By Megan R. Knell and William G. Bredthauer
Gathering agreements have long been a staple in the oil and gas industry. And, for decades, these agreements and the dedication provisions within them were construed as covenants running with the land. As a result, the ruling in Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC stunned both producers and midstream companies alike. In Sabine, a New York bankruptcy court interpreting Texas law found that four gathering agreements were executory contracts, not covenants running with the land, subject to rejection by the debtor. However, the recent cases of Monarch Midstream, LLC v. Badlands Production Co. and Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC indicate that Sabine may not be the final say.
Executory Contracts
Section 365(a) of the Bankruptcy Code allows a debtor to assume or reject any of its executory contracts, subject to court approval. While the Bankruptcy Code does not define an executory contract, most courts have adopted the Countryman definition: “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that failure of either to complete performance would constitute a material breach excusing the performance of the other.” Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L.R. 439, 460 (1973). However, it is worth noting that some courts have begun to move away from the Countryman definition, opting instead for an approach of working “backward from an examination of the purposes to be accomplished by rejection, and if they have already been accomplished then the contract cannot be executory.” See In re Magness, 972 F.2d 689, 693 (6th Cir. 1992); In re Cardinal Indus., Inc., 146 B.R. 720 (Bankr. S.D. Ohio 1992); In re Drexel Burnham Lambert Group, Inc., 138 B.R. 703, 708 n.24 (Bankr. S.D.N.Y. 1992). Typically, a bankruptcy court will approve a debtor’s motion to reject an executory contract when it is shown that the rejection of such a contract is a reasonable exercise of the debtor’s business judgment benefitting the bankruptcy estate.
Covenants Running With the Land
Although executory contracts may be rejected by a debtor, contracts with real property covenants running with the land cannot be rejected in bankruptcy. Gathering agreements frequently have dedication provisions whereby a producer dedicates production from certain leasehold estates and/or acreage to a gathering system. These dedication provisions provide midstream companies with assurances for continuous throughput, and it also provides producers with guaranteed capacity on a system to transport and process their production. And, generally speaking, both producers and gatherers have subscribed to the idea that these dedications within gathering agreements create real property covenants that run with the land, and thus the agreements would remain in effect and pass with the land and leases burdened by them despite a producer or gatherer’s bankruptcy.
Because property interests are defined by state law, the state in which the land at issue is located will govern in determining whether a covenant runs with the land. Although the factors considered by courts in determining whether a covenant runs with the land may vary from state to state, the following two factors, either alone or together with other factors, are typically included in a court’s analysis: (i) whether the covenant “touches and concerns” the land, and (2) whether there is privity of estate (vertical, horizontal, or mutual) among the parties. In Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC (In re Sabine Oil & Gas Corp); Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Resources, Inc); and Monarch Midstream, LLC v. Badlands Production Co. (In re Badlands Energy, Inc.), the courts discussed these two factors at length.
“Touches and Concerns”
In evaluating whether a covenant touched and concerned the land, Sabine, Alta Mesa, and Badlands all focused on (i) whether the covenant affected the nature or value of the land itself, and (ii) whether the promisor’s property rights in the land at issue are lessened or rendered less valuable, and the promisee’s rights in the land at issue, as owner, are rendered more valuable, because of the promise. See Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC (In re Sabine Oil & Gas Corp.), 550 B.R. 59 (Bankr. S.D.N.Y. 2016); aff’d, 567 B.R. 59 (Bankr. S.D.N.Y. 2016); aff’d 567 B.R. 869 (S.D.N.Y. 2017); aff’d 734 F.ed. Appx. 64 (2nd Cir. 2018); Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Resources, Inc.), 613 B.R. 90, 99-100 (Bankr. S.D.Tex. 2019); Monarch Midstream, LLC v. Badlands Production Co. (In re Badlands Energy, Inc.), 608 B.R. 854 (Bankr. Col. 2019).
In Sabine, the court analyzed a number of covenants within the gathering agreements to determine if the agreements “touched and concerned” the land. First, the gathering agreements contained dedications of oil and gas “produced and saved” from certain lands. Under Texas law, minerals that have been severed and produced from the land are personal property, not real property. As such, the court in Sabine held that dedications of produced oil and gas were conveyances of personal property interests, and thus the gatherers did not acquire a real property interest by virtue of the dedication provisions. Further, the gathering agreements contemplated that Sabine would deliver the produced minerals to its gatherers at certain central delivery points rather than connecting the gathering system directly to Sabine’s wells. As such, the court reasoned that the gatherers had no right to the minerals until they were produced. Lastly, the gathering agreements contained express provisions providing that Sabine reserved the right to operate its oil and gas properties without interference by the gatherers. Considering all of the above, the court in Sabine held that none of the covenants contained in the gathering agreements touched and concerned the land. The court explained that the agreements affected personal property (produced oil and gas), not minerals in place, and the dedications contained therein did not burden the mineral estate in any way. Additionally, Sabine retained control over production of the minerals, and the fact that the surface estate was burdened by the gathering system had no impact on the use or value of Sabine’s mineral estate in the land at issue.
