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Use of Bank Drafts for Bonus Payment in Oil and Gas Leasing

Exploration companies have traditionally used bank drafts to pay bonuses for oil and gas leases.  Since drafts look a lot like a check, they can be misleading to mineral owners.  Some mineral owners’ recent experiences with dishonored drafts have highlighted the problems with use of these financial instruments.

 A draft is like a check, but different.  It is an order issued to a bank to pay a party, conditioned on the happening of a specified event.  As used by exploration companies, it is an order issued by a company or its landman to the company’s bank to pay the bonus to the mineral owner.  Typically, the draft provides that the company has a period of time – 30 to 90 days – from the date its bank receives the draft to “honor” the draft – that is, to tell the bank to pay the bonus to the mineral owner.  The draft typically has language like the following:

On approval of lease or mineral deed described herein, and on approval of title to same by drawee not later than 30 days after arrival of this draft at collecting bank.

In other words, the company has 30 days to approve the oil and gas lease being paid for and to approve the mineral owner’s title to the minerals being leased.  If the company does not approve the lease, or if it determines that the mineral owner does not have good title to the minerals being leased, it can refuse to pay the draft.

 Use of drafts to pay for leases would seem to be a good way, in theory, to facilitate the lease transaction.  And in fact, drafts are used every day in hundreds of lease transactions, without incident.  But there are problems with its use, and those problems can put landowners at risk.  My advice to landowners is to avoid using drafts if possible.

Granting an oil and gas lease can be compared to selling a piece of land without first entering into a contract.  An oil and gas lease is a form of conveyance.  The mineral owner is conveying a fee simple determinable estate in the minerals to the lessee, for the term of the lease.  So think of a lease as a kind of deed.  The first problem with a draft is that the exploration company is asking the mineral owner to deliver the lease to the company before it has committed to pay the bonus.  It is like a land purchaser requesting that the seller sign and deliver a deed before the purchaser agrees to pay the purchase price.  Not a good idea.  If the exploration company refuses to pay the bonus but does not return the signed lease, the mineral owner has a problem.  He/she has signed and delivered the lease, but has not been paid for it.  If the lease gets recorded, the mineral owner will have to sue to cancel the lease.

 It is possible to conditionally deliver the oil and gas lease with the draft, so that the lease is not delivered to the company unless the company agrees to honor the draft.  This is what is known as a documentary draft.  The responsibility is placed on the bank to hold on to the lease and not deliver it to the company until the company agrees to honor the draft and pay the lessor.  But most banks don’t understand this and will deliver the lease to the company without requiring the company to first honor the draft.

 The use of drafts has continued, notwithstanding the potential problems they present, because most companies follow through with their commitment to lease the property.  When the draft reaches the company’s bank the company makes a final check of the mineral owner’s title, and if the mineral owner has not already leased the property, or sold it, the company honors the draft and then records the lease.  So the system has worked pretty well because the companies and their landmen understand the practice and know that their reputation depends on doing what they committed to do.

 Two recent developments have made use of drafts more problematic.  First: at least one company, Chesapeake, dishonored outstanding drafts for economic reasons, for leases in the Haynesville Shale area in Louisiana and East Texas.  When the bubble burst and companies stopped buying leases, Chesapeake refused to honor drafts for leases that it had committed to take – not because of problems with the lease or the title, but because it had changed its mind about paying such high bonuses.  Second:  companies were using drafts in the Marcellus Shale play in Pennsylvania as if they granted the lessee the option to lease the property.  A landman would get the mineral owner to sign the lease and submit it to the company, and the mineral owner would submit the draft for payment – and then the company would review the lease to see if its terms were acceptable and it was in an area the company wanted to lease.  This was not the usual and ordinary practice.  Both of these problems with drafts have made mineral owners more suspect of their use.

 The better practice for landowners, where possible, is to directly exchange the lease for a bonus check.  Don’t deliver the lease until payment has been received.  Most companies are willing to do this, at least for a lease of any material amount of acreage.

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