Takeaways

Midstream companies now have a roadmap for ensuring that a debtor remains subject to a midstream agreement.
To prevent rejection in bankruptcy, covenants in midstream agreements should include dedications of mineral interests or unextracted minerals to ensure that the covenants “touch and concern” real property.
The decision is likely to be heavily relied upon in the next wave of oil and gas bankruptcies.

Three and a half years after the court in Sabine[1] upended long-held expectations in the oil and gas industry by holding that that midstream gas gathering agreements did not constitute covenants running with the land, and thus could be rejected in bankruptcy, Judge Kimberley H. Tyson, of the United States Bankruptcy Court for the District of Colorado (the “Court”) issued an order[2] holding that a debtor’s midstream gas gathering/processing and saltwater disposal agreements constituted covenants running with the land that could not be rejected under Bankruptcy Code section 365. The decision is significant, not only because it is the first decision on the issue from a bankruptcy court located in a state with a significant oil and gas industry, but also because it provides a court-tested example of language to incorporate in gas gathering or other midstream agreements.

Badlands Attempts to Sell Assets Free and Clear of Midstream Agreements

Badlands Energy, Inc. and its subsidiary, Badlands Production Company (collectively, “Badlands”), were a consolidated natural gas and petroleum exploration and production company that filed for chapter 11 bankruptcy protection in August 2017. In October 2017, the Court authorized the sale of Badlands’ oil and gas assets located in the Uintah Basin, Utah (the “Assets”) to Wapiti Utah, LLC free and clear of liens, claims, encumbrances and interests pursuant to Bankruptcy Code section 363. The sale agreement for the Assets provided that contracts with Monarch Natural Gas, LLC and its affiliates (“Monarch”) would not be assumed and assigned to the purchaser. Monarch objected to the sale on the basis that the sale agreement’s failure to assign its gas gathering and processing agreement (the “GPA”) and salt water disposal agreements (the “SWDA” and together with the GPA, the “Agreements”) to the purchaser of the Assets was tantamount to an impermissible rejection of the Agreements. Monarch argued that the Agreements could not be rejected as executory contracts under Bankruptcy Code section 365 because they constituted covenants running with the land. Before the hearing to approve the sale, Monarch filed an adversary proceeding requesting a declaratory judgment that the Agreements burdened the Assets as covenants running with the land.[3] In response, the purchaser did not agree to assume the Agreements, but it did agree to purchase the Assets subject to the outcome of the declaratory judgment action. Subsequent to the sale hearing, the purchaser filed a motion for judgment on the pleadings and Monarch filed a motion for summary judgment.

The Agreements Constitute Covenants Running with the Land

Although the Agreements were governed by Colorado law, the Court applied Utah law to determine whether the Agreements constituted covenants running with the land because the Assets were located in Utah and property interests are created and determined by state law.[4] Under Utah law, covenants running with the land must have the following four attributes: (1) the covenant must touch and concern the land; (2) the covenanting parties must intend for the covenant to run with the land; (3) there must be privity of estate; and (4) the covenant must be in writing.[5]

A critical inquiry for the Court in Badlands was whether the Agreements touched and concerned the land. In Sabine, the court found that the covenants related only to extracted natural gas and condensate, which are personal property under Texas law. Because the covenants did not have a direct impact on real property, the Sabine court concluded that they did not touch and concern the land.[6] In contrast, the covenants in the GPA related to the “Dedicated Reserves,” which were defined as:

[T]he interest of Producer in all Gas reserves in and under, and all Gas owned by Producer and produced or delivered from (i) the Leases and (ii) other lands within the AMI, whether now owned or hereafter acquired, along with the processing rights, subject to certain volume exclusions as described herein, and any and all additional right, title, interest, or claim of every kind and character of Producer or its Affiliates in (x) the Leases or (y) lands within the AMI, and Gas production therefrom, and all interests in any wells, whether now existing or drilled hereafter, on, or completed on, lands covered by a Lease or within the AMI . . . .[7]

Accordingly, the Court concluded that covenants in the GPA touched and concerned the land because Badlands had dedicated its interests in its oil and gas reserves, i.e., unextracted minerals, which are real property interests under Utah law.[8]

The Court also distinguished Sabine on the horizontal privity element.[9] The Sabine court concluded there was no horizontal privity because the pipeline easement and land conveyed related only to the surface estate and horizontal privity requires the conveyance of an interest in the property that is burdened with the covenant, i.e., the mineral estate, even if the two estates may be “somewhat related.”[10] In distinguishing Sabine, the Court first noted that the covenants at issue did burden Badlands’ real property interests, i.e., the Dedicated Reserves.[11] Furthermore, in the GPA, Badlands had granted Monarch a floating easement across the leases and lands in which Badlands had an interest.[12] As such, the leases were subject to the easement and the dedication,[13] which together, were conveyances that burdened the same real property interest, thus satisfying the horizontal privity element.[14]

