ZEHENTBAUER FAMILY LAND, LP; HANOVER FARMS, LP; EVELYN FRANCES YOUNG, Successor Trustee of Robert Milton Young Trust, Plaintiffs-Appellees, v. CHESAPEAKE EXPLORATION, L.L.C.; CHESAPEAKE OPERATING, INC.; CHK UTICA, L.L.C.; TOTAL E&P USA, INC., Defendants-Appellants.
No. 18-4139
United States Court of Appeals for the Sixth Circuit
Argued: June 19, 2019; Decided and Filed: August 15, 2019
19a0198p.06
Before: GILMAN, STRANCH, and NALBANDIAN, Circuit Judges.
RECOMMENDED FOR FULL-TEXT PUBLICATION Pursuant to Sixth Circuit I.O.P. 32.1(b). Appeal from the United States District Court for the Northern District of Ohio at Youngstown. No. 4:15-cv-02449—Benita Y. Pearson, District Judge.
COUNSEL
ARGUED: Gregory G. Garre, LATHAM & WATKINS LLP, Washington, D.C., for Appellants. Dennis E. Murray, Jr., MURRAY & MURRAY, CO., L.P.A., Sandusky, Ohio, for Appellees. ON BRIEF: Gregory G. Garre, Elana Nightingale Dawson, Samir Deger-Sen, Charles S. Dameron, LATHAM & WATKINS LLP, Washington, D.C., Daniel T. Donovan, KIRKLAND & ELLIS LLP, Washington, D.C., Timothy B. McGranor, VORYS, SATER, SEYMOUR AND PEASE LLP, Columbus, Ohio, for Appellants. Dennis E. Murray, Jr., William H. Bartle, MURRAY & MURRAY, CO., L.P.A., Sandusky, Ohio, Scott M. Zurakowski, Terry A. Moore, Gregory W. Watts, KRUGLIAK, WILKINS, GRIFFITHS & DOUGHERTY CO., L.P.A., Canton, Ohio, for Appellees. L. Bradfield Hughes, PORTER WRIGHT MORRIS & ARTHUR LLP, Columbus, Ohio, Andrew J. Pincus, MAYER BROWN LLP, Washington, D.C., for Amici Curiae.
RONALD LEE GILMAN, Circuit Judge. This appeal concerns oil and gas leases in Ohio’s Utica Shale Formation. The defendants are exploration and production companies that have contracted with landowners to drill for oil and gas on the leased properties, and the plaintiffs are a putative class of such landowners. Between 2010 and 2012, the plaintiffs and the defendants entered into hundreds of oil and gas lease agreements that provide for royalty payments to the plaintiffs based on the gross proceeds received by the defendants from the sale of each well’s oil and gas production.
The defendants sell the oil and gas extracted from the leased properties to so-called midstream companies affiliated with the defendants. To calculate the price that an unaffiliated entity would have presumptively paid for the oil and gas, the defendants use the “netback method.” According to the plaintiffs, the defendants underpaid the royalties due to the plaintiffs during the years in questiоn because the netback method (1) does not accurately approximate an arm’s-length-transaction price, and (2) improperly deducts post-production costs from the price.
The district court granted class certification. In this interlocutory appeal, the defendants argue that class certification under
I. BACKGROUND
A. Factual background
Chesapeake Exploration, LLC, and a predecessor company, Ohio Buckeye Energy, LLC, entered into hundreds of oil and gas leases with landowners in Ohio, including the three named plaintiffs in the present case. These leases establish that Chesapeake Exрloration and its assigns are entitled to produce oil and gas from beneath the surface of the landowners’ properties in exchange for royalty payments based on the gross proceeds received from the oil and gas sold.
The plaintiffs have split the leases into three subclasses. Group A’s royalty provisions contain language governing the sale price and royalty percentage, but the gas royalty provisions contain a definitional clause and a comparable-sales requirement that the oil royalty provisions do not. The definitional clause outlines the substances governed by the provision and the comparable-sales requirement governs gas sales to companies affiliated with the defendants. Zehentbauer Family Land, LP, and Hanover Farms, LP—two of the three named plaintiffs—are in the Group A subclass.
Group B’s royalty provisions contain a definitional clause and comparable-sales requirement for both oil and gas sales. Evelyn Frances Young, Successor Trustee of the Robert Milton Young Trust—the third named plaintiff—is in the Group B subclass.
