Frontier Energy LLC et al v. Aurora Energy, Ltd.
Filing
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OPINION ; signed by Judge Robert Holmes Bell (Judge Robert Holmes Bell, kcb)
UNITED STATES DISTRICT COURT
FOR THE WESTERN DISTRICT OF MICHIGAN
SOUTHERN DIVISION
FRONTIER ENERGY, LLC,
Appellant/Cross-Appellee,
File No. 1:12-CV-424
v.
HON. ROBERT HOLMES BELL
AURORA ENERGY, LTD.,
Appellee/Cross-Appellant.
/
OPINION
This matter is before the Court on an appeal of the bankruptcy court’s entry of
judgment in a natural gas royalty dispute, and a cross-appeal of the bankruptcy court’s
determination that the term “lease” in 11 U.S.C. § 365 applies to oil and gas leases. For the
reasons that follow, the Court will affirm the judgment and dismiss the cross-appeal as moot.
I.
Appellant Frontier Energy, LLC, owns the mineral rights formerly held by North
Michigan Land and Oil Company. Appellee Aurora Energy, Ltd., is a company involved in
extracting oil and gas.
In 2002, Aurora entered into an agreement with Frontier (the “Hudson Agreement”)
to lease a large mineral estate in Charlevoix County, Michigan.
Under the Hudson
Agreement, Aurora, as lessee, agreed to lease oil and gas producing properties from Frontier,
as lessor, in exchange for the payment of royalties to Frontier. The negotiated agreement
departed from the standard State of Michigan form lease in several significant respects. The
parties agreed on an initial royalty of 15% of the proceeds of sale before Payout, subject to
deductions for “costs incurred by lessee for CO 2 removal, third party transportation, and
necessary compression.” (Dkt. No. 3, Attach. 1, Agreement, Ex. A, ¶¶ 5- 6.) After Payout,
the parties agreed that royalties would increase from 15% to 50% depending on the price for
which the gas was sold by the lessee. (Id. at ¶ 5.)
Gas extraction began in 2005. In June 2007, Frontier began to question Aurora’s
calculation of the royalty payments. In February 2008, Frontier filed a state court action
against Aurora alleging breach of contract based on failure to properly compute and pay
royalties. Frontier contends that Aurora underpaid it by more than $1.5 million.
In 2009, Aurora filed a Chapter 11 bankruptcy. Aurora removed the state court action
to the bankruptcy court as an adversary proceeding. At the conclusion of an 11-day trial, the
bankruptcy court issued an opinion and order construing the Agreement. Frontier Energy,
LLC v. Aurora Energy, Ltd. (In re Aurora Oil & Gas Corp.), 460 B.R. 470 (Bankr. W.D.
Mich Oct 28, 2011). On February 18, 2012, the bankruptcy court entered a judgment in favor
of Defendant Aurora, and against Plaintiff Frontier, and disallowed the claims filed by
Plaintiff Frontier in Bankruptcy Case No. 09-08254. Frontier filed this appeal, challenging
the bankruptcy court’s construction of the Agreement. Aurora filed a cross-appeal of the
bankruptcy court’s ruling that the Agreement is a “lease” under 11 U.S.C. § 365. See
Frontier Energy , LLC v. Aurora Energy, Ltd. (In re Aurora Oil & Gas Corp.), 439 B.R. 674
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(Bankr. W.D. Mich. Aug. 13, 2010).
II.
On appeals from the bankruptcy court, this Court reviews the bankruptcy court’s
factual findings for clear error and its legal conclusions de novo. In re Global Technovations
Inc., 694 F.3d 705, 714 (6th Cir. 2012) (citing Nicholson v. Isaacman (In re Isaacman), 26
F.3d 629, 631 (6th Cir. 1994)). “A factual finding will only be clearly erroneous when,
although there is evidence to support it, the reviewing court on the entire evidence is left with
the definite and firm conviction that a mistake has been committed.” In re Musilli, 379 F.
App’x 494, 497 (6th Cir. 2010) (quoting Rembert v. AT & T Universal Card Servs., Inc. (In
re Rembert), 141 F.3d 277, 280 (6th Cir. 1998)).
III.
