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INDEPENDENT PETROLEUM ASSOCIATION AMERICA v. BRUCE BABBITT </h1> <p class="docCourt"> </p> <p> August 27, 1996 </p> <p class="case-parties"> <b>INDEPENDENT PETROLEUM ASSOCIATION OF AMERICA, ET AL., APPELLANTS<br><br>v.<br><br>BRUCE BABBITT, ET AL., APPELLEES</b><br><br> </p> <div class="caseCopy"> <div class="facLeaderBoard"> <script type="text/javascript"><!-- google_ad_client = "ca-pub-1233285632737842"; /* FACLeaderBoard */ google_ad_slot = "8524463142"; google_ad_width = 728; google_ad_height = 90; //--> </script> <script type="text/javascript" src=""> </script> </div class="facLeaderBoard"> <div class="numbered-paragraph"><p><br> Appeals from the United States District Court for the District of Columbia</p></div> <div class="numbered-paragraph"><p> Before: Buckley, Sentelle and Rogers, Circuit Judges.</p></div> <div class="numbered-paragraph"><p> Sentelle, Circuit Judge</p></div> <div class="numbered-paragraph"><p> FOR PUBLICATION</p></div> <div class="numbered-paragraph"><p> FOR THE DISTRICT OF COLUMBIA CIRCUIT</p></div> <div class="numbered-paragraph"><p> Argued April 16, 1996</p></div> <div class="numbered-paragraph"><p> (No. 93cv02544)</p></div> <div class="numbered-paragraph"><p> (No. 94cv02123)</p></div> <div class="numbered-paragraph"><p> Consolidated with No. 95-5245</p></div> <div class="facAdFloatLeft"> <script type="text/javascript"><!-- google_ad_client = "ca-pub-1233285632737842"; /* FACContentLeftSkyscraperWide */ google_ad_slot = "1266897617"; google_ad_width = 160; google_ad_height = 600; //--> </script> <script type="text/javascript" src=""></script> </div class="facLeaderBoard"> <div class="numbered-paragraph"><p> Opinion for the court filed by Circuit Judge Sentelle.</p></div> <div class="numbered-paragraph"><p> Separate dissenting opinion filed by Circuit Judge Rogers.</p></div> <div class="numbered-paragraph"><p> Appellants, an oil and gas producer and a petroleum industry trade association, challenge as arbitrary and capricious and inconsistent with applicable law a Department of the Interior ("DOI") decision to collect royalties and interest charges from the gas producer appellant on a settlement payment made to a lessee of a natural gas well on allotted Indian lands in exchange for a compromise of accrued and prospective take-or-pay liabilities under an outstanding contract. The gas producer appellant also claims that, even if the DOI decision to collect royalties was valid, the government is barred by a statute of limitations from collecting royalties and interest on the specific take-or-pay settlement payment at issue in this case. The District Court granted summary judgment for the government on both issues. Because we conclude that DOI impermissibly departed from its established practices in attempting to collect royalties on the settlement payment, we reverse the District Court and hold that the gas producer appellant cannot be required to pay any royalties on the settlement payment. We accordingly find it unnecessary to consider the statute of limitations issue.</p></div> <div class="numbered-paragraph"><p> I. Background: The Natural Gas Industry and Royalties on "Take-or-Pay" Payments and Settlements</p></div> <div class="numbered-paragraph"><p> DOI, through its Minerals Management Service ("MMS"), issues and administers leases for offshore oil and gas production under the Outer Continental Shelf Lands Act ("OCSLA"), 43 U.S.C. Section(s) 1331 et seq., for onshore production on federal lands under the Mineral Leasing Act ("MLA"), 30 U.S.C. Section(s) 181 et seq., and the Mineral Leasing Act for Acquired Lands, 30 U.S.C. Section(s) 351 et seq., and for production on Indian tribal and allotted lands under 25 U.S.C. Section(s) 396, 396a-396g. Certain DOI leases include royalty provisions which calculate royalties as a percentage of the "amount or value of the production saved, removed, or sold" by the lessee. See, e.g., OCSLA, 43 U.S.C. Section(s) 1337(a)(1)(A), (C) & (G); MLA, 30 U.S.C. Section(s) 226(b) & k(1)(2); see also 25 C.F.R. Section(s) 211.13 (1995) (tribal leases); 25 C.F.R. Section(s) 212.16 (1995) (Indian allotted land leases). This case involves a dispute over whether lump-sum payments made by gas pipelines to lessees to settle large "take-or-pay" liabilities accrued under long-term gas purchase contracts are properly subject to royalties.