Finally, all of Group C’s oil and gas royalty provisions have a definitional clause, but do not have a comparable-sales requirement. None of the named plaintiffs, however, are in the Group C subclass.
The lease agreements provide that Zehentbauer and Hanover are entitled to a 17.5% royalty and that Young is entitled to a 20% royalty “based upon the gross proceeds paid to Lessee” from the sale of oil or gas sold from the leased premises. The leases define the term “gross proceeds” as “the total consideration paid for oil, gas, associated hydrocarbons, and marketable by-products produced from the leased premises.”
For gas sales, the leases specify that the royalties are based on the gross proceeds paid to the defendants “computed at the wellhead.” Royalties are based on the defendants’ sales price when they sell gas “in an arms-length transaction to an unaffiliated bona fide purchaser.” The comparable-sales requirement of the leases accounts for the possibility that the defendants might sell gas to their own affiliates. In such cases, the Zehentbauer and Hаnover leases provide that
the price upon which royalties are based shall be comparable to that which could be obtained in an arms length transaction (given the quantity and quality of the gas available for sale from the leased premises and for a similar contract term) and without any deductions or expenses except for Lessee to deduct from Lessor’s royalty payments Lessor’s prorated share of any tax, severance or otherwise, imposed by any government body.
The Young lease has a nearly identical provision, but its exception for deducting the plaintiffs’ share of taxes is incorporated in the sentence following the phrase “and without any deductions or expenses.”
For oil sales, the Young lеase uses virtually the same royalty language, but omits the phrase “at the wellhead.” The Zehentbauer
Following the execution of these leases, Chesapeake Exploration assigned some of its rights under the leases to CHK Utica, LCC, and to Total E&P USA, Inc., both of which are defendants in the present case. CHK Utika is an affiliate of Chesapeake Exploration.
As permitted by the leases, the defendants sell the extracted oil and gas to their affiliates. Chesapeake Exploration and CHK Utica sell the oil аnd gas to an affiliated company called Chesapeake Energy Marketing, LLC. Total E&P USA sells the oil and gas to a corporate affiliate called Total Gas & Power North America, Inc. These affiliates are midstream companies that buy raw oil and gas at the wellhead and then process the raw products, transport them, and sell them to unaffiliated downstream companies that in turn sell the refined oil and gas products to consumers.
Because the defendants sell the extracted oil and gas to affiliates, the royalty payments are governed by the lease provisions specifying that such payments are to be based on the prices that an unaffiliated entity would have paid for the oil and gas in an arm’s-length transactiоn. (The defendants appear to employ the same method when calculating Group A’s oil royalties, despite the lack of comparable-sales language in the governing provision.) In order to determine the arm’s-length-transaction price, the defendants and their midstream affiliates employ the “netback method.” That method takes a weighted average of prices at which the midstream affiliates sell the oil and gas at various downstream locations and adjusts for the midstream company’s costs of compression, dehydration, treating, gathering, processing, fractionation, and transportation to move the raw oil and gas from the wellhead to downstream resale locations.
These costs are referred to as post-production costs. The netback method is intended to account for the midstream costs associated with moving the raw oil and gas from the wellhead to the downstream markets. Because the refined products that the midstream companies sell downstream are chemically distinct from the raw products extracted at the wellhead, and because the midstream products are closer to downstream markets, they are worth more than the raw upstream products.
The midstream affiliates pay the reduced price calculated by the netback method to the upstream producers. Based on these prices, Chesapeake Operating, LLC, makes royalty payments to the plaintiffs on behalf of Chesapeake Exploration, CHK Utica, and Total E&P USA. The plaintiffs receive royalty checks and statements showing the prices, based on the netback method, at which the oil and gas would have purportedly been sold in arm’s-length transactions at the wellhead. These royalty statements consistently reflect zero dollars in deductions.
B. Procedural background
In October 2015, the named plaintiffs sued the defendants in Ohio state court, seeking relief on behalf of themselves and a putative class consisting of “[a]ll persons entitled to royalty payments” from the defendants under what the plaintiffs called “uniform oil and gas leases, known generally as Gross Royalty Leases.” The plaintiffs identified 224 putative class members with interests in 295 leases with the defendants.
market values for those products” and “[w]hether the various types of post-production costs, expenses, or fees that were charged, directly or indirectly, by Defendants to Plaintiffs and the Class members breached the express and/or implied provisions of the Gross Royalty Leases.”
