Oil and Gas Industry Update

In a leading precedent handed down in 2018—Sabine Oil & Gas Corp. v. Nordheim Eagle Ford Gathering, LLC (In re Sabine Oil & Gas Corp.), 734 Fed. Appx. 64 (2d Cir. May 25, 2018)—the U.S. Court of Appeals for the Second Circuit upheld 2016 and 2017 rulings authorizing a chapter 11 debtor to reject certain gas gathering and handling agreements under section 365 of the Bankruptcy Code. According to the Second Circuit, the lower courts did not err in finding that the agreements could be rejected because, under applicable nonbankruptcy law, the agreements contained neither real covenants "running with the land" nor equitable servitudes.

In late 2019, however, two bankruptcy courts came to a different conclusion on this question. In Monarch Midstream, LLC v. Badlands Production Company (In re Badlands Energy Utah LLC), 2019 WL 5549463 (Bankr. D. Colo. Sept. 30, 2019), the U.S. Bankruptcy Court for the District of Colorado denied a chapter 11 debtor's motion to sell its oil and gas assets free and clear of a gas gathering and processing agreement and a saltwater disposal agreement, finding that the agreements were covenants that ran with the land under Utah law, thereby preventing a free and clear sale. Most recently, the U.S. Bankruptcy Court for the Southern District of Texas held in Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Resources, Inc.), Adv. Proc. No. 19-03609 (Bankr. S.D. Tex. Dec. 20, 2019), that oil and gas gathering agreements could not be rejected by a chapter 11 debtor because the agreements formed real property covenants that ran with the land under Oklahoma law rather than executory contracts.

These recent decisions represent an encouraging development for gas gathering and handling agreement counterparties.

Sabine Oil

In Sabine Oil, the Second Circuit concluded that it need not determine whether the gas gathering agreements at issue "touch and concern" the land, as required under Texas law for a covenant to run with the land, "because we find that Texas still requires horizontal privity and that it was not satisfied in this case." The court rejected the argument that horizontal privity of estate is established through separate agreements conveying a pipeline easement and a separate parcel of land. The Second Circuit also rejected the argument that the agreements created equitable servitudes amounting to a property interest that could not be rejected under section 365 because there was no benefit to any real property owned by the non-debtor counterparty.

The decision was unwelcome news to gas gathering and handling agreement counterparties. As discussed below, however, Sabine Oil was not the last word on treatment of gas gathering and handling agreements in bankruptcy.

Badlands Energy

Prior to filing for chapter 11 protection in August 2017, the predecessors of Colorado-based Badlands Production Company and an affiliate (collectively, "Badlands") agreed to sell gas gathering and saltwater disposal systems in Utah to the predecessor of Monarch Midstream, LLC (collectively, "Monarch") under an asset purchase agreement. The parties also entered into a gas gathering and processing agreement ("GPA") and a saltwater disposal agreement ("SWDA" and, collectively, "agreements").

The GPA expressly provided that "[t]he dedication and commitment made by [Badlands] under this Agreement is a covenant running with the land." The GPA defined the "Dedicated Reserves" to mean "the interest of [Badlands] in all Gas reserves in and under, and all Gas owned by [Badlands] and produced or delivered from (i) the Leases and (ii) other lands within the [covered territory] … and all interests in any wells, whether now existing or drilled hereafter, on, or completed on, lands covered by a Lease or within the [covered territory]." The SWDA similarly provided that "[t]he commitment made by [Badlands] hereunder is a covenant running with the land." Both agreements provided that they were governed by Colorado law, even though the oil and gas assets were located in Utah.

After filing for bankruptcy, Badlands sought court authority to sell its oil and gas assets free and clear of liens, claims, encumbrances, and interests under sections 363(b) and 363(f) of the Bankruptcy Code. The sale agreement with the proposed purchaser—Wapiti Utah, L.L.C. ("Wapiti")—provided that Wapiti would not assume the agreements or any other contracts with Monarch as part of the sale. Monarch responded by filing an adversary proceeding seeking a declaratory judgment that Wapiti could not purchase the assets free and clear of the agreements because the agreements were covenants that ran with the land.

In its ruling, the bankruptcy court initially explained that, although the agreements contained a Colorado choice of law provision, Utah law governs whether the agreements constitute real covenants because the oil and gas assets are located in Utah (citing Butner v. United States, 440 U.S. 48, 55 (1979); Clarke v. Clarke, 178 U.S. 186, 191 (1900)).

