas properties in the ground to which all working interest owners have an
undivided interest or only Chesapeake's share of the oil and gas properties after they have
been produced.” Id. at 316. The court determined that, by the plain language of the VPPs,
the Chesapeake Defendants had sold only their interest in the oil and gas after it was
produced from the ground. Id. The Second Circuit agreed, finding “[a]s a matter of law,
the conveyances from the Chesapeake Defendants to the banks were term overriding
royalty interests, which conveyed only an interest in gas produced and not ownership of
the unproduced gas in the ground.” McCall v. Chesapeake Energy Corp., 509 F. App’x
62, 64 (2nd Cir. 2013).
Chesapeake argues that, pursuant to McCall, the Court should interpret the 2007
VPP at issue in this case to sell only Chesapeake’s 87.5 percent revenue interest in the oil
and gas produced from the wells. A critical problem with this argument is that the Court
has not seen the 2007 VPP. As Chesapeake recognizes, in McCall, the court made its
decision only after it “painstakingly examined the VPP.” (DE 70-1, Mem. at 14.) The
court also conducted a similar analysis of language of the JOA between the parties.
Without reviewing the 2007 VPP, the Court has no basis for ruling that the VPP conveys
only Chesapeake’s revenue interest in the gas produced from the wells.
Chesapeake also moves to dismiss Back’s fraud and accounting claims. Its
arguments for dismissing these claims depends upon the Court finding that it has not
breached the royalty provision of the lease. As discussed, the Court is unable to make that
finding at this point in the litigation.

9

B.

Motion to Dismiss for Failure to Join Indispensable Party

Next Chesapeake argues that Back’s complaint must be dismissed under Federal
Rule 12(b)(7) because he failed to join the two parties who co-own Back’s 1/8 royalty
interest and because he failed to join the current lessee. Chesapeake asserts that these
non-parties are “necessary” to this action.
One problem with Chesapeake’s argument is that, even if the non-parties are
“necessary” to this litigation, that alone does not mean the case must be dismissed.
Determining whether a party is necessary to the litigation is simply the first step in ruling
on a motion to dismiss for failing to join an indispensable party. Keweenaw Bay Indian
Cmty. v. State, 11 F.3d 1341, 1345 (6th Cir. 1993). If the Court finds the non-party
necessary, then the Court must consider the issues of the Court’s jurisdiction over the
non-parties and their indispensability. Id. Chesapeake does not address the Court’s
jurisdiction over the non-parties. Instead it argues that “[i]f joinder is impossible,” then
the Court should find the non-parties indispensable and dismiss the case. (DE 70-1, Mem.
at 11.) The Court cannot dismiss a case on a 12(b)(7) motion merely on the possibility
that joinder of necessary parties is impossible.
A second problem with Chesapeake’s argument is that it has not established that
the non-parties are necessary to this action. In ruling on a motion to dismiss for failure to
join an indispensable party, “a court may go outside the pleadings and look to extrinsic
evidence.” Davis Cos. v. Emerald Casino, Inc., 268 F.3d 477, 480 n.4 (7th Cir. 2001).
See also 16th & K Hotel, LP v. Com. Land Title Ins. Co., 276 F.R.D. 8, 12 (D. D. C.
2011) (“In evaluating the need for the absent person under Rule 12(b)(7), the court must

10

accept as true the allegations in the complaint, and may also consider extrinsic evidence
submitted by the parties.”)
Chesapeake submits the affidavit of Chesapeake’s in-house counsel who states
that Back co-owns the 1/8 royalty interest in the lease with Jimmie A. Back and Elkhorn
Hazard Coal Land LLC. Chesapeake refers to these co-owners as the Non-party Lessors.
Neither of them is a party to this action. In addition, according to the affidavit,
Chesapeake sold its interest in the lease to Core Appalachia Production, LLC, who
subsequently transferred its interest in the lease to Diversified Gas & Oil PLC.
Diversified is not a party to this action.
Under Rule 19(a)(1), a party is necessary if:
(A) in that person's absence, the court cannot accord complete relief
among existing parties; or
(B) that person claims an interest relating to the subject of the action and
is so situated that disposing of the action in the person's absence may:
(i) as a practical matter impair or impede the person's ability to
protect the interest or
(ii) leave an existing party subject to a substantial risk of incurring
double, multiple, or otherwise inconsistent obligations because of
the interest.
Chesapeake argues that courts “routinely” find that all parties to a contract are
necessary parties in cases in which the contract is at issue. (DE 70-1, Mem. at 9.) This
may be true, but “[t]here is no hard and fast rule. . . that requires all parties to a contract
to be joined as parties in a breach of contract suit that is before a federal court sitting in
diversity.” Hirschfield v. B'nai B'rith Int'l, No. 2:09CV1535, 2010 WL 11565250, at *5
(W.D. Pa. Aug. 10, 2010) (citing cases). Chesapeake must show why in this case the
Non-party Lessors and the current lessee are necessary parties.
11

