MINERAL RIGHTS AND REAL ESTATE PURCHASES: A BREEDING GROUND FOR CONTRACT DISPUTES

Oct 2009
12
Posted by: Jeff R.
3:48:05 PM

No issue has given rise to as many contract disputes in North Texas in recent years as the effect of Barnett Shale development on real estate transactions. For decades, real estate practitioners in North Texas rarely considered mineral rights when negotiating and drafting contracts for sale. However, the rapid rise in the value of mineral rights resulting from the financial success of Barnett Shale drilling, coupled with the increased awareness of the public with respect to minerals, has led to a sometimes heated negotiation over post-closing mineral rights. Many times these disputes lead to a complete breakdown in the deal, resulting in ill-feelings among the parties and loss of anticipated income by brokers, agents, mortgage companies and other participants in the transaction. Unfortunately, most of these disputes can be traced back to misinformation and misunderstanding of the law concerning mineral rights, further compounded by rather loose and careless drafting at the contract stage. To fully understand the effects of mineral rights on a real estate transaction, real estate practitioners and investors must have a sound understanding of real estate, oil and gas, contract and title law. In this article I shall summarize ten basic mineral issues that often arise in real estate transactions.

1. Are minerals included in the contract? Although a complete definition of the term “minerals” is beyond the scope of this article, suffice it to say that in today’s local environment, most transactions focus on the rights to oil and gas, which are both considered minerals under Texas law. Moreover, all minerals are considered part of the real estate in Texas; as a result, a contract of sale for real estate would typically include the rights to the surface of the land as well as the minerals underneath. However, minerals have a unique characteristic in that they may be severed from the surface; that is, ownership of the minerals can be separated from the ownership of the surface of the land, leading to a dual ownership of portions of the real estate. Moreover, the ownership of the minerals can be further divided into separate ownership components: the right to lease bonuses, rentals, royalties, the right to execute oil, gas and other mineral leases (the “executive” or “executory” rights) and the right to develop. If separated out, all these rights often lead to conflicts among the various owners.

2. If the minerals are owned by a third party, what can a contract purchaser of real estate do? Because the minerals are considered part of the real estate in Texas, a seller under a contract that fails to mention minerals would have a contractual requirement to convey the entire real estate, including the surface and all minerals, to the buyer. But if in fact all or a portion of the minerals are owned by a person not a party to the contract, what rights does the buyer have? In Texas, most well drafted contracts include a provision whereby a buyer may object to any defect or encumbrance to free and clear title to the contracted for property. If the seller is unable to cure the title objection, then the buyer can typically terminate the contract and receive a refund of their earnest money. As a result, potential buyers can steer clear of future conflicts with other mineral interest owners by terminating the contract prior to closing. However, if a buyer fails to terminate the contract, then they must take title to the property subject to whatever pre-existing mineral rights are held by other parties.

3. What if the contract is silent as to minerals, but the seller had previously expressed an intent to reserve the minerals? In Texas, the Statute of Frauds requires that all agreements regarding the purchase and sale of real estate must be in writing and signed by both seller and buyer to be effective. Any oral understandings or unsigned written documents will not supersede a signed contract that is silent as to the seller’s desire to retain ownership of the minerals. Many times the seller will express their intention to retain the minerals orally, within a written broker’s listing agreement, or as part of a Multiple Listing Service entry. However, unless such intent is included in the actual written contract executed by both seller and buyer, the mineral reservation will not be valid or enforceable. The seller in such situations has a contractual duty to convey both the surface and the minerals to the buyer.

4. What if the Contract provides that the Seller shall reserve the minerals, but such reservation is not included in the Deed executed at Closing? The Doctrine of Merger provides that all written agreements leading up to the closing of a real estate transaction will merge with the final closing documents; that is, absent a written agreement that certain obligations shall survive closing, the terms of the Contract will cease to be enforceable after closing. Only the final closing documents will validly represent the final agreements of the parties. Since the Deed is the document that actually conveys title of the real estate from the seller to the buyer, the terms of the Deed represent the final agreement of the parties as to what interest in the property is transferred or retained (except for other closing documents and “survival clauses” to the contrary). This issue leads to plenty of sleepless nights for real estate practitioners; if a contract calls for a reservation of minerals on behalf of the seller, but the attorney preparing the Deed for use in the transaction fails to include proper mineral reservation language, ownership of the minerals will transfer to the buyer despite the contract terms. The drafting attorney would be well advised to prepare for the legal consequences brought on by one angry seller.

