Shale Gas: Environmental Concerns are the Tip of the Iceberg

By: Kenneth Anspach

On December 10, 2011 the United States Environmental Protection Agency (“USEPA”) announced the publication of a 120-page report, which concluded that the process known as ‘fracking’ does cause contamination of water supply. The study was based on analysis of water from test well sites in Pavillion, Wyoming, and concluded that contaminants including glycol ethers and at least ten organic compounds known to be present in fracking fluid were also found in the groundwater. It further concluded that these chemicals were most likely due to seepage from the gas-drilling process. Michael Ricciardi, Newest EPA Report Confirms Fracking Fluids Contaminating Pavillion, Wyoming Water Supply, http://www.planetsave.com, December 10, 2011 at 2.

Yet, while USEPA is indicating the existence of potential problems with the shale gas industry, other federal agencies are pushing for its expansion. The U.S. Department of Energy touts research it sponsored as playing a role in the shale gas drilling boom by making it possible to tap gas trapped in shale formations deep underground. Indeed, the United States Energy Information Administration (“EIA”), a division of the Energy Department, has steadily increased its estimates of U.S. natural gas supplies. Ian Urbina, Behind Veneer, Doubt on Future of Natural Gas, N.Y. Times, June 27, 2011, at A1.

By the same token, the Securities and Exchange Commission (“S.E.C.”) made changes in its rules during the waning days of the Bush administration in 2008 that have given companies wider latitude in how they estimate reserves in areas that have not yet been drilled. The rules, titled “Modernization of Oil and Gas Reporting,” 17 C.F.R. Parts 210, 211, 229, and 249, relax restrictions on how large an area shale gas companies may include in their “proved” reserves without drilling to test first. Moreover, the industry neither needs to disclose the technology utilized to estimate the size of these reserves nor be subject to third party audits to verify the reserve estimates. As a result of this change, some shale gas companies have increased their stated reserves by more than 200 percent. Ian Urbina, S.E.C. Leads to Worries of Overestimation of Reserves, N.Y. Times, June 27, 2011, at A12.

Accordingly, not all EIA officials are so sanguine regarding the shale gas industry. According to a senior adviser to the EIA, “the shale industry may be ‘set up for failure. It is quite likely that many of these companies will go bankrupt.’” Ian Urbina, Behind Veneer, Doubt on Future of Natural Gas, N.Y. Times, June 27, 2011, at A1. For financial institutions extending loans to companies in the shale gas industry, the risk of default is real.

Many in the industry, as well as some government officials, have begun to question whether some companies are overstating the amount of gas that can be produced from such reserves. According to the N.Y. Times, “[t]his practice, known as overbooking, is illegal because it misleads investors trying to assess a company’s strength and banks that use reserves as collateral for loans.” Ian Urbina, S.E.C. Leads to Worries of Overestimation of Reserves, N.Y. Times, June 27, 2011, at A12.

The concern regarding overbooking is not simply theoretical. Industry data for more than 10,000 wells in three major shale formations shows that, while there are some wells that are quite productive, they are often encircled by ones that are not economically viable. Moreover, the amount of gas produced by the active wells is falling much faster than the shale gas companies initially predicted. Ian Urbina, Behind Veneer, Doubt on Future of Natural Gas, N.Y. Times, June 27, 2011, at A1.

Under these circumstances, it is entirely likely that we will see a wave of litigation brought by financial institutions relating to the misrepresentation of shale gas reserves. Of course, it also is quite possible that these lawsuits will give rise to yet another wave of coverage litigation. The outcome of the coverage litigation will rest largely on whether the misrepresentations were negligent or intentional, and whether courts deem negligent misrepresentation to satisfy the definitions of “occurrence” under the policies at issue. Recently issued S.E.C. rules governing the types of reserves that may be booked, based on whether the reserves are proven, probable or merely possible also should inform the outcome of coverage actions arising out of such misrepresentations, because the guidelines inherently require the exercise of judgment – and poorly exercised judgment suggests negligence rather than intent.

Insurance Coverage of Producers and Their Agents May Play a Pivotal Role in the Recompense of Financial Institutions.