A. Construction in Favor of Lessor (Rule of Fagan)
Frontier’s first assignment of error concerns the bankruptcy court’s construction of
the Agreement. Frontier contends that the bankruptcy court erred by applying ordinary rules
of contract interpretation on the issue of intent and by reserving strict interpretation in the
lessor’s favor only as a last resort if other interpretive aids failed.
The Michigan Supreme Court has recognized the “established rule” that “oil and gas
leases are to be construed for the benefit of the lessor and against the lessee.” J.J. Fagan &
Co. v. Burns, 247 Mich. 674, 681 (1929). The bankruptcy court recognized the continued
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viability of the Fagan rule,1 but rejected Frontier’s contention that the Fagan rule trumped
other rules of contract interpretation. The bankruptcy court determined that the Fagan rule
“must yield to other interpretive rules designed to ascertain the objectively manifested intent
of the parties.” (Bankr. Op. 15.) The bankruptcy court stated that it would first apply the
applicable rules of contract interpretation cited by Michigan courts involving controversies
between parties to oil and gas leases, such as trade usage and/or course of performance, and
then, only if these interpretative aids failed, would it resolve ambiguities in favor of Frontier
as lessee. (Bankr. Op. 15.)
When discussing and applying the Fagan rule, Michigan courts have uniformly noted
that other contract interpretation rules still apply. See, e.g., McClanahan Oil Co. v. Perkins,
6 N.W.2d 742, 743 (Mich. 1942) (noting that the ordinary rules of construction of contracts
govern oil and gas leases, except that ambiguities are strictly construed in favor of the
lessor); Schroeder v. Terra Energy, Ltd., 565 N.W.2d 887, 892 (Mich. Ct. App. 1997)
(noting that nothing in Fagan purported to abolish general precepts of contract construction).
Frontier agrees that other contract interpretation rules apply to oil and gas leases, but
objects to the bankruptcy court’s use of the Fagan rule as a rule of last resort. Frontier
1
See, e.g., Mich. Wis. Pipeline Co. v. Mich. Nat’l Bank, 324 N.W.2d 541, 544 (Mich.
Ct. App. 1982) (“In construing an oil and gas lease, this Court is guided by the Supreme
Court’s decision in J J Fagan & Co. v. Burns, 247 Mich. 674, 226 N.W. 653, 67 A.L.R. 522
(1929).”)
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contends that the Fagan rule should be integrated with other indicia of the parties’ intent.
There can be no dispute that “‘[t]he primary goal in the construction or interpretation
of any contract is to honor the intent of the parties.’” Klapp v. United Ins. Group Agency,
Inc., 663 N.W.2d 447, 456 (Mich. 2003) (quoting Rasheed v. Chrysler Corp., 517 N.W.2d
19, 29 n.28 (Mich. 1994)). In Klapp, the Michigan Supreme Court held that the rule of
contra proferentem (requiring that ambiguities be construed against the drafter) was a rule
of last resort. The rule of contra proferentem does not aid in determining the parties’ intent.
Id. at 456.
“[T]his rule is only to be applied if all conventional means of contract
interpretation, including the consideration of relevant extrinsic evidence, have left the jury
unable to determine what the parties intended their contract to mean.” Id. at 455. It is not
a rule of interpretation, but a rule of legal effect; its purpose is not to give meaning to the
contract, but to ascertain the winner and the loser in connection with a contract whose
meaning is unclear, even after application of conventional rules of interpretation. Id.
The Michigan Supreme Court did not discuss Fagan or oil and gas leases in Klapp.
Nevertheless, Klapp makes a strong case for trying to discern the intent of the parties first,
and to only consider the party’s status as drafter if the parties’ intent cannot be discerned. The
Fagan rule, like the rule of contra proferentem, is a rule based on the party’s status as lessor.
Like the rule of contra proferentum, it is not designed to discern the parties’ intent, and
should only be applied as a tie-breaking rule. See Lomree, Inc. v. Pan Gas Storage, LLC, No.
10-14425, 2011 WL 3498131, at *9 (E.D. Mich. Aug. 10, 2011), rev’d on other grounds, No.
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11-2132, 2012 WL 3871882 (6th Cir. Sept. 6, 2012) (“J.J. Fagan affirmed that contra
proferentem is applicable in oil and gas leases, essentially re-stating the rule by declaring that
oil and gas leases are to be construed ‘for the benefit of the lessor and against the lessee.’”).
