Energy Sector Update: More Bankruptcy Courts Join the Fray in Dispute Over Rejection of Gas Gathering Agreements

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 rulings authorizing a chapter 11 debtor to reject certain executory 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 that would continue to burden the affected property even if the agreements were rejected.

Since then, bankruptcy courts in Colorado, Texas, and Delaware have joined the fray in the debate on this issue. As discussed in more detail below, their findings and conclusions on the real covenants question varied due to the facts of the cases and the applicable state law. However, in a notable development, some of these courts have ruled that the answer to this question does not matter for the purpose of determining whether a gathering agreement can be rejected in bankruptcy. Instead, those courts have held that a gathering agreement can be rejected (or sold free and clear) even if it creates a covenant that runs with the land under applicable law.

Sabine Oil

In Sabine Oil, the debtors filed a motion to reject three gas gathering and handling agreements governed by Texas law. The counterparties argued that the relevant hydrocarbon dedications in the agreements were covenants running with the land that would survive rejection. Under Texas law, at least four conditions must be met for a covenant to run with the land: (i) it "touches and concerns the land"; (ii) it relates to a thing in existence or specifically binds the parties and their assigns; (iii) the covenant is intended by the original parties to run with the land; and (iv) the successor to the burden has notice of the covenant. A covenant "touches and concerns" land if it: (i) reduces the promisor's legal relations or increases the promisee's legal relations with respect to the land; or (ii) affects the nature, quality, or value of the subject of the covenant or affects the mode of enjoying it. Some courts have held that a fifth requirement—"horizontal privity of estate," meaning a mutual or successive relationship to the same rights in property—is also required. The bankruptcy court approved rejection of the gathering agreement over the counterparties' objections.

On appeal, the Second Circuit ultimately concluded that it need not determine whether the gas gathering agreements at issue touched and concerned 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 counterparties.

Badlands Energy

After filing for chapter 11 in 2017 in Colorado, Badlands Production Company ("Badlands") sought court authority to sell its oil and gas assets, including a gas gathering and processing agreement and a saltwater disposal agreement (collectively, "agreements") with Monarch Midstream, LLC ("Monarch"), 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.

The U.S. Bankruptcy Court for the District of Colorado ruled in favor of Monarch. Initially, the court noted that, despite a Colorado choice of law provision, Utah law governed whether the agreements constituted real covenants because the oil and gas assets were located in Utah. Under Utah law, 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 Monarch Midstream, LLC v. Badlands Production Company (In re Badlands Energy Utah LLC), 608 B.R. 854 (Bankr. D. Colo. 2019).

The bankruptcy court found that the agreements "touched and concerned" the land under Utah law because Badlands's interests in the associated oil and gas leases were "diminished" by the agreements, and the burdens imposed by the agreements consequently impacted Badlands's use and enjoyment of its interests in the leases. In addition, both of the agreements expressly provided that the covered dedications and commitments were covenants running with the land and 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 agreements 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 further concluded that vertical, mutual and horizontal privity of estate existed because: (i) Wapiti was the successor to the estate of the original entity burdened by the covenant; (ii) Badlands and Monarch held simultaneous ownership interests in the covered oil and gas leases; and (iii) the covenants in the agreements burdened Badlands' real property interests in connection with a simultaneous conveyance of real property interests to Monarch.

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

Alta Mesa

In 2015, upstream oil and gas producer Alta Mesa Holdings, LP ("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. 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. 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.

After filing for chapter 11 protection in 2019 in Texas, AM sought a declaratory judgment that it could reject the gathering agreements. Kingfisher argued that the agreements could not be rejected because they were real property covenants rather than executory contracts.

Chief Judge Marvin Isgur of the U.S. Bankruptcy Court for the Southern District of Texas ruled in Kingfisher's favor, concluding that the agreements satisfied all of the requirements under Oklahoma law for the creation of real property covenants. See Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Resources, Inc.), 613 B.R. 90 (Bankr. S.D. Tex. 2019). First, 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, Judge Isgur 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 dedicating nearly 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.

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.

Extraction Oil & Gas

Extraction Oil & Gas, Inc. ("EOG") is a Colorado-based oil and gas producer. Prior to filing for chapter 11 protection on June 14, 2020, in Delaware, it entered into transportation service agreements ("Agreements") with various midstream counterparties, including Elevation Midstream, LLC, Platte River Midstream, LLC ("Platte"), DJ South Gathering, LLC, Grand Mesa Pipeline, LLC ("Mesa" and, collectively, the "counterparties"), to transport hydrocarbons directly to market in Oklahoma and dispose of wastewater generated by its operations. In connection with a proposed bankruptcy sale of substantially all of its assets, EOG sought court authority to reject the Agreements, and commenced adversary proceedings against the counterparties seeking declaratory judgments that the Agreements did not create covenants running with the land under Colorado law. EOG moved for summary judgment in each of the proceedings.