The defendants removed the case to the United States District Court for the Northern District of Ohio. Thereafter, the plaintiffs moved to certify the putative class under
The district court granted the plaintiffs’ motion for class certification regarding the Group A and Group B subclasses. Because none of the named plaintiffs are in Group C, the court concluded that the plaintiffs had failed to establish “typicality” under
The district court agrеed with the plaintiffs that “the issue of the propriety of the ‘netback’ method is the central issue in this case,” and that “[t]he answer to that question will resolve the claims of each and every individual in the class.” Although the court acknowledged that individual issues governing the market prices of oil and gas at the wellhead were relevant, it ultimately concluded that analyzing those issues would become necessary only for calculating the plaintiffs’ damages and therefore did not preclude class certification. The defendants responded by seeking leave to appeal the district court’s class-certification order under
II. ANALYSIS
A. Standard of review
We review a district court’s class-certification decision under the abuse-of-discretion standard. In re Whirlpool Corp. Front-Loading Washer Prods. Liab. Litig., 722 F.3d 838, 850 (6th Cir. 2013). “An abuse of discretion occurs if the district court relies on clearly erroneous findings of fact, applies the wrong legal standard, misapplies the correct legal standard when reaching a conclusion, or makes a clear error of judgment.” Id. (quoting Young v. Nationwide Mut. Ins. Co., 693 F.3d 532, 536 (6th Cir. 2012)). “We will
B. Class-certification requirements
“The class action is ‘an exception to the usual rule that litigation is conducted by and on behalf of the individual named parties only.’” Wal-Mart Stores, Inc. v. Dukes, 564 U.S. 338, 348 (2011) (quoting Califano v. Yamasaki, 442 U.S. 682, 700–01 (1979)). “In order to justify a departure from that rule, ‘a class representative must be part of the class and “possess the same interest and suffer the same injury” as the сlass members.’” Id. at 348–49 (quoting E. Tex. Motor Freight Sys., Inc. v. Rodriguez, 431 U.S. 395, 403 (1977)). A putative class must also comply with
In addition to the four requirements of
“[I]t may be necеssary for the court to probe behind the pleadings before coming to rest on the certification question.” Comcast, 569 U.S. at 33 (citations and internal quotation marks omitted). In addition, “certification is proper only if the trial court is satisfied, after a rigorous analysis, that the prerequisites
C. Ohio’s oil and gas law
The plaintiffs’ claim that the defendants are improperly trаnsferring the burden of paying for post-production costs is part of a broader debate about how oil and gas royalties should be calculated. Until the 1960s, the law uniformly applied the “at-the-well rule,” meaning that “oil and gas leases that are either silent on the point at which royalty calculations are to occur, or provide for royalties ‘at the wellhead,’ authorize lessees to apportion post-production costs in determining the value of the lessor’s royalty.” Peter A. Lusenhop & John K. Keller, Deduction of Post-Production Costs—An Analysis of Royalty Calculation Issues Across the Appalachian Basin, 36 Energy & Min. L. Inst. 837, 840–41 (2015). A majority of states where oil and gas are produced still use the at-the-well rule. Id. at 840.
But critics of the at-the-well rule argue that it is “inherently unfair to lеssors who lack the necessary expertise to negotiate clauses to protect their interests” and that it therefore gives “the lessee (which is in the best position to control post-production costs) a windfall.” Id. at 849. Partially in response to this criticism, “[b]eginning around 1960, a number of courts have held the lessee alone responsible for costs incurred up to the place of sale of minerals produced by the lessee or to the point at which a ‘marketable product’ has been obtained by the lessee.” 3 Williams & Meyers, Oil and Gas Law § 645 (2018). The Kansas Supreme Court, for example, invoked traditional duties of oil and gas producers to hold that “[t]he lessee has the duty to produce a marketable product, and the lessee alone bears thе expense in making the product marketable.” Sternberger v. Marathon Oil Co., 894 P.2d 788, 799 (Kan. 1995). This default rule is known as the “marketable-product rule,” and it has also been adopted by Colorado, Oklahoma, Virginia, and West Virginia. Lusenhop & Keller, supra, at 850–51.