Chesapeake argues that, if the Court were to conclude that “reformation [of the
lease] were appropriate, it would be necessary to join the Non-Party Lessors as parties so
they could assert their rights with regard to the proposed reformation.” (DE 70-1, Mem.
at 9.) Chesapeake argues that the Non-party Lessors may not agree with Back that the
royalty provision of the lease has been amended. Likewise, Chesapeake argues that the
current lessee is a necessary party because Back is attempting “to change the obligations
of the existing lessee (Diversified) without including it as a party.” (DE 70-1, Mem. at
10.) But Chesapeake does not explain why the Non-party Lessors’ or the current lessee’s
ability to argue in the future that the lease has not been amended would be impaired or
impeded if they are not joined in this action. Perhaps Chesapeake’s theory is that these
parties would be bound by the Court’s decision under theories of claim preclusion or
issue preclusion. If so, Chesapeake does not argue this, much less establish it.
In a recent similar case, a district court in this circuit rejected the argument that
the co-lessors of the plaintiff Bounty Minerals, LLC were necessary parties in an action
by Bounty against two Chesapeake entities that the court referred to as the Chesapeake
Defendants. Bounty Minerals, LLC v. Chesapeake Expl., LLC, No. 5:17CV1695, 2019
WL 7048981, at *8 (N.D. Ohio Dec. 23, 2019). The Court noted that “Bounty’s breach of
contract claims are based upon the Chesapeake Defendants’ manner of calculating oil and
gas royalty payments to Bounty pursuant to the royalty provision” of the leases at issue.
Id. The claims were “specific to Chesapeake’s method and manner of calculating royalty
payments to Bounty (and not to any other potential co-lessors of the property).” Id.
“Thus, the Court will be able to accord complete relief as between the parties to this
action in the absence of Bounty’s co-lessors.” Id.

12

Similarly, Back’s claims here are specific to the manner by which Chesapeake
calculated royalties. Back does not name the current lessee, and he does not assert that
the current lessee engaged in any wrongful conduct. Back can obtain complete relief on
his claim without the presence of the current lessee.
As to the Non-party Lessors, Back asserts a claim on his own behalf and on behalf
of a purported class of other persons entitled to royalties from Chesapeake. If a class is
not certified, the Court’s decision regarding Back’s claim for royalties will affect only
Back’s claims against Chesapeake. If a class is certified, then Back will either be
obligated to adequately represent the interests of his co-lessors or his co-lessors could
choose to pursue their own litigation. Either way, proceeding in this action without the
co-lessors as named plaintiffs would not seem to impair or impede their ability to protect
their own interests in future litigation.
As to whether Chesapeake will face “inconsistent obligations” if the Non-party
Lessors are not joined, it is important to distinguish “inconsistent obligations” from
“inconsistent adjudications.” Winn-Dixie Stores, Inc. v. Dolgencorp, LLC, 746 F.3d
1008, 1040 (11th Cir. 2014). “Inconsistent obligations occur when a party is unable to
comply with one court's order without breaching another court's order concerning the
same incident.” Id. (quoting Delgado v. Plaza Las Ams., Inc., 139 F.3d 1, 3 (1st
Cir.1998)). “Inconsistent adjudications or results, by contrast, occur when a defendant
successfully defends a claim in one forum, yet loses on another claim arising from the
same incident in another forum.” Id.
In the Bounty case, the Chesapeake defendant argued that it faced no risk of
incurring inconsistent obligations because if two courts reached inconsistent decisions

13

about the lease language, “Chesapeake would be able to comply with both decisions
because, after all, this is simply a case about money damages.” Bounty, 2019 WL
7048981, at *9. Here too, even if a different court should reach a different decision about
the lease language in a suit by the co-lessors, Chesapeake could comply with both
decisions. It may face the possibility of inconsistent adjudications, but not inconsistent
obligations.
Based on the arguments and record currently before it, the Court cannot find that
the Non-party Lessors or the current lessee are necessary parties to this action.
III. Conclusion
For all these reasons, the Court hereby ORDERS that Chesapeake’s motion to
dismiss (DE 70) this action is DENIED.
Dated February 18, 2020

14