Chief Judge Christopher S. Sontchi of the U.S. Bankruptcy Court for the District of Delaware granted summary judgment to EOG. Initially, he noted that Colorado law "disfavors the creation of covenants running with the land as a derogation of the common law's preference for the free alienability of land." To create a covenant running with the land under Colorado law, he explained: (i) the parties must intend to create a covenant running with the land; (ii) the covenant must touch and concern the land with which it runs; and (iii) there must be privity of estate between the original covenanting parties at the time of the covenant's creation. See Extraction Oil & Gas, Inc. v. Elevation Midstream, LLC (In re Extraction Oil & Gas, Inc.), Adv. Proc. No. 20-50839 (CSS) (Bankr. D. Del. Oct. 14, 2020); Extraction Oil & Gas, Inc. v. Platte River Midstream, LLC and DJ South Gathering, LLC (In re Extraction Oil & Gas, Inc.), 2020 WL 6694354 (Bankr. D. Del. Oct. 14, 2020); Extraction Oil & Gas, Inc. v. Grand Mesa Pipeline, LLC (In re Extraction Oil & Gas, Inc.), Adv. Proc. No. 20-50816 (CSS) (Bankr. D. Del. Oct. 14, 2020).

According to Judge Sontchi, although certain of the Agreements manifested an intent to create covenants running with the land, the "central issue" before the court was whether the dedications in the Agreements actually "touched and concerned" the relevant land. The court found that they did not. After examining the gathering services provided by the counterparties under the Agreements and the related dedications, the court concluded that the commodity produced by EOG and gathered under the Agreements did not constitute a real property interest in Extraction's mineral estate. Instead, the court found, it concerned only personal property and did not affect the physical use of real property or even closely relate to real property.

In so ruling, the court distanced itself from the courts in Alta Mesa and Badlands, which concluded that a gathering system can touch and concern land because it enhances the value of the relevant mineral interest. Instead, the Extraction court agreed with Sabine in finding that the primary effect of a dedication is on the use and enjoyment of personal property—i.e., the commodity produced—rather than real property.

In addition, the Extraction court determined that the dedications in the Agreements did not run with the land due to the absence of horizontal privity. In particular, the court found that the dedications were not created in conjunction with the conveyance of an independent real property interest in the relevant mineral estate. According to the court, even though EOG conveyed easements and other property rights to the counterparties, the rights were interests in a severed surface estate rather than EOG's mineral estates.

The bankruptcy court ultimately concluded that the Agreements did not satisfy Colorado's requirements for creating covenants running with the land and were therefore executory contracts that could be rejected by EOG in bankruptcy.

The court denied Mesa's request that it abstain from resolving the dispute in favor of a Colorado state court. It also denied Mesa's motion for relief from the automatic stay to commence a proceeding before the Federal Energy Regulatory Commission ("FERC") to determine whether rejection of the Agreements is consistent with the public interest and the Interstate Commerce Act. Both Mesa and FERC appealed that ruling.

On October 28, 2020, Mesa and the other counterparties appealed the bankruptcy court's decision regarding EOG's ability to reject the Agreements.

On November 2, 2020, the bankruptcy court granted EOG's motion to reject the Agreements with Mesa and Platte nunc pro tunc to the bankruptcy petition date. See In re Extraction Oil & Gas, Inc., 2020 WL 6389252 (Bankr. D. Del. Nov. 2, 2020). Notably, in authorizing rejection, the court concluded that: (i) even if the agreements created covenants that run with the land (which they did not), they could be rejected and "any covenant running with the land still exists (as the contract still exists), but it is unenforceable against [EOG] and [its] assigns after the Rejection Counterparties' claims are satisfied as part of the reorganization process"; (ii) although "heightened scrutiny" above and beyond the "business judgment" test normally applied to rejection was unwarranted, after balancing the equities and considering the public interest, rejection was appropriate; (iii) any determination by FERC concerning the proposed rejection was unnecessary because "payment of claims through the plan and confirmation process is [not] an abrogation of FERC approved rates"; and (iv) there is "no prohibition on or limitation against rejecting a FERC approved contract" under section 365(a) of the Bankruptcy Code. FERC appealed the ruling.

Chesapeake Energy

Chesapeake Energy Corp. and certain affiliates (collectively, "Chesapeake") filed for chapter 11 protection in June 2020 in Texas. In 2016, Chesapeake entered into a series of related agreements (collectively, "agreement") with ETC Texas Pipeline, Ltd. ("ETC") to sell natural gas produced from Chesapeake's wells. The dedication under the agreement stated that it "is a covenant running with the land." In the event of a breach, the agreement provided that the "sole and exclusive remedy" of the parties was recovery of monetary damages. The agreement further provided that the agreement and all transactions contemplated by it "constitute 'forward contracts' and/or 'swap agreements' and [that] this Agreement constitutes a 'master netting agreement' as defined in section 101 of the Bankruptcy Code." In addition, it stated that the parties "are entitled to the rights under, and protections afforded by, sections 362, 546, 553, 556, 560, 561 and 562 of the Bankruptcy Code."

In bankruptcy, Chesapeake filed a motion to reject the agreement. ETC opposed the motion, arguing that the agreement was not executory because it contained a covenant running with the land under Texas law. Chesapeake countered that the agreement did not create such a covenant and that, even if it did, the existence of such a covenant did not prevent Chesapeake from rejecting it.