Given this situation, what recourse do financial institutions have against their shale gas customers defaulting on loans where overbooked reserves have been pledged as collateral? Certainly, where intentional misrepresentation and fraud are involved, banks have a right of action against these companies. Yet, that option provides little solace where the customer is insolvent. Moreover, insurance coverage would be unavailable for claims involving solely intentional conduct. On the other hand, where the misrepresentation of reserves is merely negligent, the companies’ insurance coverage may play a pivotal role in the banks’ recovery of losses.

Although the record of reported decisions is sparse, some coverage actions arising out of suits for negligent misrepresentation of mineral reserves have been decided. For example, in Bankers Trust Co. v. Old Republic Ins. Co., 697 F. Supp. 1483 (N.D. Ill. 1988), the bank sought a declaratory judgment that one of two excess carriers owed coverage under policies issued to a firm of consulting petroleum engineers, based on the firm’s negligent appraisal of oil and gas reserves upon which the bank relied in extending over $100 million in loans. In In re Royal Dutch/Shell Transp. Sec. Litig., 380 F. Supp. 2d 509 (D.C. N.J. 2005), reversed in part upon reconsideration, 404 F. Supp. 2d 605 (D.C. N.J. 2005), Royal Dutch Shell was sued for the alleged dissemination of materially false and misleading statements concerning the companies’ reported proved oil and natural gas reserves. Similarly, in Koch v. Koch Indus., Inc., 203 F.3d 1202 (10th Cir. 2000), plaintiffs alleged that defendants misrepresented and omitted material facts during negotiation of a stock purchase agreement, resulting in plaintiffs’ undervaluation of defendant corporation’s stock. While jurisdictions are divided with respect to whether such negligent misrepresentation claims are covered, as described below the better-reasoned approach is to find that such claims are, in fact, covered.

Many Jurisdictions Deem Negligent Misrepresentation to be a Covered Claim.

A number of appellate courts have considered whether the tort of negligent misrepresentation is covered under a policy of general liability insurance. Of these, the better-reasoned decisions have held such claims are covered. The analysis of the court in Sheets v. Brethren Mutual Ins. Co., 342 Md. 634, 637-658 (Md. 1996), one of the leading decisions, is instructive. There, the insureds were sued by the purchasers of their home who alleged that the insureds, inter alia, negligently misrepresented that the septic system at their farmhouse was in “good working condition” before selling the property to the plaintiffs in the underlying suit. According to the plaintiffs, as a result of the misrepresentation plaintiffs purchased the farm and moved in with their nine children. Thereafter, the septic system began leaking and was condemned by the county health department, requiring replacement. The insureds sought coverage, but the insurer contended that the insureds’ policy did not cover the claim because (1) there was no causal nexus between the misrepresentation and the property damage, (2) the claims for misrepresentation were merely for economic losses, not property damage, and (3) the insureds’ misrepresentations did not constitute an occurrence. The appellate court reversed the trial court’s entry of summary judgment in favor of the insurer.

In particular, the Sheets court found: (1) that the alleged lack of a causal nexus was a factual issue, relying on the well-established rule that an insurer owes a duty to defend where the action is potentially covered under the policy and may not simply contradict the allegations contained in the underlying complaint; (2) that the alleged “loss of use” of the property claimed by the purchasers constituted a claim for property damage as defined by the policy and was therefore covered; and (3) that negligent misrepresentation is a form of negligence, and that when a negligent act causes damage that is unforeseen or unexpected by the insured, the act is an “accident” as defined by the policy. Thus, because the claim for negligent misrepresentation, which allegedly caused the property damage, was potentially covered by the policy, the court concluded that the insurer owed a duty of defense to its insureds. Sheets v. Brethren Mut. Ins. Co., 342 Md. at 644-58.

Similarly, the analysis of the First Newton Nat’l Bank v. Gen. Cas. Co. of Wisconsin, 426 N.W.2d 618, 621-625 (Iowa 1988), court also is instructive. In that case, the bank was sued in the underlying action for, inter alia, negligent misrepresentation arising out of its conduct in financing two distressed farms, which were ultimately liquidated and foreclosed. The bank sought a declaratory judgment that the insurers had a duty to defend under a primary and an excess liability policy. The insurers had denied coverage, arguing that the bank’s alleged negligent misrepresentations were not accidental, and therefore did not satisfy the definition of an “occurrence” under the policies. The primary policy defined “occurrence” to include “an accident, including continuous or repeated exposure to conditions, which results in bodily injury or property damage neither expected nor intended from the standpoint of the insured.” The umbrella policy contained a similar definition of “occurrence.” The court rejected the insurers’ argument that the underlying complaint alleged intentional conduct by the bank. The court based its analysis on the Restatement (Second) of Torts, Section 552, which provides:

The very definition of “negligent misrepresentation” connotes negligent rather than intentional conduct:

one who, in the course of his business, profession or employment, or in any other transaction in which he has a pecuniary interest, supplies false information for the guidance of others in their business transactions, is subject to liability for pecuniary loss caused to them by their justifiable reliance upon the information, if he fails to exercise reasonable care or competence in obtaining or communicating the information.

