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Accepting Drafts in Payment for Lease Bonus – A Ticking Time Bomb?

The recent volatility in prices for oil and gas leases has raised issues with the time-honored custom in the industry of paying lease bonuses with drafts. Problems have arisin because companies have refused to honor the drafts or because lessors have sought to cancel the transaction after signing and delivery the lease and lessor’s deposit of the draft. When someone wants to back out of “the deal” after a lease has been exchanged for a draft, the lessor and lessee run to their lawyers to find out what legal rights and obligations have been created by the exchange. No one is happy.

As I have written previously, it is generally my advice to avoid using drafts for payment of lease bonuses. My practice is to hold my client’s original signed lease until I receive a check for the bonus from the company, then send the check to my client and the lease to the company. I find that most companies are willing to close the deal in this manner.

But most lease transactions are consummated using a draft. So, herein is an additional discussion of problems arising from use of drafts..

I am indebted to Laura Lesikar of Haynes and Boone and Terry Cross of McClure & Cross, whose article, “Paying Lease Bonus with Time Drafts – Inspection Report on a House of Cards,” is an excellent summary of the legal rights and questions raised by using drafts to pay lease bonuses.

First, a draft is not a check (although it may look like one). Legally, it is a request made by the party signing the draft – usually the landman – to the lessee, through banking channels, to pay the lessor the agreed bonus for an oil and gas lease. The landman hands the signed draft, made payable to the lessor, to the lessor in exchange for the signed lease. The draft directs the lessee’s bank to pay the specified bonus amount to the lessor. The lessor takes the draft to his/her bank, and that bank sends the draft to the lessee’s bank. The lessee’s bank notifies the lessee and asks the lessee if it wants to pay the draft. If the lessee agrees, the bank takes money from the lessee’s account and sends it to the lessor’s account at the lessor’s bank.

Although the draft says “pay to the order of” the lessor, it has other language that imposes very important conditions. Typically, a draft has something like the following language somewhere on the face of the draft:

“On approval of lease described hereon and on approval of title to same by drawee not later than ____ days after arrival of this draft at collecting bank.”

The number of days in the blank is typically 30. This language means that (1) the lessee has 30 days from arrival of the draft at its bank to authorized payment, and (2) the lessee need not approve payment of the draft unless the lessee approves the lease and approves the lessor’s title. If the lessee examines the records and finds that the lessor does not own the mineral interest for which the lessee has agreed to pay, then the lessee does not have to pay the draft. Also, if the lessee does not “approve the lease,” the lessee need not pay the draft. This language is imprecise and can lead to disagreements. If the lessor and lessee have already negotiated the terms of the lease, then arguably the lessee has already “approved the lease.” Also, it is not clear what problems with the lessor’s mineral title would justify the lessee in rejecting the lease.

Many drafts also contain language like the following:

In the event this draft is not paid within said time, the collecting bank shall return the same to fowrarding bank and no liability for payment or otherwise shall be attached to any of the parties hereto.

In effect, this language means that the lessee can reject the lease and refuse to pay the draft for any reason or no reason, without liability.

This “no liability” language has led to a curious result in Texas. Texas courts have held that, since the lessee is not bound to accept the lease and can reject it for any reason, the lessor can also withdraw his offer to lease, even after the lease has been signed and delivered to the lessee. So if a lessor has signed a lease and deposited a draft for the bonus, but later receives a better offer, he can notify the original lessee that he has changed his mind and lease to the second company!

One problem with using a draft to pay lease bonus is that the lessee has possession of the lease before the bonus is paid. The lessee can record the lease and still reject the draft. Texas courts have held that the lessee’s recordation of the lease is not acceptance of the lease, and the lessee can still decide not to pay for the lease. In that event, the lessee is legally obligated to sign and record a release of the lease, to avoid clouding the lessor’s mineral title.

I have heard reports of lessees who have recorded leases and failed to pay the draft, and then have insisted that they have a valid lease and that the lessor is legally bound to accept the bonus payment. In such a situation, the lessor has a problem. If he does not want to accept the bonus, he is left with a recorded lease that clouds his title, so that he cannot lease to anyone else, and he must bring suit against the lessee to cancel the lease. Some lessors in this situation have been advised to record an affidavit signed by the lessor reciting the facts and asserting that the lease is not valid. While such an affidavit might prevent the lessee from selling the lease to another company, it will not clear the title so that the lessor can lease to another company.

It is possible to use what is known as a “documentary draft” to pay the bonus. A documentary draft is a draft that is accompanied by a document for which payment is being made — in this case, the lease. The lessee’s bank receives the draft, accompanied by the lease, and notifies the lessee of its receipt. If the lessee authorizes payment of the draft, then the bank delivers the lease to the lessee. In effect, the bank is acting as agent for the parties in exchanging the bonus for the original signed lease. I have used this method in the past. If everything goes well, it works to avoid some of the problems arising from use of drafts. But I have found that some banks do not understand the use of documentary drafts and will deliver the signed lease to their customer, the lessee, without requiring first that the customer authorize payment of the draft. So use of documentary drafts does not solve all problems.

It is also possible to use a third party to “close” the transaction. The lessee delivers the bonus to the third party, and the lessor delivers the lease to the third party. The third party then delivers the lease to the lessee and the bonus to the lessor. This must be done under an escrow agreement among all three parties which addresses how much time the lessee has to approve the lessor’s title and what happens if the lessee fails to deliver the agreed bonus. In my experience, drafting such an agreement and engaging the third party to act as escrow agent is more trouble than it is worth except for very large leases.

From the lessor’s point of view, if the lease is to be delivered to the lessee before the bonus is paid, then it is important to have a binding agreement of the lessee that the lessee will pay the bonus as long as the lessor owns the mineral interest being leased. If a draft must be used, it is possible to alter the language in the draft so that it obligates the lessee to pay the draft within the specified time subject only to approval of the lessee’s title. The draft should specify the mineral interest being leased and the description of the property. The lessee should also have written confirmation from the lessee that the form of lease has been agreed to between the parties. If the draft is constructed in this way and the lessee fails to pay the draft, then the lessor has a legally enforceable claim against the lessee for the bonus due. This arrangement does not solve all problems, but it greatly reduces the risks.

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