5. How much of the minerals will be conveyed? This is where attorneys and real estate agents get into trouble. The wording used in the contract will dictate the seller’s obligation to convey minerals. All too often the wording is incomplete, unclear or both. For some reason many agents have been instructed to include the following language in their contracts: “All minerals to convey.” As an attorney, I struggle in interpreting the meaning of this clause. Does that mean Seller is promising to convey all the minerals, or merely promising to convey all the minerals he or she owns? If a portion of the minerals had been previously reserved, and the seller does not own all the minerals, they are not in position to validly convey all the minerals. As a result, a buyer may object to the title defect and terminate the contract. If the contract says: “Seller to retain ½ of the minerals”, it is again unclear. Does this mean the seller desires to retain ½ of all the minerals, or merely ½ of the minerals he or she actually owns? If ½ of the minerals were previously reserved, and seller contracts to retain the other ½, a buyer may be unpleasantly surprised to learn that he or she will not receive any portion of the minerals.

6. What about surface rights? In Texas, the owner of a mineral interest holds a superior right to enter upon the surface of the property and drill a well, subject to municipal and other regulations. While not much of an issue in platted subdivisions, this issue is of huge importance when negotiating and documenting a sale involving acreage. An uninformed buyer of acreage typically assumes that they will be able to enjoy the entirety of the surface of the property without disturbance. But if the seller or a previous owner has reserved the minerals, they have a right to access their mineral interest by drilling. The only way for a buyer to protect themselves from such intrusion is to provide in the contract for a waiver of surface rights by the seller and any other previous holder of a mineral interest. If the contract is silent as to a waiver of surface rights, then the buyer cannot demand it; they must buy the property subject to the drilling rights of their predecessors in title. One additional word of caution: if the seller has already executed a Mineral Lease on the acreage, the Lessee (the gas company) typically has a right to drill; a buyer would have to negotiate and secure a waiver of surface rights from the Lessee gas company (very unlikely), or otherwise take the property subject to its drilling whims.

7. What if a party does not want to hold the entire mineral estate, but merely the right to receive a bonus or other partial mineral interest? Especially in residential contracts, more and more sellers understand that the biggest item of value when it comes to minerals is most often the bonus payment to be paid upon execution of the lease. Since future royalty payments on minerals underneath small homesites will typically not amount to much, Sellers are often asking to reserve only the bonus, and convey the rest of the mineral rights. Other parties are concerned with the location and placement of wells on the property, so they will negotiate to hold the executive rights (the right to negotiate and execute mineral leases). Many such clauses contain the unfortunate words: “Seller to retain rights to bonus”. Such loose language leads to the following legitimate questions: Which bonus? The bonus to an existing lease that has yet to be paid, or some anticipated lease, or all future leases? Without tight wording regarding these issues, future disagreements are bound to occur.

8. If the seller has already leased the minerals prior to executing the contract, seller retains the contractual rights to future royalties regardless of what the contract says, right? Wrong. This is a common misunderstanding. Many sellers are under the mistaken assumption that if they have executed a legal document wherein the lessee has agreed to pay seller future royalties, that contractual right stays with the seller, even after the property is sold. Many also assume that in such situations, the minerals have already been contracted away under the existing lease, so no mineral rights remain to be passed on to the buyer. In fact, the royalties lawfully will be paid to the owner of the minerals at the time the royalties are earned. Even if the minerals are leased, ownership of the minerals will still be conveyed to a buyer unless reserved. Likewise, royalty rights under an existing gas lease will transfer to the buyer, unless the seller reserves the minerals in the deed, or at least reserves the rights to receive future royalties in the deed.

9. Since the seller holds legal ownership of the minerals until closing, the seller has a right to execute a gas lease prior to closing and keep the bonus, right? Wrong. While it is true that the seller in such situations retains the legal right to lease the minerals until ownership is transferred, once a contract is signed a seller has a contractual obligation to convey the property to the buyer in the same condition as it was in at the time of contract. If seller promises to convey all his or her ownership interest to the buyer, he or she must convey all mineral rights as well, including the right to sign a lease and receive the bonus payment. Failure to do so could lead to a termination right of buyer, or perhaps an expensive claim for specific performance or even bad faith. If a seller signs a lease without informing the buyer, and the lease has not been filed prior to closing, the seller could be sued for breach of title warranties contained in the deed given to the buyer, in addition to numerous other claims. Again, an unpleasant result.

10. How do we avoid these problems? The simple answer: make sure the desires of the parties are clearly and completely stated in the contract. Unfortunately, most contracts merely contain cursory language when it comes to the mineral rights. Since proper wording is most often somewhat lengthy and complex, most contract drafters simply set out the basics, with the expectation that the title company attorney charged with the duty to draft the actual deed will insert the proper legalese in the closing documents. This custom is quite precarious for all involved, especially the attorney drafting the deed. Since most contracts contain insufficient language, the drafting attorney does not have enough information to properly deal with issues such as the actual percentage seller intends to convey, whether seller intended to convey minerals previously leased, whether surface rights were meant to be waived, rights under future leases, etc. If the attorney seeks clarification from the parties, such discussion is liable to open up a “can of worms” that very well could sink a transaction. Such situations are ripe for conflicts of interest and malpractice claims, and a prudent attorney must carefully navigate these extremely murky, and dangerous, waters.

Copyright 2009 Jeffrey A. Rattikin, all rights reserved