By Michael K. Hurst and Jonathan R. Childers

Litigation in the Texas energy sector has increased substantially as a result of the drop in oil prices. Cases related to unconventional oil and gas litigation in Texas have risen approximately 180 percent since 2014. Many producers that expanded operations in previous years while enjoying easy access to capital now struggle to carry holdings that were never intended to withstand a lower-price environment. As prices plunged, producers sought to manage liability and risk. Texas lawyers assisted by advising clients faced with inevitable disputes involving contractors, insurers, lenders, partners, and employees. Trends in Texas oil and gas litigation reflect a market reality where all participants are forced to embrace “lower for longer” pricing.

“Hot” Litigation Trends

“Hot” litigation trends include bankruptcy litigation and workouts, royalty disputes and Fair Labor Standards Act class actions and other employment disputes. Litigation has “cooled” for municipalities seeking to enforce ordinances that ban or limit hydraulic fracturing, as have discussions about potential lawsuits seeking damages for seismic activity allegedly connected to oil and gas operations. Should oil prices continue their slow, incremental climb, we expect to see an increase in trade secret misappropriation cases, more shareholder and partnership disputes, and more lawsuits concerning private equity investments. Each of these areas should intensify as merger and acquisition activity continues to accelerate.

Bankruptcy and workout litigation is prevalent. Producers who were unable to extend liquidity turned to the bankruptcy courts for relief from mounting debts, loss of long-term contracts, unfavorable borrowing base redeterminations, tapped-out revolving credit facilities, and wary and inquisitive shareholders. Some producers opted for formal restructuring early for the prospect of emerging a debt-free enterprise. These proceedings have kept bankruptcy, restructuring and capital markets lawyers busy. But the legal work extends beyond substantive bankruptcy tasks. Business litigators have filed adversary proceedings, navigated intercreditor disputes, and handled disputes involving the value of reserves that secure lender financing.

Some E&P companies have tried to manage costs by attempting to reject or renegotiate what they consider to be overpriced gathering and transportation agreements with their pipeline providers. In the Sabine Oil & Gas Chapter 11 proceeding, the Southern District of New York bankruptcy court permitted Sabine to reject its midstream agreements as executory contracts even though the agreements contain language expressly stating they are covenants running with the land. The court issued a nonbinding analysis, through which it concluded “without deciding in a binding way” that the gathering agreements at issue did not run with the land under Texas law, such that Sabine could reject the contracts. Producers and midstream companies are monitoring the issue closely as they determine how to negotiate given the uncertainty created by the Sabine decision. The Texas Supreme Court has yet to chime in.

Oil and gas partnership disputes are also on the rise. Many investors who claim they were cheated out of millions now chase some of the accused bad actors into bankruptcy. Others have discovered that the oil and gas funds in which they invested are not properly registered, or contend that they have been defrauded by the advisers of “pooled” vehicles in violation of the federal Investment Advisory Act.

Another trend is litigation over deals gone badly or that never consummated, including failed mergers and acquisitions. Most notably, on June 24, 2016, the Delaware Court of Chancery ruled that it would not compel Energy Transfer Equity LP to complete its proposed acquisition of the assets of the Williams Companies Inc. The court held that the inability of Energy Transfer’s tax counsel to deliver a “Section 721” opinion evidenced a failure to complete a closing condition. Because a condition precedent to the merger did not occur, Energy Transfer’s soft exit was justified.

Of course, there are many lawsuits resulting from pure economic distress. Some operators have been sued because they chose not to drill even when they were contractually obligated to do so. Others argue that the precipitous fall of oil prices was an unforeseen event capable of invoking the force majeure provisions in their contracts with vendors, such that the contracts are voidable or their payment obligations excused. We anticipate seeing more lawsuits challenging “constructive production.” Operators will likely defend claims by nonparticipating royalty interest owners, who will assert that wells that have been drilled but are not producing and for which no market exists are incapable of “producing in paying quantities,” such that the lease cannot be maintained through shutin royalty payments.

Royalty cases have far surpassed other types of energy litigation. Falling prices have increased royalty owner sensitivity to lease administration issues. And royalty owners are scrutinizing their statements much more closely as they have seen their royalty payments drop. The popularity of royalty lawsuits stems primarily from a large number of cases targeting Chesapeake Energy Corp.’s operations in the Barnett Shale. Royalty disputes gained more viability after the Texas Supreme Court issued its 5-4 decision in Chesapeake Exploration LLC v. Hyder, providing a notable win for royalty interest holders. The Texas Supreme Court held that Chesapeake improperly deducted post-production costs from the overriding royalty interest. It explained that “the effect of a lease is governed by a fair reading of its text,” and that the text of the lease provision at issue called for a “perpetual, cost-free ...overriding royalty” and did not state that the royalty was to be paid on market value “at the well.”

