the Effective Date of the Contract. It is acknowledged that the amount of the Prepayment is predicated upon the foregoing representations. Seller further represents, warrants and guarantees that there exist no encumbrances or other rights superior to the rights of Buyer to recoup the said Prepayment. Seller agrees and covenants that until such time as Buyer has fully recouped the Prepayment, it shall not assign, transfer or otherwise encumber its interests in the Subject Well, in whole or in part, without the prior written consent of Buyer, which consent shall not be unreasonably withheld. No such transfer, however, shall relieve Seller of its obligations to Buyer hereunder.

6.

Seller hereby waives any and all claims relating to or arising out of the Contract, including any failure to take gas or to pay for gas not taken by Buyer, in respect of all natural gas available for production from all properties committed to the Contract from the Effective Date of the Contract through June 30, 1990.

7.

This Settlement Agreement and the exhibits attached hereto represent the entire agreement between the parties regarding the settlement of their disputes and all previous negotiations and representations are superseded.

8.

It is understood and agreed that this is a compromise of disputed claims and that Buyer denies any liability whatsoever in the premises, this compromise settlement being entered into primarily for the purpose of avoiding litigation.

9.

The parties to this Settlement Agreement and their attorneys agree that, unless required to do so by order of the court or regulatory body asserting competent jurisdiction, they will refrain from disclosing to any persons or entities the terms of this Settlement Agreement and any information or materials obtained in connection with the settlement discussions resulting in this Settlement Agreement. Notwithstanding this restriction, Seller and Buyer agree that this information may be disclosed to financial institutions, lawyers or other consulting personnel, as may be necessary in the ordinary course of business, provided that such financial institutions, lawyers or other consulting personnel agree and covenant in writing to all other parties to refrain from disclosing the information to other persons or entities, unless such institutions and professionals are already required by their normal conduct of business to maintain client confidentiality. The parties further agree that this restriction shall not be construed as prohibiting any party from reflecting the payments made herein in financial statements or in regulatory filings by Buyer.

10.

It is the intent of the parties to include all gas sales and purchase agreements between Buyer and Seller within the definition of "Contract,"

whether or not specifically identified on Exhibit A. To the extent the same may be hereafter required, the parties agree to execute further instruments to evidence this intent.

11.

This Settlement Agreement shall be binding upon and inure to the benefit of the parties hereto, their respective successors and assigns.

IN WITNESS WHEREOF, the parties have executed this Settlement Agreement, in duplicate originals, as of the day and year first hereinabove written.

Pursuant to paragraph 1 of the settlement agreement quoted above, Arkla and Malibu also entered into the gas purchase contract amendment (contract amendment) attached thereto as an exhibit. The purpose and effect of the contract amendment was to change the mechanism for determining the price of gas purchased by Arkla under the contract, effective May 1, 1988.

Pursuant to paragraph 2(d) of the settlement agreement, quoted above, Malibu executed an assignment of limited term overriding royalty (production payment), granting Arkla the following interest in the subject wells:

as a limited term overriding royalty interest, fifty percent (50%) of all of Assignor's [Malibu's] interest in all gas produced, saved, and sold to Assignee [Arkla], if as and when produced, saved, and sold to Assignee but not otherwise, on and after May 1, 1988 from those certain wells specified on Exhibit A attached hereto ("Subject Wells") and by this reference made a part hereof, under the gas purchase agreement between Assignor and Assignee applicable to the Subject Wells. Assignor further does hereby grant bargain, sell, transfer, set over, convey and deliver unto Assignee an interest in the oil and gas leases and other mineral rights of Assignor within the drilling and spacing unit for each Subject Well sufficient to convey to Assignee the overriding royalty interest above described, the legal description of which unit is more fully described on Exhibit A.

The assignment was to last until:

such time as the total production attributable to the interest assigned hereunder equals in value that certain total sum stipulated in the "Settlement Agreement" between Assignor and Assignee dated April 25, 1988, at which time the interest assigned hereunder shall terminate and revert to Assignor. *

* * *

Finally, paragraph 3 of the settlement agreement, quoted above, provides that upon Malibu's request, the parties will enter into a release agreement in the form attached to the

settlement agreement as an exhibit. Under the release agreement, Malibu and Arkla would agree as follows:

