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Click here for the full text of this decision FACTS:The class members were Texas royalty owners who leased their property to Phillips Petroleum Co. for oil and gas production. They alleged that Phillips underpaid royalties due under the leases through self-dealing transactions. In September 2000, the trial court signed its first order certifying three subclasses and shortly thereafter signed a trial plan pursuant to the Texas Supreme Court’s 2000 holding in Southwest Refining Co. v. Bernal. Subclass No. 1 royalty owners alleged that Phillips breached an implied covenant to market under the leases. Subclass No. 2 royalty owners alleged that Phillips breached their Gas Royalty Agreements (GRAs) by paying royalties based on the dry residue gas component of natural gas petroleum but not on the liquid components of the gas produced, and by using a measurement system which failed to include the heat content of the gas. Subclass No. 3 royalty owners alleged Phillips breached the implied covenant to market by assessing an unreasonably high service fee to its marketing affiliate through percentage of the proceeds (POP) contracts, thereby reducing income to the royalty owners. In Phillips’ first interlocutory appeal, the 14th Court of Appeals reversed the certification order and remanded the case to the trial court to resolve deficiencies in the class action certification. The deficiencies of Subclasses Nos. 1 and 3 related to changes in oil and gas law. On remand, the royalty owners filed an amended motion for class certification and attempted to address the 14th Court’s concerns. In June 2002, the trial court granted class certification after a second hearing. The revised Subclass No. 1 only included claims from royalty owners paid on an amount-realized or proceeds basis and who asserted claims for breach of an implied covenant or express covenant to market. In the revised Subclass No. 2, Royce Yarbrough and Ted Powell were substituted as representatives of the class. The revised Subclass No. 3 included a claim that Phillips breached the implied covenant to manage and administer the lease by entering into POP contracts with one of its marketing affiliates, paying it an unreasonably high fee to process the gas. The second certification order excluded the claims the class representatives decided not to pursue. Phillips filed a second interlocutory appeal challenging the second class certification order. The 14th Court of Appeals reversed and remanded the certification order. The court granted the royalty owners’ petition for review. HOLDING:Affirmed in part, reversed and remanded in part. Subclass No. 1 was comprised of royalty owners who have natural gas leases with Phillips, which in turn produces natural gas and sells it to its affiliate Phillips Gas Marketing Co. (PGM). Specifically, this subclass only included royalty owners with gas royalty clauses requiring Phillips to calculate the royalty as a percentage of the proceeds Phillips receives for selling the gas. Subclass No. 1 consisted primarily of royalty owners in Fort Bend and Brazoria counties where Phillips sells gas to PGM. According to the royalty owners, there were approximately 2,330 oil and gas leases in Fort Bend County and 538 leases in Brazoria County eligible for membership in Subclass No. 1. These leases were not all identical. Some of the leases, including leases for the named representatives, contained gas royalty clauses providing for an amount-realized basis if the gas was sold at the well by Phillips and a market-value basis if Phillips sold or consumed the gas off the premises or uses the gas to manufacture gasoline. Additionally, many of the leases had a separate express clause requiring Phillips to exercise reasonable diligence to market the gas it produces. Although the leases contained different royalty clauses, including some express duty to market provisions, the royalty owners argued there was a common question for Subclass No.1: whether Phillips failed to reasonably market the gas. Specifically, they argue Phillips failed to act as a reasonably prudent operator when it entered into a gas purchase agreement with its wholly owned affiliate PGM. The royalty owners alleged that Phillips, by selling gas at a lower price to PGM, failed to diligently market and achieve the higher price it received or could receive for arms-length transactions to third parties. The court, however, found that the royalty owners did not produce classwide evidence that would account for variations in post-production charges, such as transportation charges or other service charges, between each particular well and point of delivery. Although it might be possible, the court stated, under certain circumstances to show that a lessee failed to diligently market the gas and obtain a reasonable price for a class of lessors, the royalty owners in this case did not provide classwide evidence of these alleged deficiencies. Thus, because individual issues predominated, the court found that the the trial court abused its discretion in certifying the class as to Subclass No. 1. Subclass No. 2 was comprised of royalty owners whose royalties are calculated under uniform language in Gas Royalty Agreements (GRAs). The GRAs provided that Phillips would pay a royalty on all gas, other than casinghead gas, produced from the leases and “sold or used off the premises.” First, the court concluded that the pricing provisions of the GRAs were unambiguous and could be construed classwide for royalty owners who executed substantially identical GRAs. The GRAs in Subclass No. 2, the court stated, required royalties to be paid based on the volume of natural gas metered at the wells multiplied by a price averaged from sales to third parties, before liquid products are extracted or processed. Thus, the court held that the trial court erred in its trial plan by proposing to send the interpretation of the GRAs to the jury and, accordingly, the 14th Court erred in decertifying Subclass No. 2 on predominance grounds. Second, the court concluded that the 14th Court erred in finding that the GRAs were ambiguous. Third, the court agreed that Powell did not show that he was an adequate representative for Subclass No. 2 but held that Yarbrough’s interests are not in conflict with the class. Therefore, the court reversed the 14th Court’s judgment decertifying Subclass No. 2. Subclass No. 3, the court stated, was comprised of royalty owners in the Texas Panhandle whose leases provided for royalties, either under an amount-realized/proceeds basis or under a market-value basis, when Phillips sells gas under a POP contract with its affiliate GPM. A POP contract is a gas purchase contract providing payment to the purchaser as a percentage of the proceeds realized by the purchaser upon the resale of the gas. The POP contracts provided for Phillips to receive a price for the raw natural gas based on the volume of residue gas and natural gas liquids after GPM gathered and processed the gas. A typical POP contract includes an 80/20 split between the lessee and subsequent purchaser, similar to the percentages in the contracts at issue for Subclass No. 3. In such a contract, Phillips would receive a gas price calculated by adding 80 percent of the proceeds GPM receives for residue gas times the volume and 80 percent of the published prices for liquids times the volume. Thus, GPM would retain for itself 20 percent of the proceeds from the resale of the gas. The royalty owners argued that the 80/20 split, or other similar percentages, constituted an unreasonable and fraudulent postproduction fee for GPM. They argued that Phillips breached its covenant “to manage and administer the leases as a reasonably prudent operator” based on this “excessive” processing charge. Holding that Subclass No. 3 failed to meet the predominance requirement, the 14th Court reversed certification of the subclass based on the numerous individual factors the jury would need to consider to determine if Phillips breached its duty by paying unreasonable fees to GPM. While the 14th Court did not address Phillips’ argument that there is no recognized implied covenant to manage and administer the lease properly, the Texas Supreme Court stated that no such duty exists. Since market value leases do not have such an implied covenant, while proceeds leases do, Subclass No. 3 did not satisfy the commonality requirement of Rule 42, the court stated. Finally, the court found that the royalty owners failed to explain how a reasonable processing fee could be proven classwide, even for proceeds leases only. A factual analysis of the circumstances surrounding each POP contract, the court stated, would be necessary to ascertain if the production fee was reasonable or if Phillips breached any duties owed. Like Subclass No. 1, individual issues would predominate. Thus, the court found that the trial court abused its discretion by certifying Subclass No. 3. Accordingly, the court held that the trial court abused its discretion in certifying Subclasses Nos. 1 and 3 but not Subclass No. 2. OPINION:Wainwright, J., delivered the opinion of the court. Brister, J., did not participate in the decision.

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