First Newton Nat’l Bank v. Gen. Cas. Co. of Wisconsin, 426 N.W.2d 618, 625 (Iowa 1988) (emphasis added) (quoting Beeck v. Kapalis, 302 N.W.2d 90, 97 (Iowa 1991) (quoting Restatement (Second) of Torts § 552 (1977)). Given that plaintiff’s underlying complaint was grounded on a theory of negligence, the court found the insurer owed a duty to defend.

In Wood v. Safeco Ins. Co. of America, 980 S.W.2d 43, 52 1998 Mo. App. LEXIS 1612 (Mo. App. 1998), the insured sold certain property, and after it flooded the buyer sued alleging negligent misrepresentation. The court found the negligent misrepresentation claims covered as an “occurrence.”

The court in Universal Underwriters Ins. Co. v. Youngblood, 549 So.2d 76, 78-79, 1989 Ala. LEXIS 565 (Ala. 1989), applied similar logic. Employees of the insureds alleged that the insureds misrepresented that they were being paid in accordance with the terms of an employment contract. The court rejected the insurer’s argument that no duty to defend existed because the innocent or reckless misrepresentation claims did not constitute an occurrence within the meaning of the policy. The court ruled that “[a]ctions for innocent or reckless misrepresentation have been held to be covered under policy provisions like those now before us[,]” and that the insurer “is obligated to defend.” Universal Underwriters Ins. Co. v. Youngblood, 549 So.2d at 79.

Finally, the analysis of the Minnesota Supreme Court in Reinsurance Ass’n of Minnesota v. Timmer, 641 N.W.2d 302, 306-312, 2002 Minn. App. LEXIS 283 (Minn. 2002), also is applicable. In that case, the underlying plaintiffs alleged that the insureds sold them dairy cows that were infected with bovine viral diarrhea virus, thus introducing the virus into plaintiffs’ herd, causing loss of milk production, breeding problems and death of some of the animals. The plaintiffs brought a claim for, among other things, misrepresentation, which the court construed as including both negligent and intentional. The insurer denied coverage and sought a declaratory judgment that it had no duty to defend or indemnify, because the claimed losses did not arise out of an “occurrence.”

The insurer relied heavily on the decision of the Tschimperle v. Aetna Casualty & Surety Company, 529 N.W.2d 421, 1995 Minn. App. LEXIS (Minn. App. 1995), a case involving misrepresentation of the value of a tractor in which the court declared that “[n]egligent misrepresentations cannot be ‘accidents’ because the insured intends to induce reliance on the statement.” Tschimperle v. Aetna Cas. & Sur. Co., 529 N.W.2d at 424. The Timmer court distinguished Tschimperle, noting that:

We do not consider Tschimperle to be applicable to the present facts. Here, it must be assumed that the Timmers intended to make the alleged representations, but a claim of negligent misrepresentation presupposes that they did not intend their representations to be false. Such a negligent misrepresentation may cause an “accident” where, as here, the allegedly false representation causes a buyer to accept delivery of diseased cattle that infect a formerly-healthy herd. That accident was neither expected nor intended and is an “occurrence.”

Reinsurance Ass’n of Minnesota v. Timmer, 641 N.W.2d at 313. On this basis, the court found that the policy arguably provided coverage for a claim of negligent misrepresentation that the insurer was required to defend. (The issue of indemnity was deferred until a final determination in the underlying action.)
Thus, in cases such as Sheets, First Newton National Bank, Youngblood and Timmer, courts have found that policies of general and excess liability cover claims for negligent misrepresentation, the same type of claim that is potentially involved with the overbooking of shale gas reserves.

