ExxonMobil Corp. v. Alabama Dept. of Conservation and Natural Resources, 2007 WL 3224585 (Ala. Nov. 1, 2007).

Stephanie Showalter, J.D., M.S.E.L.

In ExxonMobil Corp. v. Alabama Dept. of Conservation and Natural Resources, a contract dispute between a corporation and the state resulted in decades of litigation and an eye-popping, jaw-dropping punitive damage award 180 times greater than the compensatory damages. Cor­ porate greed and arrogance can easily enflame the passions of ordinary citizens serving on juries who have little patience for the word games played by attorneys. Especially when the corporation is Exxon.
      In 1979, one of the largest natural gas reserves in the United States was discovered in Mobile Bay. The Alabama Department of Con­servation and Natural Resources (DCNR) awarded seven leases to Exxon in 1981 and fifteen more in 1984. Although most standard lease forms are prepared by the oil companies, Exxon’s leases were executed using forms prepared by DCNR and contained royalty provisions more favorable to the state.
      Exxon began making monthly royalty payments when the wells started production in December 1993. About the time Exxon began making payments, DCNR discovered during an audit of Shell Oil that the oil company was interpreting the lease provisions differently than the state.1 When the state got around to auditing Exxon in 1996, the state discovered similar disparities in its royalty payments. In February 1997, DCNR notified Exxon that it had miscalculated its royalty payments and as a result owed an additional $50 million to the state of Ala­ bama. On July 28, 1999, Exxon sued the state to obtain judicial resolution of the calculation dispute. The state responded by filing a counterclaim alleging breach of contract and fraud.
      The method for calculating royalties on oil and natural gas sales differs depending on where the lease is located (federal or state waters) and the terms of the individual leases. Although royalties are calculated based on sales, oil companies can reduce the value of their sales by deducting certain costs, such as transportation, processing, brokerage fees, and pipeline reservation fees. Excessive deductions can deprive the federal and state governments of millions of dollars in unpaid royalties.
      According to Exxon, “the case is a simple disagreement over how to interpret the company’s contract with the state, including what expenses it could deduct before paying royalties to the state.”2 Alabama claimed Exxon intentionally underpaid the royalties in a scheme to cheat the state. Key to the state’s fraud case was a memo prepared by in-house counsel Charles Broome as construction at the drilling sites was nearing completing in 1993. An Exxon accounting manager asked Broome “to perform a legal analysis of the royalty provisions of the lease agreement ‘to ensure that royalties were paid in accordance with the terms of the mineral lease’ and to evaluate potential areas of cost recovery for Exxon in the production and treatment process.”3 In his memo, Broome analyzed three different interpretations of the lease language and the likelihood of success. After discussing the state’s position, Broome presented two possible interpretations, labeled “more extreme con­ truc­ tion[s],” that would permit a broader range of deductions. Broome cautioned that these interpretations had little chance of success in court. “If we adopt anything beyond a ‘safe approach,’ we should anticipate a quick audit and subsequent litigation.”4 But, the memo suggested a way to calculate the risk. “Our exposure is 12% interest on underpayments calculated from the due date, and the costs of litigation.”5 Exxon, with full knowledge of the state’s position, began paying royalties based on a “more extreme construction” of the lease agreement.
      In December 2000, a jury awarded the state $60 million in additional royalties, $27 million in interest, and $3.42 billion in punitive damages. The Alabama Supreme Court reversed this verdict in 2002 on evidentiary grounds. The Court held that the Broome letter, which was heavily relied on by the state during the 14-day trial, was a confidential attorney-client communication which should not have been admitted. The case was retried in late 2003.
      Despite being handicapped by the loss of a key document, the state did even better the second time around. In 2003, the jury handed down the largest verdict in Alabama history. The state of Alabama was awarded $63,769,568 in additional royalties for the period of October 1993 through December 2002, $39,235,154 in interest, and $11.8 billion in punitive damages!
      Large punitive damage awards are rarely rationally related to the damage actually caused by the company. That’s what compensatory damages are for. Punitive damages are intended to hurt and send a warning to companies engaging in egregious conduct. According to the jury foreman, the jury “wanted to set an amount that would get their attention.”6 Exxon argued that something more was going on. Alabama was facing serious budget cutbacks in 2003 and the state’s fiscal woes were widely reported by the press around the time of the trial. A few comments by jurors afterwards, such as “the verdict would help bail the state out if its financial crisis,”7 hint at this ulterior motive. Exxon sought a rehearing to consider whether the punitive damages were excessive and the trial judge reduced the award to $3.5 billion in adherence with U.S. Supreme Court guidelines.8