</p></div> <div class="numbered-paragraph"><p> This controversy arises from a fundamental change in the natural gas industry over the past several years. See generally United Distribution Cos. v. FERC, No. 92-1485 (D.C. Cir. July 16, 1996) (per curiam) (discussing the line of cases beginning with Associated Gas Distributors v. FERC, 824 F.2d 981 (D.C. Cir. 1987), cert. denied, <a>485 U.S. 1006</a> (1988) ("AGD I"), and including American Gas Ass'n v. FERC, 888 F.2d 136 (D.C. Cir. 1989), cert. denied sub nom. FERC v. Public Util. Comm'n, <a>498 U.S. 952</a> (1990) ("AGA I"), and American Gas Ass'n v. FERC, 912 F.2d 1496 (D.C. Cir. 1990), cert. denied sub nom. City of Wilcox v. FERC, <a>498 U.S. 1084</a> (1991) ("AGA II")). Previously, natural gas pipelines acted as gas merchants, purchasing gas at the wellhead, transporting it, and reselling it to local distribution companies ("LDCs") and large end users. In the 1980s, after concluding that this system resulted in various market distortions and inefficiencies, the Federal Energy Regulatory Commission ("FERC") began the lengthy process of transforming pipelines from gas merchants to common carriers of gas. Along the way, Congress completed the deregulation of wellhead gas prices through the Natural Gas Wellhead Decontrol Act of 1989 ("Decontrol Act"), Pub. L. No. 101-60, 103 Stat. 157. Under regulated wellhead pricing, the pipelines, consistent with FERC policy, had entered into long-term, fixed price wellhead purchase contracts. After wellhead price deregulation the market price for gas dipped well below the long-term contract prices pipelines were committed to pay. AGD I, 824 F.2d at 995-96.</p></div> <div class="numbered-paragraph"><p> Unfortunately for the pipelines, the wellhead contracts usually contained take-or-pay provisions, which required the pipeline to pay for as much as seventy-five percent of the contracted-for gas even if it did not take the gas. Id. at 996. (Often, the pipeline could credit these payments toward "make-up gas," gas taken at a later date. See Diamond Shamrock Exploration Co. v. Hodel, <a>853 F.2d 1159</a>, 1164 (5th Cir. 1988) ("Diamond Shamrock")). Because the pipelines could not rely on corresponding long-term sales contracts with their customers (FERC had allowed those customers to abrogate such contracts with pipelines, see Wisconsin Gas Co. v. FERC, 770 F.2d 1144, 1152 (D.C. Cir. 1985), cert. denied, <a>476 U.S. 1114</a> (1986)), they soon found themselves headed for financial ruin as their customers switched to cheaper supply sources. FERC experimented with several relief mechanisms, see United Distribution Cos., No. 92-1485, slip op. at 12-16; Baltimore Gas & Elec. Co. v. FERC, 26 F.3d 1129, 1132-33 (D.C. Cir. 1994); but the major resolution of the take-or-pay liabilities occurred through settlements between pipelines and their suppliers. See AGA II, 912 F.2d at 1508-09 (upholding FERC's decision to allow private negotiations, under incentives structured by the Commission, to remedy the industry's take-or-pay problems). The pipelines could then pass on at least some of the costs of these settlements to their customers. See Order No. 528, Mechanism for Passthrough of Pipeline Take-or-Pay Buyout and Buydown Costs, 53 FERC Para(s) 61,163 (1990), order on reh'g, 54 FERC 61,095, reh'g denied, 55 FERC Para(s) 61,372 (1991).</p></div> <div class="numbered-paragraph"><p> The take-or-pay settlements were of two types-"buydowns" and "buyouts." In a buydown, the pipeline pays a cash lump sum to the producer in exchange for contract amendments (or a new contract) providing for continued sale of the contracted-for gas at reduced prices. In a buyout, the pipeline pays a cash lump sum in exchange for release of the pipeline from the gas purchase contract. The producer is then free to sell the gas to someone else. Some contract settlements included both partial buydowns and partial buyouts. In some cases, the settlement payments (or portions thereof) could be recouped through future gas purchases in which the payments would be credited toward the purchase price of gas. See, e.g., Blackwood & Nichols Co., Ltd., MMS-88-0008-O&G (Apr. 20, 1989), 10 Gower Fed. Serv., Royalty Valuation and Management at 2 ("Blackwood & Nichols Co.") (construing a settlement agreement containing both a recoupable and a nonrecoupable payment). Both types of contracts also often include a settlement of existing liability for previously incurred take-or-pay obligation.</p></div> <div class="numbered-paragraph"><p> As DOI lessees were among the producers entering settlement agreements, MMS began to address the royalty implications of take-or-pay payments and contract settlement payments on lessees' liabilities. As we noted earlier, the statutes governing the leases require that they contain a royalty clause contemplating royalties to be paid on a set percentage of the "amount or value of the production saved, removed, or sold" by the lessee. See, e.g., OCSLA, 43 U.S.C. Section(s) 1337(a)(1)(A); MLA, 30 U.S.C. 226(b); see also 25 C.F.R. Section(s) 211.13 (1995) (tribal leases); 25 C.F.R. Section(s) 212.16 (1995) (Indian allotted land leases). MMS' general rule on royalties, known as the "gross proceeds rule," provides that "under no circumstances shall the value of production for royalty purposes be less than the gross proceeds accruing to the lessee for lease production." 