The bankruptcy court’s approach of first applying applicable rules of contract
interpretation to determine the parties’ intent, and resolving ambiguities in favor of Frontier
as lessor only if those interpretive aids failed, is consistent with Michigan case law. In
Schroeder, the Michigan Court of Appeals recognized that “ambiguities in the oil and gas
lease should be resolved in favor of the lessors as a policy matter.” 565 N.W.2d at 892. The
court nevertheless rejected the lessor’s interpretation of the disputed contract phrase and
adopted the lessee’s interpretation because it “better conform[ed] with the parties’ intent as
gleaned from the contractual language.” Id. at 892, 894. In Lomree, the Eastern District of
Michigan recognized its duty to construe gas leases for the benefit of the lessor. 2011 WL
3498131, at *4. The court nevertheless commenced its interpretation of a gas lease by
reaffirming its obligation to enforce a contract according to the parties’ intent, and only
applied the rule of contra proferentem in favor of the lessor when, “after applying all other
conventional means of contract interpretation,” the terms were still ambiguous. Id. at *5.
On appeal, the Sixth Circuit did not reverse the methodology used by the district court in
determining that the contracts were ambiguous. 2012 WL 3871882, at *7. The Sixth Circuit
reversed because the district court applied the doctrine of contra proferentum while there
were still unresolved issues of fact concerning the parties’ intent: “The doctrine requires
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construing a contract against the drafter . . . when the parties’ intent is still unclear after
reviewing all the evidence. But because it is too early to say what weight a reasonable fact
finder might place on the extrinsic evidence offered by Lomree, summary judgment in favor
of Lomree was inappropriate in this case.” Id. (citation omitted).
The Court concludes on review that the bankruptcy court did not err in the manner in
which it applied the rule of Fagan.
B. Determination re ambiguous and unambiguous terms
Frontier also contends that the bankruptcy court erred in its determination of which
contract terms were ambiguous and which contract terms were unambiguous.
The
Agreement provided that the royalty was subject to deductions for “costs incurred by lessee
for CO 2 removal, third party transportation, and necessary compression.”
(Dkt. No. 3,
Attach. 1, Agreement, Ex. A, ¶¶ 5- 6.) Throughout the parties’ relationship, Aurora used the
services of HPPC to transport all of Aurora’s gas. HPPC was a subsidiary of Aurora. During
the life of the Agreement, Aurora’s ownership in HPPC steadily grew from 48.5% in 2004,
to 100% in 2009. Frontier, 460 B.R. at 477-78. The bankruptcy court determined that the
term “third party transportation” was not ambiguous, and that HPPC qualified as third party
transportation. Id. at 484.
Frontier contends that the bankruptcy court erred both in its determination that “third
party transportation” was not ambiguous and in its determination that transportation provided
by HPPC, a subsidiary of Aurora, qualified as third party transportation. Frontier contends
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that the bankruptcy court should have found, based on the extensive extrinsic evidence
offered by Frontier, that the term “third party” presents a latent ambiguity in the context of
this case.
“A latent ambiguity exists when the language in a contract appears to be clear and
intelligible and suggests a single meaning, but other facts create the necessity for
interpretation or a choice among two or more possible meanings.” Shay v. Aldrich, 790
N.W.2d 629, 641 (Mich. 2010) (internal quotations omitted). “To verify the existence of a
latent ambiguity, a court must examine the extrinsic evidence presented and determine if in
fact that evidence supports an argument that the contract language at issue, under the
circumstances of its formation, is susceptible to more than one interpretation. Then, if a
latent ambiguity is found to exist, a court must examine the extrinsic evidence again to
ascertain the meaning of the contract language at issue.” Id.
The bankruptcy court began its analysis by noting that the “plain and ordinary
meaning” of “third party” is someone other than the principals involved in a transaction.
Frontier, 460 B.R. at 483. The bankruptcy court acknowledged that although Aurora’s
business and legal interests were closely intertwined with HPPC, Aurora and HPPC were
separate corporate entities. The bankruptcy court further noted that elsewhere in the
Agreement the term “independent nonaffiliated third party” is used, which confirms that the
parties knew how to distinguish related and unrelated third parties. Frontier, 460 B.R. at
483. Because the parties used the unmodified term “third party” in the royalty section, the
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bankruptcy court determined that it was proper to construe the term “third party” according
to its ordinary meaning. Id. The bankruptcy court permitted Frontier to present extrinsic
evidence, but ultimately found that there was no latent ambiguity, in part because it found
that the testimony of David and Dale Nielson regarding contract negotiations was not
credible. Id. at n.5. This Court agrees with the bankruptcy court’s determination that the
contract was not ambiguous and that HPPC qualified as “third party transportation.”
