The Pennsylvania attorney general’s office filed suit against Chesapeake Energy Corp. (NYSE: CHK) on Dec. 9, accusing the Oklahoma company of deceptive conduct in securing fracking leases and later underpaying Marcellus Shale royalties.

The suit says Chesapeake engaged in a self-dealing scheme that resulted in reduced royalty payments to landowners.

Under the terms of landowners’ leases, Chesapeake could only make deductions from royalties for costs paid to non-affiliated third parties. The suit contends that Chesapeake failed to disclose that its deductions, which lowered royalty payments, were actually for expenses paid to affiliated companies.

“This alleged conduct amounts to a ‘bait-and-switch,’” said Pennsylvania Attorney General Kathleen G. Kane. “Pennsylvania landowners were deceived in thousands of transactions by a company accused of similar conduct in several other states. This lawsuit should serve as notice that we will not allow our residents to be exploited.”

Chesapeake has repeatedly faced royalty-related suits, including cases filed in Texas, Pennsylvania, Ohio, Oklahoma and Arkansas. The company has also been served subpoenas by the U.S. Department of Justice, U.S. Postal Service and various states seeking information on its royalty practices.

Chesapeake spokesman Gordon Pennoyer said the company strongly disagrees with “Attorney General Kane’s baseless allegations and will vigorously contest them in the appropriate forum.”

The suit seeks civil penalties of $1,000 for every violation of the state’s Unfair Trade Practices and Consumer Protection Law and $3,000 for violations involving anyone 60 years of age or older.

The suit does not specify an overall dollar amount it is seeking.

The attorney general also wants Chesapeake frozen out of the Marcellus—including exploring, drilling, extracting, gathering, transportation or sale of gas—until the company makes good on any court-ordered awards and penalties.

Midstream Maze

The attorney general says that by the end of 2011, Chesapeake had overleveraged its balance sheet with excessive debt as it raced to expand its exploration and drilling for natural gas.

“Chesapeake Energy faced a projected cash flow shortage of about $10 billion in 2012,” the suit says.

Chesapeake planned to divest roughly $11.5 billion to cover its operations in 2012.

In part, that includes selling oil and gas infrastructure.

Chesapeake executed a series of gas gathering agreements with its midstream unit guaranteeing a minimum rate of return before it was acquired, the lawsuit says.

“The gas gathering agreements between Chesapeake Energy and its midstream unit were not negotiated at arm’s length,” the suit says. “Thus resulting in a scheme of artificially inflated and/or unreasonably excessive post-production costs to be passed on to Pennsylvania landowners.”

Williams Partners LP (NYSE: WPZ) acquired Chesapeake Midstream Operating LLC in December 2012.

The state’s suit says Williams entered agreements with Chesapeake to provide midstream services in the Marcellus. The company is accused of concealing that deductions charged to landowners were inflated to “satisfy a guaranteed rate of return to Williams Partners, while indicating that the deductions for midstream services resulted from arm's length negotiations.”

“Chesapeake … misled Pennsylvania landowners into believing they were being charged deductions for midstream services borne of a free and fair market,” the suit said.

Land Tactics

Pennsylvania’s attorney general also accuses Chesapeake of empowering landmen to use unfair and deceptive negotiation tactics with landowners, the suit said.

As the Marcellus was being developed, landmen identified commercially viable areas and acquired as much oil and gas rights acreage as possible.

The lawsuit accuses Chesapeake’s landmen of high pressure pitches in which they dissuaded contact with other landowners to compare terms, presented “take it or leave it contracts” and limited time for consideration.

The Pennsylvania suit says Chesapeake’s “unfair and deceptive conduct” is not limited to the Marcellus Shale but also the Utica and any other natural gas plays where oil and gas leases remain in effect.

Most landowners lack sophistication in understanding oil and gas leases, the suit says.

“The dynamic of the landman knocking, often unannounced and unscheduled, on the door of a landowner's house to pitch an oil and gas lease … would reasonably confuse most, if not all, landowners,” the suit says.

Even veteran investors have taken Chesapeake to court over its lease agreements.

In early September prominent Texas billionaire Ed Bass, a veteran oil and gas investor, and more than a dozen other Barnett Shale mineral rights owners settled a royalty suit filed against Chesapeake.

Bass and others sued the company saying it underpaid oil and gas royalties and breached contracts with landowners. The settlement terms are confidential.

In a federal suit, Chesapeake was accused of underpaying royalty and overriding payments either by basing its payments on below-agreed prices or by effectively deducting “contractually forbidden production and post-production costs.”

“Such underpayments violate the express language of the relevant leases and assignments, each of which forbid most, if not all, deductions that Chesapeake has made and continues to make,” the suit said.

The suit, filed in 2013, was settled for an undisclosed amount. Chesapeake could have faced damages of at least $8.6 million and other damages, according to the suit.

Fort Worth, Texas-based McDonald Law Firm represents more than 22,000 gas royalty owners across the country, including over 16,000 in Texas in suits against Chesapeake. As of July, the firm said it has filed nearly 300 lawsuits against Chesapeake.

The law firm contends that Chesapeake Energy has underpaid gas royalty owners by several hundred million dollars.

Darren Barbee can be reached at dbarbee@hartenergy.com.