Judge David R. Jones of the U.S. Bankruptcy Court for the Southern District of Texas ruled in favor of Chesapeake. Initially, he noted that ETC cited no authority for the proposition that the agreement could not be an executory contract because it contained a covenant running with the land. See In re Chesapeake Energy Corp., 2020 WL 6325535 (Bankr. S.D. Tex. Oct. 28, 2020). According to Judge Jones, ETC's reliance on Alta Mesa and Badlands was misplaced. Although the courts in those cases held that gathering agreements containing covenants running with the land could not be rejected, he agreed with those decisions because "[i]n each case, the debtors sought to remove the entirety of the burden from their real property interests." Moreover, Judge Jones noted, no party asserted in those cases that the agreements could be rejected "notwithstanding that a real property covenant would continue to burden the land post-rejection." However, the court determined that further analysis of this issue was moot in light of its conclusion that the agreement with ETC did not contain a covenant running with the land.

In this regard, among other things, the bankruptcy court found that:

• Despite the express language of the agreement, the parties did not intend for the obligation to sell certain quantities of gas to run with the land. The exclusive remedy for breach was an award of monetary damages, "a remedy … inherently personal in nature and unrelated to any real property interest held by Chesapeake." This, together with the acknowledgment that the agreement was a two-party forward contract, "suggest[s] that the added language that 'the parties intended for the obligation to run with the land' was an ill-conceived attempt to portray the [agreement] as a horse of a different color."
• The dedication in the agreement did not "touch and concern" the land because Chesapeake did not assign a specific interest in the gas leases themselves, but only the gas produced at the wellhead, which is personal property under Texas law.

Finally, the bankruptcy court rejected ETC's argument that the agreement could not be rejected because it created an equitable servitude on Chesapeake's property interests. This argument, the court wrote, does not apply to the analysis of whether an alleged executory contract can be rejected and, "if applicable at all, would be raised in response to [Chesapeake's] request for authority to sell its property interests under 11 U.S.C. § 363."

The court accordingly granted Chesapeake's motion to reject the agreement. The parties agreed to certify a direct appeal of the ruling to the Fifth Circuit on November 20, 2020.

Southland

Prior to filing for chapter 11 protection in January 2020 in Delaware, upstream energy company Southland Royalty Company LLC ("Southland") entered into two gas gathering agreements with midstream service provider Wamsutter LLC ("Wamsutter") pertaining to Southland's assets in Wyoming. In bankruptcy, Southland asked the bankruptcy court to determine whether, among other things, it could either sell its assets free and clear of any interest asserted by Wamsutter in the agreements or reject the agreements. Wamsutter argued that neither a free and clear sale nor rejection was permitted because the agreements contained covenants that ran with the land or equitable servitudes under Wyoming law.

Judge Karen B. Owens of the U.S. Bankruptcy Court for the District of Delaware ruled that the agreements did not contain covenants that ran with the land or equitable servitudes and that even if they did, Southland could either reject the agreements or sell its assets free and clear of any associated covenants. See Southland Royalty Company LLC, v. Wamsutter LLC (In re Southland Royalty Company LLC), 2020 WL 6685502 (Bankr. D. Del. Nov. 13, 2020). After examining the agreements, Wyoming law, and recent court rulings on the issues, Judge Owens concluded, "for many of the same reasons set forth by the courts in Sabine and Extraction," that the agreements contained no real covenants but were service contracts relating to Southland's personal property.

Nowhere in one of the agreements, she wrote, "do the parties unambiguously express an intention for all promises therein to run with the land." Moreover, although such an intention was expressed in the second gas gathering agreement, the dedication in that agreement did not "touch and concern the land" because it did "not alter Southland's legal rights in its real property" but merely affected produced gas, which is personal property under Wyoming law. Judge Owens also determined that privity of estate did not exist with respect to the second agreement because "the estate burdened by the various easements and other rights of access—Southland's surface lands—is not the same estate allegedly burdened by the [dedication in the agreement]—Southland's mineral interests." Because the dedication in the second agreement did not touch and concern the land, Judge Owens also ruled that it did not create an equitable servitude.

Judge Owens held that, even if the agreements had created covenants running with the land, they could be rejected. Agreeing with the court in Extraction on this point, she wrote that "Wamsutter will then have a prepetition claim against the estate for damages resulting from Southland's nonperformance."

Finally, Judge Owens ruled that, despite the existence of covenants running with the land, Southland could sell its assets free and clear of any interest asserted by Wamsutter under section 363(f) of the Bankruptcy Code because: (i) Wyoming law permitted a free and clear sale (by means of foreclosure); and (ii) Wamsutter could be compelled to accept a money satisfaction of its interest in a legal or equitable proceeding because both legal and equitable remedies are available under Wyoming law in covenant enforcement actions.

Outlook

Considered together, these rulings 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. Southland, Extraction, and, to a lesser extent, Chesapeake Energy add a notable wrinkle to the analysis in indicating that, even if a gas gathering agreement does contain a covenant running with the land, the agreement can still be rejected.

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