In late May 2016, Chesapeake agreed to pay $52.5 million to 13,000 people who claimed their royalties were underpaid for leases in the Barnett Shale. Around July 6, 2016, the requisite 90 percent of claimants accepted the settlement, and Chesapeake agreed to pay a prorated amount of approximately $51 million. On May 24, 2016, the city of Fort Worth reached a settlement with Chesapeake for $15 million. Because of these settlements, the battleground in royalty litigation has shifted south to Texas’s Eagle Ford Shale. Filings of royalty cases in the Eagle Ford are growing, especially since March 2016.

The drop in the price of oil has also spawned many employment disputes. FLSA wage-and-hour class action cases are prevalent. They focus upon the alleged misclassification of oil field workers, and particularly oil field well-site managers, who allege they are owed overtime exceeding a day rate. Employment disputes have also increased in the oil and gas sector because of reductions in force.

Lower oil prices have also forced operators to become even more protective of profit margins. There are two noticeable trends incidentally relating to tighter expense monitoring. First, intellectual property lawsuits, and particularly patent litigation filings, have increased, as operators have grown more protective of licensing revenues. Second, there has been an apparent increase in indemnity disputes between operators and their contractors over which company will be ultimately responsible for the payment of personal injury claims.

“Cooling” Litigation Trends

Lawsuits by municipalities seeking to enforce ordinances that ban or limit hydraulic fracturing have cooled. This is because of House Bill 40, which became law on May 18, 2015. The bill created Texas Natural Resources Code Section 81.0523, which stringently restricts the ability of municipalities to enact ordinances aimed to ban, limit or regulate oil and gas operations within their boundaries. While it is anticipated that municipalities will use the courts to interpret specific provisions within House Bill 40, such as what constitutes an “oil and gas operation,” and also to provide context for whether a municipal ordinance is “commercially reasonable,” they will do so only in a higher-priced market. This is because economics have relegated operators to the safety of established fields and plays instead of to new, more speculative prospects in urban areas as existed during higher pricing.

Moreover, the Texas Supreme Court’s recent decision in BCCA Appeal Group v. City of Houston, which struck down a Clean Air Ordinance enacted by the city of Houston, further supports that a municipal ordinance is unenforceable where it is inconsistent with a state statute that addresses the particular subject matter. The city of Houston contended that it had the right to regulate its own air quality. The Texas Supreme Court held that the Texas Clean Air Act and the regulatory scheme of the Texas Commission on Environmental Quality preempted the Houston ordinance, making it unenforceable.

Discussions have also cooled over possible lawsuits targeting injection well operators for seismic activity allegedly stemming from oil and gas disposal activities. This is largely because the Texas Railroad Commission decided to leave intact challenged well disposal permits for XTO Energy and EnerVest after a Southern Methodist University study suggested that disposal wells had contributed to earthquakes around the towns of Reno and Azle, Texas, atop the Barnett Shale, from late 2013 through spring 2014. Public concern in the seismic issue has also waned, in large part because there have been fewer noticeable earthquakes during the past year.

Anticipated Trends as Oil Prices Stabilize

Predicting anticipated litigation trends is especially difficult since the trends tend to correlate with the price of oil. It seems likely that oil prices will not return to peak levels in the immediate future, and instead that prices will continue to meander upward gradually, with volatility and price drops along the way. Trade secret disputes are primed for growth as oil prices rise. This is because the energy industry is highly competitive and technology-driven, with constant demand for knowledge about optimal well locations and drilling and recovery techniques, many of which involve proprietary formulas and data.

Trade secret disputes are also likely to increase as merger and acquisition activity does, since trade secrets are usually the “secret sauce” examined in data rooms. This anticipated rise in trade secret litigation will coincide with courts eager to interpret the relatively new Texas Uniform Trade Secrets Act (TUTSA) as well as the brand-new federal Defend Trade Secrets Act of 2016. The recent ruling from the Texas Supreme Court in Southwestern Energy Production Co. v. Helfand suggests that those seeking damages for trade secret violations must take excruciating care in presenting evidence. Plaintiffs seeking to obtain trade secret damages should present a compensation structure that correctly monetizes use of the trade secret.

As prices rise and M&A activity increases, shareholders and limited partners will grow increasingly emboldened in protecting their portion of profits and in policing perceived insider benefits and selfdealing. We also expect to see more lawsuits by investors who claim they have been afforded improper tax treatment or who experience phantom income because they do not receive the cash distributions necessary to cover their tax obligation. This is especially true with master limited partnerships, since savings to the MLP in the form of debt reduction can nevertheless result in cancellation of indebtedness income being allocated amongst its unitholders. It would not be surprising to see an increase in tax litigation in future years, given that the tax effect to investors may not be felt until oil prices are higher.

Finally, as prices rise, private equity will re-enter the energy sector, as many cash-rich funds will deploy capital and also sell portions of their portfolios. Expect to see litigation involving fights over proceeds, as well as disputes between management teams and sponsors.

As business trial lawyers, we look forward to the future, when litigation eventually shifts from disputes involving the stark reality of low prices, to disputes over the rewards gained from wise strategy and well-placed risk.

—By Michael K. Hurst and Jonathan R. Childers

Michael Hurst and Jonathan Childers are partners at Dallas-based Lynn Pinker Cox Hurst. They practice business trial and litigation law. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.