Under Utah law, the court wrote, "a covenant that 'runs with the land' binds successive owners of the burdened or benefited land" (quoting Stern v. Metro. Water Dist. of Salt Lake & Sandy, 274 P.3d 935, 945 (Utah 2012)). Utah law provides further that a covenant runs with the land if: (i) the covenant "touches and concerns" the land; (ii) the parties intend the covenant to run with the land; (iii) there is "privity of estate"; and (iv) the covenant is in writing. See Flying Diamond Oil Corp. v. Newton Sheep Co., 776 P.2d 618, 622 (Utah 1989).

The bankruptcy court focused on the same elements of the test addressed by the courts in Sabine—the "touch and concern" and "privity of estate" requirements. However, unlike in Sabine, the Badlands Energy bankruptcy court found that, under Utah law, the agreements created real covenants because they "touched and concerned" the land and satisfied the requirements of vertical, mutual, and horizontal privity.

Citing Flying Diamond, the bankruptcy court explained that, "to touch and concern the land, a covenant must bear upon the use and enjoyment of the land and be of the kind that the owner of an estate or interest in land may make because of his ownership right." According to the court, the "broad test" for this requirement does not require a "physical effect upon the land." Instead, the court must determine whether a covenant "enhances the land's value [on the benefit side], and for the burden side, whether it diminishes the land's value."

The bankruptcy court found that the agreements "touched and concerned" the land under Utah law because Badlands' interests in the associated oil and gas leases were "diminished" by the agreements, and the burdens imposed by the agreements consequently impacted Badlands' use and enjoyment of its interests in the leases. In addition, as in Flying Diamond, both of the agreements provided that any successors and assigns were bound by their terms.

The bankruptcy court distinguished Sabine. It explained that Sabine involved a "very different dedication"—the agreements in Sabine concerned personal property rather than real property under Texas law because they covered only minerals extracted from the ground (the dedication was for "all [gas and condensate] produced and saved … from wells … located within the dedicated area"). By contrast, the court noted, the dedicated reserves in the GPA were interests in real property under Utah law, not personalty, because they included "non-extracted minerals," even though one of the objectives of the agreements was the gathering, processing, and disposal of "produced gas" and water, which are not real property interests under Utah law.

The court rejected Wapiti's argument that there must be a conveyance of an interest in real property for a covenant to satisfy the "touch and concern" requirement. According to the bankruptcy court, although the Sabine court held that this is a requirement under Texas law, Flying Diamond indicates that it is not under Utah law. Rather, the "touch and concern" requirement was satisfied in Badlands Energy because, under the agreements, the dedicated interest in the oil and gas reserves, leases, and all other property limited Badlands' right to possess, develop, and dispose of the minerals and salt water.

Addressing the "privity of estate" requirement, the bankruptcy court ruled that:

• "Vertical privity" existed because Wapiti was the successor to the estate of the original entity burdened by the covenant;
• Although the Utah Supreme Court has not addressed whether "mutual privity" is required, such privity existed in this case due to the simultaneous ownership interests of Badlands and Monarch in the oil and gas leases subject to the agreements; and
• "Horizontal privity" existed because, unlike in Sabine, the covenants in the agreements burdened Badlands' real property interests in connection with a simultaneous conveyance of real property interests to Monarch and because floating easements across the oil and gas leases and lands granted to Monarch in the GPA "are conveyances that simultaneously burden the same real property interest."

The bankruptcy court accordingly ruled that "the Agreements are part of the bundle of sticks Wapiti Utah acquired when it purchased the [oil and gas assets], and they are not subject to elimination utilizing Section 363(f)."

Alta Mesa

Alta Mesa Holdings, LP and an affiliate (collectively, "AM") are Texas limited partnerships doing business in Oklahoma as an upstream oil and natural gas producer. In 2015, AM entered into oil and gas gathering agreements with Kingfisher Midstream, LLC ("Kingfisher") to construct a gathering system linking AM's Oklahoma wells to central collection points in exchange for fixed gathering fees. Kingfisher and AM are commonly owned.

Under the agreements, AM conveyed to Kingfisher "any easement or rights-of-way for purposes of constructing, owning, operating, repairing, replacing and maintaining any portion" of the gathering system. The agreements also dedicated to Kingfisher "all Interests within the Dedicated Area" and required AM to deliver to Kingfisher "all Committed [oil and gas] produced." In addition, the agreements provided that they were "covenants running with the land" that the parties were obligated to record, and that any assignee or transferee was bound by their terms. Finally, as amended, the agreements gave Kingfisher the exclusive right to transport oil and gas produced from AM's wells.