If the at-the-well rule applies, then a producer may deduct post-production costs before calculating a lessor’s royalties, even if the contract provides that the royalties are to be calculated based on “gross” proceeds and “without deductions.” EQT Prod. Co. v. Magnum Hunter Prod., Inc., 768 F. App’x 459, 466 (6th Cir. 2019) (applying the at-the-well rule under Kentucky law). By contrast, if the marketable-product rule applies, then most post-production costs “are not
deductible even where . . . the royalty is to be paid based on [the] market price at the mouth of the well.” Sternberger, 894 P.2d at 799.
Ohio has not adopted either default rule. See Lutz v. Chesapeake Appalachia, L.L.C., 71 N.E.3d 1010, 1013 (Ohio 2016). In 2015, an Ohio district court certified to the Ohio Supreme Court the question “whether Ohio law imposes the ‘at-the-well’ rule or the ‘marketable product’ rule.” Id. at 1012. The Ohio Supreme Court declined to apply either rule, holding instead that, “[u]nder Ohio law, an
The defendants in the present case have been calculating royalties as though the leases incorporate the at-the-well rule. If they are correct, and if the parties always intended the royalties to be calculated based on the wellhead prices, then applying the marketable-product rule “runs the risk of giving [the plaintiffs] the benefit of a bargain not made.” See id. at 1014 (O’Neill, J., dissenting). But if they are incorrect, then the plaintiffs have been systematically undercompensated for the oil and gas removed from their land. Both sides argue that the leases expressly require their own respective royalty-calculation method.
D. Because the plaintiffs no longer argue that the defendants breached the leases by selling oil and gas to thе defendants’ midstream affiliates at below-market prices, class certification is appropriate.
The defendants argue that the district court improperly certified the class because the plaintiffs failed to establish predominance under
claims rely on showing that the defendants’ royalty payments were based on sale prices that fell below what an unaffiliated company would have paid for the oil and gas at the wellhead. The defendants contend that proving liability on this theory requires estimating the market prices for the raw oil and gas produced at each wellhead and comparing these estimated market prices to the prices calculated using the netback method. According to the defendants, the inquiry to determine these market prices is highly individualized because the market prices depend on the quality of the oil and gas sold at each well, the quantity of the oil and gas so sold, and the proximity of the well to processing facilities and downstream markets.
The district court, however, agreed with the plaintiffs’ argument that the key question for the purposes of
We agree with the defendants’ argument that the plaintiffs have not met their burden of showing that common issues predominate with respect to the plaintiffs’ theory that the defendants sold oil and gas to midstream affiliates at below-market prices. But the defendants’ argument ultimately fails because the plaintiffs no longer pursue at the class-certification stage the theory that the defendants breached the leases by selling oil and gas at below-market prices at each wellhead. And the plaintiffs stipulated during oral argument and asserted in their brief that they are willing to proceed solely on their post-production-costs theory of liability.
E. The plaintiffs satisfy the requirements of Rule 23(b)(3) with their liability theory based on the defendants’ deductions of pоst-production costs.
We will now address the sole theory of liability that the plaintiffs argue at the class-certification stage. The plaintiffs argue that the netback method breached the leases because the defendants improperly deducted post-production costs, in violation of the lease language prohibiting the defendants from deducting any expenses other than the plaintiffs’ share of taxes.
We conclude that the plaintiffs satisfy the predominance requirement of
If the plaintiffs prevail in showing that the defendants’ uniform practice of deducting post-production costs to calculate royalties breached the leases, then the plaintiffs will have succeeded in proving liability. And conversely, if the defendants’ method of calculating royalty payments by deducting post-production costs did not breach the leases, then all of the plaintiffs’ claims will fail on the merits. This theory of liability, moreover, does not require an estimation of the individual market prices of oil and gas at each well. Liability will turn solely on whether the leases permit the defendants to deduct post-production costs in calculating the royalties due to the plaintiffs (like the at-the-well rule), or whether the leases prohibit the defendants from deducting post-production costs (like the marketable-product rule). And if the plaintiffs prevail on the merits, then damages will be calculated by estimating what the royalty payments would have been if the defendants had not deducted post-production costs using the netback method.