Alta Mesa and Badlands used similar tests to those utilized in Sabine. However, the courts in Alta Mesa and Badlands reached entirely different conclusions from Sabine. In Sabine, the court analyzed the “touch and concern” requirement by evaluating the provisions in the gathering agreements as they related to the fee mineral estate. Alternatively, Alta Mesa analyzed the agreement’s impact on real property by evaluating its relation to the leasehold estate. Typically, an oil and gas lease creates an implied easement in favor of the lessee across the surface of the leased premises for purposes of exploring and producing the minerals thereunder. And, “although the lease acts as a grant of the minerals to the lessee, under the rule of capture, title to the underlying hydrocarbons is not acquired until they are ‘reduced to actual possession and controlled.’” Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Resources, Inc.), 613 B.R. 90, 102-103 (Bankr. S.D. Tex. 2019). At the time that the producer entered into the gathering agreements, its rights to the mineral estate included the right to explore for and produce minerals, surface easements necessary to explore for and produce minerals, and other rights necessary to obtain production. Thus, the producer’s grant of an easement across the surface estate for purposes of the gathering system restricted the producer’s rights to use the surface estate for the production of minerals. Further, the court explained that the gatherer’s construction of the gathering system increased the value of the producer’s reserves by allowing for transportation of the minerals, once produced, to market. “Just as a home without access to a road is less valuable than one facing the street, a solitary oil and gas lease is less valuable than one attached to a gathering grid.” Id. at 104. Because all of these covenants burdened and benefitted Alta Mesa’s leasehold estate, which was an in interest in the mineral estate, the court found that the gathering agreements touched and concerned the land.
In Badlands, the court examined differences between the dedication language in Sabine and the dedication language in the gathering agreements at issue. The dedication language in Badlands specifically dedicated all “of the interest of Producer in all Gas reserves in and under, and all Gas owned by Producer and produced or delived from (i) the Leases . . . .” As such, the dedication language differed from Sabine because it specifically dedicated the producer’s mineral estate, not just produced minerals, to the gathering system. Because the dedication concerned real property, not just personal property, the court held that the gathering agreements touched and concerned the land.
Privity of Estate
While privity of estate may be a factor that is considered in determining whether a covenant runs with the land, states may differ on what type of privity is required. In Sabine, the court indicated that Texas law requires horizontal privity of estate, which exists when a covenant is created simultaneously with the conveyance of an estate. Sabine discussed that horizontal privity exists when the property being conveyed is burdened with the relevant covenant. Horizontal privity is not established simply by the conveyance of an interest in property that is “distinct from (even if somewhat related to) the property burdened by the covenant. In re Sabine Oil & Gas Corporation, 550 B.R. 59, 69 (Bankr. S.D.N.Y. 2016). The Sabine gathering agreements conveyed a surface easement across the land at issue for purposes of constructing and operating the gathering system. The court did not recognize the surface easement as a property right attributable to the mineral estate. As such, the court held that the granting of a surface easement was not a conveyance of a property interest sufficient to establish horizontal privity in the producer’s mineral estate.
Contrary to Sabine, both Alta Mesa and Badlands concluded that the grant of a surface easement would be sufficient to establish horizontal privity. As discussed above, the Alta Mesa decision indicated that its analysis was focused on the producer’s leasehold estate, and an easement in the surface estate was necessarily a property right obtained by the producer under the terms of the lease for purposes of extracting minerals. As a result, the Alta Mesa court held that horizontal privity in the mineral estate existed by virtue of the grant of a surface easement together with the covenant by which the producer dedicated production to the gathering system. The Badlands court reached a similar conclusion, but it simply provided that Utah (the state law applicable in such case) contained a less stringent horizontal privity requirement than Texas. As a result, the surface easement in Badlands through the dedicated area was sufficient to establish horizontal privity.
Conclusion
Although Alta Mesa and Badlands appear to provide new precedent contrary to the holding in Sabine, the analysis and ultimate outcome in Sabine may still create some uncertainty regarding the classification of gathering agreements in bankruptcy. As a result, parties to gathering agreements should carefully craft the language used in their agreements in order to ensure that such agreements will be construed as covenants running with the land. Otherwise, they may be forced to renegotiate such agreements with unavoidable consequences.