In Re Century Offshore Management Corporation, Debtor. United States of America v. Century Offshore Management Corporation
Docket: 95-6320
Court: Court of Appeals for the Sixth Circuit; July 23, 1997; Federal Appellate Court
Century Offshore Management Corporation, a natural gas producer operating under federal leases in the Gulf of Mexico, faced bankruptcy after selling gas to Enron Gas Marketing under fixed-price contracts. The U.S. Department of the Interior’s Minerals Management Service sought $1,855,004 in royalties from a $12,250,000 lump sum payment made by Enron to terminate these contracts and establish new ones at current market prices. Both the bankruptcy and district courts denied the government's claim, arguing the payment was not for gas "production" but merely a settlement to end the original contracts.
The key legal issue was whether this lump sum payment qualified as "the amount or value of the production [of natural gas] saved, removed, or sold" as defined by the Outer Continental Shelf Lands Act (OCSLA). The Court of Appeals reversed the lower courts' decisions, determining that the payment was indeed linked to gas production and constituted a sufficient basis for classifying it as "production sold." The case highlighted the powers granted to the Department of the Interior under OCSLA, including the authority to issue leases and set payment terms based on production value. The ruling clarified that an upfront payment for a substituted contract, which alters the pricing of the original agreement and facilitates new purchases, can qualify as production under the Act.
The Department of the Interior holds exclusive authority to implement regulations for the Act, including the "gross proceeds" rule which defines "production value" as not less than the gross proceeds received by the lessee after allowances. This rule has been applicable to offshore leases since the Act's inception. Century, the debtor, acquired working interests in three specific Gulf of Mexico leases between 1987 and 1990, all of which include statutory language regarding "amount or value of production." Two of these leases explicitly reference the "gross proceeds" standard.
In 1989 and 1990, Century entered into fixed-price production contracts with Enron Gas Marketing, Inc., which included "take-or-pay" clauses obligating Enron to pay Century for a minimum quantity of gas, regardless of whether it was taken. Notably, these payments were nonrecoupable. Additionally, Century and Enron established "excess contracts" for any additional gas, which were based on fluctuating market prices and did not include "take-or-pay" provisions.
In February 1992, Enron proposed to purchase the earlier contracts, leading to an agreement in which Enron paid Century a lump sum of $12,250,000, thereby terminating further payment obligations under the base contracts. At the time of this agreement, no "pay" payments were owed to Century under the take-or-pay clause, and Century did not remit royalties to the federal government for the lump sum received.
Century required Enron to agree to a loan of up to $1.5 million due to potential royalty liabilities highlighted by its bank. Concurrently, Enron and Century executed new contracts, termed "replacement contracts," which had floating prices tied to the natural gas spot price, without minimum quantity commitments or take-or-pay provisions, explicitly intended to replace prior agreements. Enron continued to purchase nearly all gas specified in the original contracts. Following damage from Hurricane Andrew, Century filed for Chapter 11 bankruptcy, leading the U.S. government to file a claim for $1,855,004 in royalties based on Enron’s $12,250,000 lump sum payment.
In an adversary proceeding, both Century and the government moved for summary judgment. The bankruptcy court favored Century, ruling the government's royalty claim was beyond its authority and its interpretation of the gross proceeds rule was arbitrary, capricious, retroactive, and violated the Administrative Procedure Act. The district court upheld the bankruptcy court's decision, except on the last point.
The government argued that Century owed royalties on the lump sum payment, asserting that it represented an advance for future gas purchases, akin to an installment payment, and thus linked to production value. It maintained that royalties should be assessed as production occurs under the replacement contracts. Century countered that the lump sum payment was not for reducing future prices but was calculated based on potential non-recoupable payments for minimum gas volumes under the original contracts. Century characterized the payment as a "buy-out," not related to royalties under the replacement contracts. It cited the Fifth Circuit’s ruling in Diamond Shamrock Exploration Co. v. Hodel, which stated that royalties are due only on payments made to purchase gas, asserting that the government’s interpretation was arbitrary and inconsistent with prior agency positions, and claimed it was unlawfully retroactive.