Other Courts Wrongly Read Volition and Fraud into Negligent Misrepresentation Claims to Conclude that Such Claims are Not Covered

Not all courts, however, have concluded that general liability policies cover claims for negligent misrepresentation. In so doing, these courts either offer no explanation as to how a claim for negligent misrepresentation fails to satisfy the definition of an “occurrence,” or wrongly read into the definition of negligent misrepresentation an element of intent.

The leading case finding that there is no coverage for such a claim is Safeco Ins. Co. of America v. Andrews, 915 F.2d 500 (10th Cir. 1990). In Safeco, the plaintiff in the underlying suit alleged that the insured misrepresented facts regarding property the plaintiff purchased – unbeknownst to the plaintiff purchaser, the property rested on unstable, shifting and moving earth, susceptible to sudden landslides. The Court determined there was no coverage, reasoning as follows:

The cause of the damage was Andrews’s alleged misrepresentations, which are not an “occurrence” or a “peril insured against” under the terms of the policy. There is, therefore, no potential for liability that arguably comes within the scope of the insurance coverage provided by Safeco.

Safeco Ins. Co. of America v. Andrews, 915 F.2d 500, 502 (10th Cir. 1990) (internal citations omitted; emphasis added). Thus, the court held that the “alleged misrepresentations…are not an ‘occurrence’…under the terms of the policy.” Safeco Ins. Co. of America v. Andrews, 915 F.2d 500, 502 (9th Cir. 1990). However, the court failed to explain why the allegations did not satisfy the definition of “occurrence” under the policy. The Sheets court commented on the Safeco’s lack of analysis, noting:
The Ninth Circuit found that the insurer’s allegations did not amount to an “‘occurrence’ or ‘peril insured against’ under the terms of the policy.” *** The court, however, did not explain its reasoning or cite any authority for this proposition.

Sheets v. Brethren Mut. Ins. Co., 342 Md. at 655-56 (internal citations omitted). Indeed, courts should be (and at least some apparently are) reluctant to follow the Safeco court’s bald assertion that negligent misrepresentation does not constitute an occurrence under a general liability policy. In fact, the Sheets court noted that California law appears aberrational in its view of negligent misrepresentation:
California cases that subsequently rely on Safeco hold that, under California law, negligent misrepresentation is associated more with fraud than with ordinary negligence and hence cannot be considered an accidental, unintended occurrence.

Sheets v. Brethren Mut. Ins. Co., 342 Md. at 656 (internal citations omitted).
Relying on California’s aberrational view of negligent misrepresentation, the Wyoming Supreme Court in First Wyoming Bank, N.A. v. Continental Ins. Co., 860 P.2d 1094, 1100, 1993 Wyo. LEXIS 156 (Wyo. 1993), found that:
[N]egligent misrepresentations causing investment loss or loss of other economic interest are considered purposeful rather than accidental for the purpose of insurance coverage. *** The underlying rationale of this rule is that negligent misrepresentation requires intent to induce reliance and, therefore, is a subspecies or variety of fraud which is excluded from policy coverage. (Internal citations omitted; emphasis in original).

The Sheets court also critiqued the decision in First Wyoming Bank, noting that it was one of a few decisions (including the subsequently distinguished Minnesota decision in Tschimperle) that “have focused on the insured’s intent to induce reliance on the false statement.” Sheets v. Brethren Mut. Ins. Co., 342 Md. at 656; but see, Metro. Prop. & Cas. Ins. Co. v. Flakne, Civil No. 09-2441, 2010 U.S. Dist. LEXIS 75495 (D. Minn. July 27, 2010) (following Tschimperle rather than Timmer in determining that no coverage existed for misrepresentations involving the sale of a condominium that required significant repairs.)
To the same effect, in Nova Cas. Co. v. Able Constr., Inc., 1999 UT 69, 1999 Utah LEXIS 104 (Utah 1999), the Utah Supreme Court adopted in toto the approach of Safeco in determining that allegations of negligent misrepresentation are not an occurrence under commercial general liability insurance policies. In so doing, the Court constructed a new concept – that negligent misrepresentation “is a subspecies or variety of fraud” – which appears nowhere in the definition of that cause of action. See First Newton Nat’l Bank v. Gen. Cas. Co. of Wisconsin, 426 N.W.2d at 625. Similarly, the court in Everson v. Lorenz, 280 Wis. 2d 1, 14 (Wis. 2005), read an element of volition into the definition of negligent misrepresentation in determining such a claim did not constitute an “accident” and “occurrence” under the applicable policy.