1. Buyer [Arkla] and Seller [Malibu] hereby agree to release from commitment to the Contracts for a primary term commencing May 1, 1988, and extending through June 30, 1990 and continuing on a month to month basis thereafter, unless and until terminated by either party upon 30 days written notice prior to the end of the primary term or any monthly extension (the "Release Period"), all gas otherwise deliverable by Seller each day from any well or wells committed to the performance of the Contracts which is (i) gas that is priced pursuant to the applicable Contract above the replacement cost of gas deliverability estimated by Buyer to be available on its system at the time of this release; (ii) gas that was not committed or dedicated to interstate commerce as of November 8, 1978 (within the meaning of Section 2(18) of the Natural Gas Policy Act), or if so committed or dedicated gas that qualifies under Sections 102(c), 103(c), or 107(c)(1– 4) of the Natural Gas Policy Act; and (iii) gas deliverability that is in excess of the quantities of gas requested by Buyer, from time to time, from Seller's interest in such well or wells under the subject Contracts; and Seller shall have the right to sell such excess gas deliverability to third parties on such day during the Release Period.

2. Buyer further agrees to release from commitment to the Contracts during the Release Period, subject to the prior receipt of any necessary governmental authorizations on terms and conditions acceptable to both parties, any other supplies of natural gas deliverable by Seller each day from any well or wells committed to the performance of the Contracts, provided that the gas released shall be limited to (i) gas from wells, priced at the lower of the contract price or maximum lawful price for such gas, which when combined with the deliverability and contract price of the gas released under Paragraph 1 hereof, exceeds the current replacement cost of gas deliverability estimated by Buyer to be available on its system; and (ii) deliverability from such wells which is in excess of the quantities of gas requested by Buyer, from time to time, during the Release Period from Seller's interest in such wells under the subject Contracts; and Seller shall have the right to sell such excess gas deliverability to third parties on such day during the Release Period.

3. Seller agrees that for each MMBtu of released gas nominated for purchase by any purchaser or sold by Seller (including any gas taken by Seller or an affiliate) in accordance with this agreement, Buyer shall be entitled to credit such quantities of gas against any obligations and liabilities it may have to take gas, or to pay for gas not taken, under any gas sales and purchase agreements between Buyer and Seller.

4. Seller further hereby agrees to waive and release Buyer from any and all obligations and liabilities Buyer has or may have arising out of any failure to take gas, or to pay for gas not taken, under the Contracts for all contract years commincing [sic] prior to the end of the Release Period.

None of the documents executed in connection with the settlement transaction placed any restriction on Malibu's use of the $1,850,000 payment that it received from Arkla. In fact, shortly after the settlement, Malibu lent approximately one-half of the settlement payment to its shareholders. On April 28 and May 2, 1988, respectively, Malibu lent $823,263.20 to Mr. Webb and $112,000 to Mr. Herbel. Each loan was authorized by a corporate resolution and was evidenced by a promissory note signed on the same day as the resolution. The interest rate on both loans was 8.6 percent. For the first 3 years, both loans called for the borrower to pay interest only, compounded annually. After that, principal was amortized over 11 years and was payable annually with interest.

At the time the settlement agreement was executed, the total estimated recoverable reserves of natural gas from the wells subject to the contract exceeded the amount necessary to recoup the $1,850,000 payment. During 1988, Arkla recouped $19,501.54 of the settlement payment from deliveries of natural gas by Malibu, pursuant to paragraph 2 of the settlement agreement, resulting in an unrecouped balance of the settlement payment of $1,830,498.46 as of the end of 1988. Malibu treated this amount as a liability and reported it on the line designated "Mortgages, notes, bonds payable in 1 year or more" on the balance sheet that is attached as Schedule L to Malibu's 1988 income tax return on Form 1120S, U.S. Income Tax Return for an S Corporation. As of June 1990, the unrecouped balance of the settlement payment was $1,797,175.15, and as of March 31, 1994, the unrecouped balance was $1,627,241.23.

The amounts reported on Malibu's 1988 income tax return are summarized as follows:

Attached to Malibu's 1988 return are two Schedules K-1, Shareholder's Share of Income, Credits, Deductions, Etc. Mr. Herbel's Schedule K-1 reports $3,639 as his distributive share of Malibu's loss, and Mr. Webb's Schedule K-1 reports $32,755 as his share.

Upon audit of Malibu's return for 1988, respondent determined that Malibu had understated its gross receipts by $1,825,086. Respondent's agent made the following explanation of this adjustment:

It is determined that payments made to you by Arkla, Inc. and Subsidiaries under a "take or pay" contract, in the amount of $1,825,086.00 were not reported by you on your 1988 tax return. Therefore, taxable income is increased $1,825,086.00 for 1988.

The following schedule summarizes the amounts reported on Malibu's 1988 return, and the adjustments determined by respondent:

Based upon respondent's determination that Malibu's gross receipts had been understated, respondent further determined that the gross income of each of Malibu's shareholders had been understated. The notice of deficiency issued to Mr.