Legitimate Disagreement or Fraud?
In November 2007, the Alabama Supreme Court caused a bit of a stir, to say the least, when it overturned the jury’s punitive damage award due to the lack of evidence of fraud and reduced the compensatory damage award due to some finer points of contract interpretation. In its simplest terms, this case boils down to whether Exxon openly disagreed with DCNR as to the calculation methods or intentionally schemed to cheat the state out of royalties due under the leases. If the former was the case, the state would be limited to contractual remedies (basically unpaid royalties and interest). If the latter, the state would be entitled to punitive damages because of Exxon’s fraudulent conduct.
      While the Supreme Court’s decision is hard to swallow, the evidence of actual fraud was thin. Exxon, the multi-billion dollar corporation we all love to hate, never hid anything. DCNR was on notice that the oil companies were calculating royalties differently as early as 1993 and knew about Exxon’s calculation methods by 1996. Scandals over oil royalties during this same time period sounded warnings about padded deductions.9 It should not be surprising or shocking that Exxon would attempt to game the system. But, as one of the Supreme Court justices stated in a concurring opinion, corporate greed does not equal fraud.

We are thus left with a situation in which one of the parties to a contract has taken a hard-nosed bargaining position, cynically relying on a downside that it accurately deemed to be limited to compensatory damages plus interest, without any risk of exposure to punitive damages. Although a jury could reasonably conclude from the evidence that Exxon’s business ethics would pass only the first prong of the Rotary Club’s famous “4-way Test,” that circumstance does not give rise to a basis under settled Alabama law for an award of punitive damages.10

Conclusion
Although Governor Bill Riley decided not to ask the Alabama Supreme Court to reconsider its decision, the case is not over quite yet. The parties went back to court in January to argue over whether the interest on the remaining $51.9 million in compensatory damages should be calculated at 12 or 24 percent. Judge McCooey, agreed with Exxon that 24 percent was too high and approved its calculation of royalties and interest due of $120.4 million.11 The state’s attorneys said they would appeal.12
Endnotes
1.   Shell Oil later settled with the state following a similar lawsuit agreeing to pay $27.1 million in unpaid royalties and interest and $6.4 million in attorney’s fees. See, Shell Reaches Settlement in Lawsuit by Alabama, Houston Chron., March 21, 2002.
2.   Phillip Rawls, This Case is Notorious, Mobile Register, Feb. 7, 2007.
3.   Exxon Corp. v. Alabama Dept. of Conservation and Natural Resources, 859 So. 2d 1096, 1100 (Ala. 2002).
4.   Mike France, When Big Oil Gets Too Slick, Business Week, Apr. 9, 2001 at 68.
5.   Id.
6.   Phillip Rawls, Judge Cuts Alabama Verdict Against Exxon Mobil to $3.6 Billion, AP Datastream, March 20, 2004.
7.  Editorial, Sympathy for Exxon Mobil, Birmingham News (Ala.), Aug. 20, 2005 at 15A.
8.   Rawls, supra note 6.
9.   See, Edmund L. Andrews, As Profits Soar, Companies Pay U.S. Less for Gas Rights, The New York Times, Jan. 23, 2006.
10. ExxonMobil Corp. v. Alabama Dept. of Con­ servation and Natural Resources, 2007 WL 3224585 at *36 (Ala. Nov. 1, 2007).
11. Phillip Rawls, Alabama Judge Sides with Exxon Mobil in State Royalty Dispute, AP Alert – Alabama, Jan. 8, 2008.
12. Id.