This will be done without regard to the individual market prices of oil and gas at each well. (See Part II.G. below.)
We therefore conclude that the common question of whether the defendants breached the leases by employing the netback method predominates over individual questions. The defendants, however, challenge this post-production-costs theory of
Per the defendants’ first argument, they contend that the plaintiffs are now asserting a theory of liability based on the defendants’ deduction of post-production costs that is inconsistent with the plaintiffs’ complaint. The defendants accuse the plaintiffs of “present[ing] a plausible breach-of-contract theory that would survive an initial motion to dismiss,” and then changing course by “advanc[ing] a different, implausible theory of breach that would propel a motion for class certification.”
But scrutiny of the complaint reveals that the plaintiffs asserted both theories of liability at the pleading stage. The рlaintiffs alleged in the complaint that the “Defendants breached their lease duties by systematically selling Oil and Gas to affiliated entities at below-market prices, and also passed improper and/or excessive production and/or post-production expenses to the [plaintiffs], plainly violating the leases.” (Emphasis added.) In addition, the plaintiffs assert throughout the complaint that the defendants acted improperly by deducting post-production costs. We are therefore not persuaded by the defendants’ argument that the plaintiffs presented one theory of the case to survive a motion to dismiss and then pivoted to another theory of the case to survive class certification. Instead, the plaintiffs have plеaded that the defendants’ use of the netback method has violated the leases under both theories.
The complaint thus refutes the defendants’ argument that, had they known that the plaintiffs’ claims relied on the theory that the defendants improperly deducted post-production
costs, then the defendants would have raised such an argument in a motion to dismiss under
The defendants next argue that deducting post-production costs is fully consistent with the leases. Acсording to the defendants, the leases make clear that the gas royalty payments are based on “gross proceeds paid to the Lessee” and “computed at the wellhead.” They therefore argue that the gas royalty payments should be based on the defendants’ sales to midstream companies at the wellhead, not on the sales from midstream companies to downstream companies. The netback method, the defendants argue, deducts post-production costs from the downstream prices in order to approximate what an unaffiliated company would have paid the defendants for the raw products produced at the wellhead. This argument, however, is merits-based and thus prematurely presented at the class-certification stage of the case.
The defendants counter by pointing out that the Supreme Court in Comcast noted that courts are sometimes required to look at the merits in deciding a motion for class certification. Comcast held that “it may be necessary for the court to probe behind
But the Supreme Court in Comcast authorized lower courts to look at the merits during the class-certification stage only insofar as doing so is necessary to determine “whether common questions predominate over individual ones.” Id. at 34; see also Amgen Inc. v. Conn. Ret. Plans
& Tr. Funds, 568 U.S. 455, 466 (2013) (“Merits questions may be considered to the extent—but only to the extent—that they are relevant to determining whether the Rule 23 prerequisites for class certification are satisfied.”). The defendants’ argument challenging the plaintiffs’ post-production-costs theory is a merits argument that is not germane to the predominance requirement of
F. The cases cited by the defendants in which other circuits vacated class certification to plaintiffs challenging oil and gas royalty payments are inapposite.
We will now address the defendants’ argument that caselaw from other circuits supports vacating the district court’s order certifying the class in the present case. The defendants specifically point to two oil-and-gas-royalty cases from other circuits in which the court of appeals vacated a district court’s class-certification order. One of these cases is EQT Production Co. v. Adair, 764 F.3d 347 (4th Cir. 2014), where the Fourth Circuit vacated the district court’s order certifying a class of plaintiffs who argued that the defendants underpaid their royalties for coalbed methane. The other case is Wallace B. Roderick Revocable Living Trust v. XTO Energy, Inc., 725 F.3d 1213 (10th Cir. 2013), where the Tenth Circuit similarly vacated the district court’s order certifying a class of plaintiffs chаllenging the defendant’s use of the netback method in paying gas royalties. Although these two cases share a number of factual similarities with the present case, each has a material distinguishing feature.
We turn first to EQT Production Co., where five subclasses of plaintiffs argued that the defendants underpaid their gas royalties. All five subclasses contended that “the defendants sold the [coalbed methane] at too low a price, in part, by selling the gas to affiliates in non-arms-length transactions.” EQT, 764 F.3d at 365. The district court believed that commonality and predominance were satisfied because “the defendants employed numerous uniform practices related to the calculation and payment of [coalbed methane] royalties.” Id. at 366.