After AM filed for chapter 11 protection in 2019, it commenced an adversary proceeding seeking a declaratory judgment that it could reject the gathering agreements, under which AM claimed it was obligated to pay excessive fees to Kingfisher due to the fiduciary misconduct of their common owner. Kingfisher moved for summary judgment, contending that the agreements could not be rejected because they were real property covenants rather than executory contracts.

The bankruptcy court granted Kingfisher's motion for summary judgment. Under governing Oklahoma law, the court explained, a real property covenant is created if: (i) the covenant touches and concerns real property; (ii) privity of estate exists; and (iii) the original parties to the covenant intended to bind successors (citing Beattie v. State ex rel. Grand River Dam Auth., 41 P.3d 377, 386 (Okla. 2002)). The court also noted that, under Oklahoma law, oil and gas are considered real property while they remain in the ground but become personalty once extracted.

Next, the bankruptcy court noted, although the Oklahoma Supreme Court has not determined whether oil and gas gathering agreements form real property covenants, the U.S. Court of Appeals for the Eighth Circuit has applied Oklahoma law in ruling that a gas purchase contract created a real property interest in an oil and gas lease. See Sw. Pipe Line Co. v. Empire Nat. Gas Co., 33 F.2d 248 (8th Cir. 1929). However, the Eighth Circuit did not state whether that interest amounted to a covenant running with the land.

Addressing Sabine and Badlands Energy, the Alta Mesa court noted that the elements necessary to form real property covenants under Texas, Utah, and Oklahoma law are largely indistinguishable. However, the Alta Mesa court wrote, to the extent that the pronouncements in Sabine were intended to be generalized, rather than limited to the facts of the case, "this Court must reject them."

The bankruptcy court concluded that the gathering agreements with Kingfisher satisfied all three elements required to form real property covenants under Oklahoma law. First, the court determined that the gathering agreements touched and concerned the AM oil and gas leases because the benefits and burdens of the covenants were "logically connected to [AM's] leasehold interests in real property."

Among other things, the court found that: (i) the surface easement limited AM's possessory interest in its leases by restricting AM's use of the surface land for drilling or exploration and by restricting AM's use of its reserves; (ii) by nearly dedicating all of its production to Kingfisher, AM burdened its interest under the oil and gas leases because it restricted AM's right to seek a different gatherer or build its own gathering system; and (iii) the fixed fee arrangement burdened the leases because the oil and gas produced by AM would be less profitable than it might be on more favorable terms or in a less depressed oil and gas market.

On this point, the bankruptcy court distinguished Sabine, where the court found that the surface easement did not touch and concern the mineral estate under Texas law because the surface and mineral estates were separate and the dedication was limited to post-extraction hydrocarbons. In this case, the Alta Mesa court wrote, "in the context of an oil and gas lease, the surface easement is integral to the lessee's ability to realize the value of its mineral reserves."

Second, the bankruptcy court found that privity of estate existed between AM and Kingfisher because: (i) the parties, which were the original signatories to the gathering agreements, did not dispute that vertical privity existed; and (ii) even if horizontal privity is required to create a real property covenant under Oklahoma law, the conveyance of a surface easement to Kingfisher to construct and maintain a gathering system was adequate to show the conveyance of an estate ("a property interest in [AM's] leasehold estates") necessary for a finding of horizontal privity.

On this point, the bankruptcy court once again distinguished Sabine, where the court "centered its analysis around fee mineral estates, not oil and gas leaseholds," under a surface easement is a "crucial component."

Third, the Alta Mesa court found that, considering the express language of the gathering agreements and other evidence of the parties' course of dealing, AM and Kingfisher intended for the covenant to run with the land.

The bankruptcy court accordingly ruled that the gathering agreements were not executory and could not be rejected by AM.

Outlook

Sabine, Badlands Energy, and Alta Mesa illustrate that applicable nonbankruptcy law, the specific facts and circumstances of any given case, and the venue of a debtor's bankruptcy filing are crucial elements in assessing whether gas gathering and handling agreements can be rejected in bankruptcy.

A version of this article was previously published in Lexis Practice Advisor. It has been reprinted here with permission.