Therefore, while in a number of cases courts have found claims of negligent misrepresentation to be covered, in some, such as Safeco, First Wyoming Bank and Everson, the courts did not. Under such circumstances, how may a financial institution approach with some degree of certainty with respect to coverage a claim that its mining customer negligently misrepresented its reserves?

A Regulatory Standard of Care for the Booking of Shale Coal Reserves Provides the Basis for Determinations of Coverage for Financial Institution’s Claims for Negligent Misrepresentation When the Producer’s Collateral Proves Worthless.

The issue facing financial institutions left holding worthless reserves as collateral when their mining company-customers default is whether their claims against those customers based upon negligent misrepresentation will be covered. Such claims would be covered under the holdings in Sheets, First Newton National Bank, Wood, Youngblood and Timmers, where the decisional law is based upon the duty of insurers to cover claims based upon negligent conduct. They would not be covered under the holding in Safeco, and the cases that followed in its wake, such as First Wyoming Bank, Tschimperle, Nova Casualty Company, and Everson, which read intentionality and fraud into what essentially are claims based upon negligence. In making this determination, one obvious area of inquiry would be the standard of care applicable to the booking of expanded shale gas reserves. Given that authority for the booking of such reserves is found under the new S.E.C. rules, 17 C.F.R. Parts 210, 211, 229, and 249, one may look to those regulations to determine whether and what standard of care may apply. Indeed, it is axiomatic that the violation of a statute or ordinance designed for the protection of human life or property is prima facie evidence of negligence. E.g., Davis v. Marathon Oil Co., 64 Ill. 2d 380, 389-90 (Ill. 1976). Further, evidence of administrative regulations informs the standard of care in negligence actions. Wendland v. AdobeAir, Inc., 223 Ariz. 199, 204 (Ariz. Ct. App. 2009) (citing Restatement (Second) of Torts, Section 288B, cmt. d (1965).

One of the newly revised S.E.C. rules, 17 C.F.R. §210.4-10(a)(17)(18) and (22), provides guidelines governing the types of reserves that may be booked: (1) proved oil and gas reserves are those which can be estimated with reasonable certainty, and may include areas identified by drilling, as well as adjacent undrilled portions; (2) probable reserves are those additional reserves that are less certain to be recovered than proved reserves but which, together with proved reserves, are as likely as not to be recovered; and (3) possible reserves are those additional reserves that are less certain to be recovered than probable reserves. Representations made by mining companies regarding reserves based upon these rules, where the differences between “proved,” “probable” and “possible” reserves are based upon nuance, are fraught with the potential for negligent error. In such instances, claims brought demonstrating violation of an administrative rule or regulation inform whether the standard of care has been breached, thereby giving rise to a claim for negligence. Wendland v. AdobeAir, Inc., 223 Ariz. 199, 204 (Ariz. Ct. App. 2009). Accordingly, cases such as First Newton National Bank, that focus upon the actual definition of negligent misrepresentation, which “connotes negligent rather than intentional conduct” should govern the outcome of coverage actions in this arena. First Newton Nat’l Bank v. Gen. Cas. Co. of Wisconsin, 426 N.W.2d at 625.

Cases such as First Wyoming Bank, Tschimperle, Nova Casualty Company, and Everson, which interpret “negligent misrepresentation” as the equivalent of fraud, will not be applicable, because violation of a regulatory standard is not evidence of fraud. To ensure that claims for negligent misrepresentation are covered (as in First Newton National Bank, for example), banks should allege the standard of care set forth in the S.E.C. rules and that the standard of care was violated. By doing so, banks may find greater certainty that a claim for negligent misrepresentation of shale gas reserves will be covered under the companies’ liability policies.

Conclusion.

In conclusion, not only does the new focus on shale gas reveal potential environmental problems, it has also uncovered the potential for economic failure and insolvency among shale gas producers. New S.E.C rules, which seem to authorize the overbooking of reserves leave lenders financially exposed. In the face of these new realities, coverage claims based upon negligent misrepresentation filed as a result of lawsuits against the defaulting companies offer one solution for recovery against customers whose collateral may otherwise prove worthless.

Keywords: fracking, shale gas, negligent misrepresentation, reserves, mineral reserves proved reserves, provable reserves, possible reserves, overbooking

Kenneth Anspach, Anspach Law Office, Chicago, Illinois, https://www.anspachlawoffice.com