Although the Fourth Circuit noted that these cоmmon practices were relevant to the predominance inquiry, it held “that the district court abused its discretion by failing to consider the significance of this common conduct to the broader litigation.” Id. The Fourth Circuit also
held that “the mere fact that the defendants engaged in uniform conduct is not, by itself, sufficient to satisfy Rule 23(b)(3)’s more demanding predominance requirement.” Id. Ultimately, the Fourth Circuit vacated the district
No such error was committed in the present case because the district court’s focus was not “only on the number of common practices.” See id. at 367. Rather, it determined that a common question predominates because the plaintiffs’ case turns on the propriety of the netback method under the uniform contract language, and it found both commonality and predominance on that basis. Importantly, the Fourth Circuit explained that certification might be proper if the plaintiffs were “able to identify a finite number of variations in deed language, such that the ownership question is answerable on a subclass basis.” Id. at 363. That is precisely what the district court did here.
Roderick is also distinguishable. In Roderick, the plaintiffs argued that XTO Energy “systematically underpaid royalties by deducting costs associated with placing gas (and its constituent products) in marketable condition,” in violation of Kansas’s marketable-product rule. 725 F.3d at 1216. As in the present case, the plaintiffs in Roderick argued that the defendant used the netback method to calculate royalties, thereby improperly deducting post-production costs. Id. The district court certified the class based on the common question of whether XTO’s payment methodology breached Kansas’s implied duty of marketability for lessees. Id. at 1217.
But the Tenth Circuit vacated the district court’s class-certification order because the plaintiffs failed to demonstrate commonality with respect to whether the leases abrogated Kansas’s default marketable-product rule. Id. at 1218. Specifically, because the lease language varied from lease to lease, the Tenth Circuit concluded that the plaintiffs failed to meet their burden of affirmatively demonstrating commonality based on the marketable-product rule. Id. It also agreed with the dеfendant that the issue of when the gas becomes marketable might require an individualized analysis of each well. Id. at 1219. This distinction between wells was
material because if the gas was already marketable at a particular well, then deductions for post-production costs for that well would not constitute a breach of the implied duty of marketability. Id.
Roderick is distinguishable because the district court in the present case found that the leases at issue do not have any material differences in the lease language. As the Tenth Circuit subsequently explained, Roderick’s concern about varying lease language is not implicated if the plaintiffs are able to “‘categorize[]’ the leases at issue ‘by royalty[-]clause language.’” Naylor Farms, Inc. v. Chaparral Energy, LLC, 923 F.3d 779, 795 (10th Cir. 2019) (second alternation in original). The plaintiffs did so in this case by identifying two subсlasses within which all subclass members signed materially identical oil and gas royalty provisions. And the defendants do not argue on appeal that any differences that do exist in the lease language defeat commonality or predominance. Furthermore, the defendants here do not argue that any of the wells in question produce oil or gas that is already in marketable condition, nor do they even assert that marketability is a relevant inquiry. We therefore conclude that the commonality problem in Roderick is not present here.
G. The district court must ensure that, if the plaintiffs prevail on the merits, any damages calculations match the sole remaining theory of liability.
Comcast Corp. v. Behrend, 569 U.S. 27 (2013), held that
In its class-certification order, the district court noted that “[a]n analysis of the[] physical differences [between wells] would only become necessary for damages calculations.” But no
such analysis of the physical differences between wells will be necessary at the damages stage of the litigation under the plaintiffs’ sole remаining theory of liability, i.e., that the defendants improperly deducted post-production costs. Should the plaintiffs prevail in establishing that the defendants breached the leases by deducting post-production costs, then the plaintiffs’ damages model must calculate what the royalty payments would have been had the defendants not deducted these costs in the royalty-payment calculations. This method will, in effect, base royalty payments solely on the prices at which the defendants’ midstream affiliates sold oil and gas to downstream companies. Damages will then equal the difference between the royalty payments based on the downstream prices and the actual royalty payments calculated using the netback method, the latter having deducted post-production costs. This damages model is consistent with the plaintiffs’ theory of liability.
III. CONCLUSION
For all of the reasons set forth above, we AFFIRM the judgment of the district court.