Both the government and Century argue that their interpretations of a lump-sum payment stem from the payment's nature and context, framing it as either a "buy-down" of contract prices or a "buy-out" of take-or-pay clauses. However, neither interpretation fully captures the essence of the payment. According to the Louisiana Supreme Court in Frey v. Amoco Production Co., total revenue in a gas purchase contract is influenced by both quantity and price, and the take-or-pay provision allows for lower pricing in exchange for guaranteed minimum gas delivery, which complicates the allocation of the payment.
The termination of the 1989 and 1990 contracts and the establishment of replacement contracts are treated as a single transaction, supported by the parties' intent to "replace and supersede" the earlier agreements. This scenario resembles a substituted contract where Enron's advance payment is for a new requirements contract. The analysis would not bifurcate the payment into contractual provisions and price components; instead, the lump-sum payment is seen as an advance for future gas sales under these new contracts. Consequently, it qualifies as payment for "production sold" under relevant statutes, with royalties due upon the actual production of gas.
The Fifth Circuit's ruling in Diamond Shamrock Exploration Co. v. Hodel does not conflict with this interpretation, as it specifically addressed the royalty implications of take-or-pay payments, concluding that royalties are only applicable to gas actually produced and taken, rather than on payments made under take-or-pay obligations. The court emphasized that royalties are tied to the value of production removed from the lease, underscoring that royalties are owed only upon actual production.
The primary outcome of the Diamond Shamrock case pertains to the timing of royalty payments related to gas contracts, particularly how "make-up gas" impacts these payments. Under the contracts in question, pipelines could claim credits for prior take-or-pay payments when they subsequently took gas. This credit effectively provided a discount on gas purchases, while royalties were still calculated based on the contract or fair market price. The government receives royalties on take-or-pay payments, but only when the make-up gas is actually produced and taken.
The interpretation of Diamond Shamrock indicates that a connection to production is required for royalties to be triggered, which was not established until the pipelines took make-up gas. The contracts allowed for take-or-pay payments to be applied to this make-up gas, creating the necessary nexus to production that activated the royalty provisions of the leases.
In the current case, the existence of simultaneous replacement contracts, which confirmed that nearly all previously identified gas was taken, establishes this nexus. Although the gas was not classified as make-up gas, it serves a similar function by linking payment to the actual production of gas. Consequently, royalties are owed based not only on the price paid by Enron but also on the additional lump sum payment associated with the gas taken.
Regarding the government's stance post-Diamond Shamrock, it is asserted that the Minerals Management Service (MMS) did not fully accept Century's interpretation that the Diamond Shamrock decision constrained its regulatory approach. Instead of appealing the decision or limiting its applicability to the Fifth Circuit, the MMS amended its regulations to align with the ruling, specifically removing take-or-pay payments from the definition of "gross proceeds." However, the MMS maintained that royalties would still be due once a sufficient connection to production is established, indicating the agency's intent to seek royalties when the requisite link is confirmed.
Courts should assess, ex post, whether actions create a nexus with production, as established in Diamond Shamrock. In that case, a single document demonstrated recoupability and the necessary nexus, while in the present matter, two documents, viewed as a single transaction, establish a connection between a lump sum payment and subsequent production. The government is entitled to royalties since production has occurred. Although Enron was not strictly required to take gas under replacement contracts, it ultimately did. Similarly, in Diamond Shamrock, the pipeline's actions regarding make-up gas, though not mandated, triggered refunds and royalties.
The transaction is interpreted as an advance payment for gas, leading to the Minerals Management Service amending its rules regarding advanced payments. It clarified that royalties are not owed until the specific gas tied to the advanced payment is produced, which has now occurred. Additionally, the payment appears to relate to production "saved" under statutory language, although this argument was not presented by either party. Hence, the payment is deemed royalty-bearing, tightly linked to future production sold.
Concerns about potential "absurd results" from this interpretation, particularly regarding double royalty payments, lack merit. The procedure does not lead to double-counting, aligning with Diamond Shamrock's precedent that allows for a royalty based on discounted make-up gas prices alongside its market value. Furthermore, while the district court noted minimum take requirements apportion risk between buyer and seller, this does not adequately address the nature of the payment or the possibility of obtaining lower future prices. The court finds the district court's reasoning on risk bearing unpersuasive.