30 C.F.R. Section(s) 206.152(h) (1995) (emphasis added). <a href="#D*fn1" name="S*fn1">*fn1</a> 30 C.F.R. 206.151 (1995) defines "gross proceeds" as "the total monies and other consideration accruing to an oil and gas lessee for the disposition of [gas]." The underlying issue leading to the present case is whether gas contract settlement payments are included in "gross proceeds." In a series of administrative decisions, MMS determined that royalties are due on both take-or-pay payments and payments for gas contract settlements. Before these decisions reached the stage of judicial review, DOI issued rules in January 1988 adopting a broad definition of "gross proceeds":</p></div> <div class="numbered-paragraph"><p> "Gross proceeds" (for royalty payment purposes) means the total monies and other consideration accruing to an oil and gas lessee for the disposition of ... gas.... Gross proceeds, as applied to gas, also includes but is not limited to: Take-or-pay payments.... Payments or credits for advanced exploration or development costs or prepaid reserve payments that are subject to recoupment through credits against the purchase price or through reduced prices in later sales and which are made before production commences become part of gross proceeds as of the time of first production.</p></div> <div class="numbered-paragraph"><p> Revision of Gas Royalty Valuation Regulations and Related Topics, 53 Fed. Reg. 1230, 1275 (January 15, 1988) (promulgating 30 C.F.R. 206.151 (1988)).</p></div> <div class="caseAdCopy"> <script type="text/javascript"><!-- google_ad_client = "ca-pub-1233285632737842"; /* Fac2Copy2 */ google_ad_slot = "0998899327"; google_ad_width = 300; google_ad_height = 250; //--> </script> <script type="text/javascript" src=""> </script> </div> <div class="numbered-paragraph"><p> In August 1988, some lessees successfully challenged the pre-1988 rulings requiring royalties to be paid immediately on take-or-pay payments. Because the lease and the controlling statutes contemplated royalty payments on the value of the "production" of gas, the Fifth Circuit concluded that royalties were not due on take-or-pay payments at the time those payments are made. Diamond Shamrock, 853 F.2d at 1168 (emphasis added). The court reasoned that the statute contemplates royalties on gas actually produced and taken, but take-or-pay payments are "payment for the pipeline-purchaser's failure to purchase (take) gas," not payment for gas. Id. at 1167. Accordingly, "[r]oyalty payments are due only on the value of minerals actually produced, i.e., physically severed from the ground. No royalty is due on take-or-pay payments unless and until gas [that is, make-up gas] is actually produced and taken." Id. at 1168.</p></div> <div class="numbered-paragraph"><p> Rather than seeking review of the Diamond Shamrock decision or applying it only to leases within the geographic domain of the Fifth Circuit, MMS amended its gross proceeds rule to comport with the decision. It deleted the phrase "[t]ake-or-pay payments" from the definition of "gross proceeds" and determined that royalties would only accrue on take-or-pay payments when a pipeline takes make-up gas. Revision of Gross Proceeds Definition in Oil and Gas Valuation Regulations, 53 Fed. Reg. 45,082, 45,084, 45,083 (Nov. 8, 1988). MMS also applied the rule of Diamond Shamrock in contemporaneous and subsequent administrative proceedings. See Santa Fe Energy Co., MMS-85-0046-OCS (Oct. 14, 1988), 5 Gower Fed. Serv., Royalty Valuation and Management at 4 (citing Diamond Shamrock and holding that royalties on take-or-pay payments and settlements "only become due if and when make-up gas is taken by the pipeline"); Blackwood & Nichols Co. at 2 (holding that, for a settlement agreement containing both a recoupable and a nonrecoupable payment, only the recoupable payment would become royalty bearing, and only "to the extent credited against future production"); Wolverine Exploration Co., MMS-88-0052-IND (May 2, 1990), 10 Gower Fed. Serv., Royalty Valuation and Management at 4 (denying royalties on a settlement payment because the payment was not "subject to recoupment through credits against the purchase price or through reduced prices in later sales").