C. Mich. Comp. Laws § 324.61503b
Frontier contends that the bankruptcy court erred when it rejected the application of
Mich. Comp. Laws § 324.61503b to the Payout clause.
The Michigan Natural Resources and Environmental Protection Act provides in part
that:
(1) A person who enters into a gas lease as a lessee after March 28, 2000 shall
not deduct from the lessor’s royalty any portion of postproduction costs
unless the lease explicitly allows for the deduction of postproduction costs.
If a lease explicitly provides for the deduction of postproduction costs, the
lessee may only deduct postproduction costs for the following items, unless the
lease explicitly and specifically provides for the deduction of other items:
(a) The reasonable costs of removal of carbon dioxide (CO 2), hydrogen sulfide
(H 2 S), molecular nitrogen (N 2), or other constituents, except water, the
removal of which will enhance the value of the gas for the benefit of the lessor
and lessee.
(b) Transportation costs . . . .
Mich. Comp. Laws § 324.61503b(1) (emphasis added).
Consistent with the statute, the Agreement states that Lessor’s royalty is to be free and
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clear of all costs “except as agreed herein.” (Dkt. No. 3, Attach. 1, Agreement ¶ C(2)(g),
Page ID#3723.) In a separate section the Agreement provides that Frontier’s royalty would
be determined based on a two-tiered royalty structure: a 15% royalty on production before
Payout and a higher royalty of 15% to 50% after Payout. Payout was defined as that point
in time at which Aurora had recouped its investment.2 In calculating whether Payout had
been reached, Aurora deducted postproduction costs from “proceeds of production.” Frontier
contends that by deducting postproduction costs from the proceeds of production, Aurora
delayed the occurrence of Payout, thereby reducing the royalty payments owed to Frontier.
At trial, Frontier argued that because the Payout clause affects the royalty payments, the
statute prohibiting the deduction of postproduction costs governed the calculation of Payout
under the Payout clause. Aurora argued that the statute did not apply to the Payout clause
because the statute applies to “royalties” and not to “Payout.”
2
“Payout” is defined in the Agreement as follows:
For purposes of this paragraph, the term “Payout”, with respect to a given
Antrim Unit, shall mean the point in time that the proceeds of production
attributable to the interest of the lessee in all wells drilled upon the Antrim
Unit, less royalties and other lease burdens and production or similar taxes,
equals the costs incurred by lessee for drilling, testing, completing and
equipping all wells, constructing and installing all necessary gathering lines,
facilities and pipelines, including meters, plus the cost of operating the Antrim
Unit prior to Payout. Payout for royalty determination purposes shall be
deemed to have occurred as of the first day of the calendar month succeeding
the month in which payout occurs.
(Dkt. No. 3, Attach. 1, Agreement, Ex. A, ¶ 5 (emphasis added).)
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After noting that statutes in derogation of the common law were to be narrowly
construed and that the somewhat unusual concept of Payout is not addressed within the text
of the law, the bankruptcy court declined to “stretch” the statutory language as far as
Frontier’s “novel argument would take it.” 460 B.R. at 488-89.
The bankruptcy court found that the phrase “proceeds of production” as used in the
Payout clause meant proceeds of sale minus postproduction costs, and that Aurora’s
deductions of postproduction costs in calculating Payout was consistent with the Agreement.
460 B.R. at 491. On appeal, Frontier does not contest the finding that the parties intended
that postproduction costs would be deducted from Aurora’s revenue in the calculation of
payout. Instead, Frontier contends that the statute overrides the parties’ intent, and that
because the statute is remedial in nature, the statute should have been liberally construed.
See W. Mich. Univ. Bd. of Control v. State, 565 N.W.2d 828, 834-35 (Mich. 1997).