Take-or-pay provisions transfer the risk of low prices or market liquidity to the buyer, who still must make minimum payments regardless of gas uptake. However, the risk allocation between seller/lessee and lessor is complex. Lessor royalties diminish with reduced exploration, production, and development, and lessors bear opportunity costs from alternative land uses. The notion that lessors do not share risks in gas extraction is overly simplistic; a lease/royalty arrangement represents a middle ground in risk allocation. A fractional royalty interest indicates a cooperative venture, while outright sales or fixed-amount leases would shift more risks away from the government. The district court's risk-allocation reasoning is not conclusive and does not translate effectively from private parties to the federal government, which has distinct motivations compared to private entities. The D.C. Circuit's ruling in Independent Petroleum Association of America v. Babbitt does not necessitate a different outcome; it dealt with a case lacking a production link. In contrast, Enron’s subsequent purchase under a replacement contract provides a sufficient connection to support the government's royalty claim. Century's argument that a ruling favoring the government would deter settlements of take-or-pay obligations is unfounded; the ruling simply mandates that lessees share payments linked to production. Producers will continue to produce for marginal gains, sharing profits with landowners, and the prices received remain market rates despite obligations to lessors.
Century and other oil producers do not own the land subject to their leases, as established by the Outer Continental Shelf Lands Act, which designates the outer Continental Shelf as a national resource held by the Federal Government for public use and development. Congress intended for these lands to be developed with environmental safeguards while maintaining competition. The leases granted to producers include provisions for royalties based on production, indicating the government retains a continuing interest in the lands, which it holds for the public benefit, including consumers and recreational users.
Century contends that the government's demand for royalties is retroactive and unlawful, citing lower court agreements with this view. Century argues that recent administrative cases (Shell Offshore, Inc. and Samedan Oil Corp.) have imposed new royalty obligations that deviate from prior practices, suggesting that these changes should not apply retroactively to payments made in early 1992. However, the Interior Board of Land Appeals previously limited the Minerals Management Service's ability to retroactively apply new approaches unless they represent a clear departure from established practices.
Century claims that the royalty provisions were amended after a specific opinion, leading to a consistent disavowal of royalties on certain payments. The government counters that there was no formal declaration on the matter, asserting that the agency's approach in seeking royalties was not a sudden shift from established practice. The court ultimately determined that the government's actions in this case, as well as in the referenced administrative cases, did not constitute abrupt departures from prior practices.
Century referenced a November 30, 1990, memorandum from a Minerals Management Service official regarding potential royalty refunds for Chevron after a "buy-out" payment from a gas purchaser. The memorandum indicated that "buy-out" payments, which release a purchaser from future obligations, are not linked to production removed from the lease and thus exempt from royalties. Century contends it relied on this interpretation in its transactions. However, the case involves contemporaneous replacement contracts, which resemble a buy-down rather than a straightforward buy-out. The memorandum distinguishes between buy-outs, which are not production-related, and buy-downs, which are associated with production. The ruling indicates that Enron's acceptance of gas under replacement contracts establishes a connection to production. The decision also critiques the government's stance on royalties as an effort to navigate an unclear legal area. Regarding the Administrative Procedure Act's notice and comment requirement, the district court upheld that the government's issuance of Shell Offshore was permissible as it constituted an interpretive rule clarifying the agency's understanding of relevant statutes. This interpretation does not necessitate public commentary and does not represent a significant departure from established practice. Consequently, the court disagrees with the district court's conclusion that the government is not entitled to royalties on the portion of the lump sum payment related to gas produced under replacement contracts.
The government’s actions were found not to violate the Administrative Procedure Act, leading to a partial reversal and affirmation of the district court's judgment, with the case remanded for determination of the royalty due. Enron’s agreement required a minimum purchase of gas, quantified as 90% of the maximum daily quantity times the number of days in the month. The take-or-pay requirements ensure producers receive minimum cash flow in exchange for reserving gas for purchasers, contrasting with commodity charges based on gas usage. The government argued that royalties would still be owed on lump sum payments from Enron, regardless of any replacement contracts, but this issue is not central to the current case. The court's conclusion about contract interpretation is a legal matter subject to de novo review. Century's argument that the lump sum payment reflected only the present value of future take-or-pay payments was deemed unpersuasive, lacking support from depositions and contradicting logical reasoning regarding contingent obligations. The record indicates Enron took nearly all the gas under the contract, undermining Century's claims about the payment’s relation to the substitute contract. Additionally, the memorandum warned that any buy-out payment must be carefully reviewed to ensure it is solely for contract termination.