</p></div> <div class="numbered-paragraph"><p> On May 3, 1993, MMS took another step in clarifying its treatment of settlement payments. In a letter from James W. Shaw, Associate Director for Royalty Management, MMS announced that "some or all of a settlement payment is or will become royalty bearing if production to which specific money is attributable occurs." Letter from James W. Shaw, Associate Director for Royalty Management, MMS, addressed to "Payor" (May 3, 1993) ("May 1993 letter"). An enclosed description of the MMS royalty policy on settlement payments is more explicit:</p></div> <div class="numbered-paragraph"><p> Consistent with [Diamond Shamrock], the [Royalty Management Program ("RMP")] interpretation and policy is that a payment or a portion of a payment is royalty bearing if the mineral to which the payment is attributable is produced and sold either to the original purchaser or a substitute purchaser, as part of the "gross proceeds" received for disposition of that production under applicable regulations.</p></div> <div class="numbered-paragraph"><p> May 1993 letter, Enclosure 1 at 1. Under this interpretation, royalties become due on settlement payments regardless of whether those payments are "recoupable" or not-the only relevant question is whether or not the gas which was originally spoken for in the settled contracts is eventually sold to someone.</p></div> <div class="numbered-paragraph"><p> II. The Instant Dispute: Challenges by IPAA and Samedan</p></div> <div class="numbered-paragraph"><p> A. Administrative Proceedings</p></div> <div class="numbered-paragraph"><p> In 1993, the Independent Petroleum Association of America ("IPAA") filed suit in the U.S. District Court for the Northern District of West Virginia challenging the May 1993 letter and an Assistant Secretary's June 1993 order requesting information on gas contract settlements. After transfer of the case to the D.C. District Court, IPAA dismissed its challenge to the June 1993 order. Soon thereafter, DOI issued its final decision on settlement payment royalties in a case involving gas producer Samedan Oil Corporation ("Samedan"). Samedan's case was to become the test case for the settlement payment royalty question. Samedan is a lessee of Indian lands under a 1979 lease which provides, in typical form, for a twenty percent royalty on the value of production which "shall not be deemed to be less than the gross proceeds accruing to the Lessee from the sale thereof." In 1981, Samedan entered into a ten-year take-or-pay gas sales agreement with Southern Natural Gas Company ("Southern"). The take-or-pay clause required Southern to pay for eighty-five percent of the contracted-for gas in the event that it did not take the gas. A make-up clause allowed Southern to credit take-or-pay payments against "excess" or make-up gas (gas taken over and above the contract requirements) taken over the five years following the payments. By April 1985, the market price of gas had dropped to about one-fourth of the contract price, and Southern stopped taking gas from Samedan. In 1986, Southern refused to make $51,468 in take-or-pay payments billed by Samedan. On December 1, 1987, Samedan and Southern agreed to a complete buyout, terminating the 1981 contract in exchange for a "nonrecoverable and nonrefundable" $100,000 payment "in resolution and full and final settlement of any and all obligations and liabilities that Southern has or may have under the Contract." Settlement Agreement and Release at 2 (December 1, 1987). On the same day, Samedan contracted to sell the gas formerly allocated to Southern to Hadson Gas Systems ("Hadson") at the market price. Subsequently, Samedan also sold some of the gas to Transok. By 1989, Samedan had sold all the gas which would have been sold to Southern under the 1981 contract, but Southern purchased none of it.</p></div> <div class="numbered-paragraph"> <p> Several years later and after an audit of Samedan's royalty obligations, MMS ordered Samedan to pay $20,000 in royalties, which represented twenty percent of the $100,000 settlement payment from Southern. MMS Service Order re Contract Settlement Between Samedan Oil Corporation and Southern Natural Gas Company Dated December 1, 1987 (December 2, 1993). MMS applied the policy outlined in its May 3, 1993 letter and concluded that $10,294 of the $100,000 payment represented compensation for already accrued take-or-pay liabilities and that the $89,706 represented a buyout payment for the remaining purchase obligations. Id. Samedan made an administrative appeal, but Assistant ...</p> </div> </div> </div> <div id="caseToolTip" class="caseToolTip" style="display: none;"> <div class="toolTipHead"> </div> <div class="toolTipContent"> <p> Our website includes the first part of the main text of the court's opinion. To read the entire case, you must purchase the decision for download. With purchase, you also receive any available docket numbers, case citations or footnotes, dissents and concurrences that accompany the decision. 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