The statute only prohibits the deduction of postproduction costs from the lessor’s
royalty. Mich. Comp. Laws § 324.61503b(1). Even if this Court assumes that the statute is
remedial in nature,3 the canon of liberal construction does not authorize the court to ignore
the parameters established by the plain text of the statute. See Unisys Corp v. Comm’r of
Ins., 601 N.W.2d 155, 159 (Mich. Ct. App. 1999). Even under a liberal construction of the
statute, the statute simply does not address the determination as to when payment of a royalty
3
Although the legislative history was silent on this point, the bankruptcy court noted
that “Michigan’s legislature may have intended to address a specific oil and gas lease
drafting problem” by overruling Schroeder with this statute. 460 B.R. at 488.
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might be triggered. In this case, two sophisticated parties entered into an agreement that
provided for royalty payments consistent with the statutory requirements.
The same
sophisticated parties also agreed that a higher royalty would be paid after Aurora’s proceeds
of sale minus postproduction costs equaled its investment. The bankruptcy court was correct
in its determination that the statute did not prohibit such an agreement.
D. Course of Performance
Frontier contends that the bankruptcy court erred as a matter of law in its
understanding and application of the parties’ course of performance practical construction
of the Agreement. Frontier contends that because Aurora repeatedly changed the manner in
which it reported its calculation of royalties throughout the life of the contract, there was no
acquiescence by Frontier, nor any course of performance that could be relied on for
determining the meaning of ambiguous terms such as “ownership percentages,” “proceeds
of production,” “costs incurred by lessee,” “necessary compression,” and “overhead.”
Frontier also contends that the bankruptcy court was inconsistent in its application of the
parties’ course of conduct, sometimes finding that Aurora’s conduct was evidence of
Aurora’s understanding of the contract’s terms, but at other times excusing Aurora’s
consistent conduct as an accounting mistake. Frontier contends that the bankruptcy court’s
inconsistency confirms that it fundamentally misapplied the concept of practical construction,
and undermines its reasoning with regards to the purported significance of the parties’
purported practical construction.
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“Michigan law provides that the parties’ practical interpretation of their contract, and
their course of conduct under that contract, are entitled to great weight in interpreting
ambiguous provisions of the contract.” Terry Barr Sales Agency, Inc. v. All-Lock Co., Inc.,
96 F.3d 174, 180 (6th Cir. 1996). “The practical interpretation given to contracts by the
parties to them, while engaged in their performance and before any controversy has arisen
concerning them, is one of the best indications of their true intent.” Klapp, 663 N.W.2d at
459. Although Frontier attempts to present its argument as one of law, as a general rule, the
bankruptcy court applied the parties’ course of conduct to determine their intent, and
disputed issues of contractual intent are considered to be factual issues. Terry Barr Sales,
96 F.3d at 179. Frontier has not identified any evidence to show that the bankruptcy court’s
factual findings were clearly erroneous.
Upon review, it appears that the bankruptcy court made detailed factual findings in
support of its determinations regarding the intent of the parties with respect to each of the
disputed terms. The bankruptcy court explained that it sided with Aurora in many instances
because it found Aurora’s witnesses more credible. There is evidence in the record to
support the bankruptcy court’s credibility findings and its findings with respect to the parties’
course of performance. This Court is not left with a definite and firm conviction that a
mistake has been committed. Accordingly, the bankruptcy court’s findings are not clearly
erroneous. See In re Musilli, 379 F. App’x at 497. Furthermore, the Court finds that the
bankruptcy court’s failure to apply the course of performance doctrine to every instance of
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past performance is evidence of its thoughtful application of the doctrine based on the
relevant facts rather than a misapplication of the doctrine.
IV.
Aurora contends in its cross-appeal that the bankruptcy court erred in ruling that the
Agreement was a lease for purposes of 11 U.S.C. § 365. However, Aurora has indicated that
its cross-appeal is conditional, and that if this Court affirms the bankruptcy court’s opinion
on the royalty issues, the Court does not need to reach the § 365 lease issue because it will
not affect the outcome of the case. (Dkt. No. 21, Aurora’s Br. 35-36.)
Because the Court is affirming the bankruptcy court’s opinion on the royalty issues,
the cross-appeal has been rendered moot.
An order and judgment consistent with this opinion will be entered.
Dated: March 27, 2013
/s/ Robert Holmes Bell
ROBERT HOLMES BELL
UNITED STATES DISTRICT JUDGE
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