Conclusion

Just as Sabine provided exploration and production companies with a roadmap for avoiding a burdensome midstream agreement, Badlands similarly provides midstream companies with a roadmap for ensuring that a debtor (or a purchaser of the debtor’s assets) remains subject to a midstream agreement. The decision makes it exceedingly clear that for a covenant to run with the land, it must relate to the mineral interest itself (i.e., the minerals prior to extraction) rather than extracted minerals, at least in states where extracted minerals are personal property like Utah and Texas. The Court’s rejection of Sabine’s strict application of horizontal privity (which was the basis for the Second Circuit’s affirmance) in favor of a substance over form approach[15] may also provide midstream companies a basis for arguing that easements granted in the agreements satisfy horizontal privity, especially when considering the overall purpose of the agreements.

Finally, given the reluctance of bankruptcy courts to grant motions to transfer venue,[16] Badlands is likely to be a factor in deciding where a debtor decides to file bankruptcy or a creditor decides to commence an involuntary bankruptcy proceeding. Debtors with unfavorable midstream agreements, like Sabine and Badlands, may elect to file bankruptcy petitions only in the Southern District of New York to have the most favorable environment to reject those agreements. Conversely, midstream companies who are party to agreements with financially-distressed exploration and production companies may be more willing to file an involuntary petition in a more favorable jurisdiction, such as the District of Colorado or the Southern District of Texas,[17] to win the proverbial race to the courthouse. Rather than being the final word on the rejection of midstream agreements, Badlands demonstrates that Sabine was merely the first word in what is likely to be a series of hotly contested disputes in the next downturn in the oil and gas industry.

[1] In re Sabine Oil & Gas Corp., 547 B.R. 66, 69 (Bankr. S.D.N.Y. 2016), aff’d, 567 B.R. 869 (S.D.N.Y. 2017), aff’d, 734 F. App’x 64 (2d Cir. 2018). Pillsbury’s original client alert on Sabine see, New York Bankruptcy Court Authorizes Rejection of Midstream Contracts is available here.

[2] Monarch Midstream, LLC v. Badlands Prod. Co. (In re Badlands Energy, Inc.), No. 17-01429-KHT (Bankr. D. Colo. Sept. 30, 2019) [ECF No. 61] (hereinafter “Badlands”). Page citations refer to the ECF-filed order.

[3] Monarch also asserted a breach of contract claim of approximately $1.2 million for unpaid pre-petition fees under the Agreements that it argued should be cured by the purchaser of the Assets.

[4] Badlands at 11 (citing Butner v. United States, 440 U.S. 48, 55 (1979)).

[5] Id. at 12 (citing Flying Diamond Oil Corp. v. Newton Sheep Co., 776 P.2d 618, 623, 629 (Utah 1989)). In Sabine, the court applied Texas law and found that covenants running with the land have the following attributes, “(1) it touches and concerns the land; (2) it relates to a thing in existence or specifically binds the parties and their assigns; (3) it is intended by the original parties to run with the land; and (4) the successor to the burden has notice. Sabine, 547 B.R. at 75–76 (citation omitted). The Sabine court also noted that many Texas courts also require that the parties have horizontal privity of estate. Id. at 76.

[6] Sabine, 547 B.R. at 78.

[7] Badlands at 9 (citing GPA § 1.1).

[8] Id. Under these facts, a similar conclusion would likely be reached under Texas law.

[9] For horizontal privity to exist, “there must be ‘simultaneous existing interests’ or ‘mutual privity’ between the original parties as either landlord and tenant or grantor and grantee.” In re Energytec, Inc., 739 F.3d 215, 222 (5th Cir. 2013). Horizontal privity is a highly criticized doctrine, and it is unsettled whether it is a requirement under either Utah or Texas law. See Badlands at 18; Energytec at 222. The Second Circuit’s affirmance of Sabine on basis of horizontal privity despite its uncertain status under Texas law is a topic for another day. See In re Sabine Oil & Gas Corp., 734 F. App'x 64, 67 (2d Cir. 2018).

[10] 550 B.R. at 69.

[11] Badlands at 21.

[12] The Sabine court rejected a similar argument. Sabine, 550 B.R. at 69. (The midstream company’s “argument that the Pipeline Easement constitutes an interest in the leasehold, and therefore its creation satisfies horizontal privity of estate, is unavailing.”)

[13] The “Leases” were included in the definition of the Dedicated Reserves.

[14] Badlands at 21.

[15] See Badlands at 19.

[16] See, e.g., In re White Star Petroleum, LLC, No. 19-12145-JDL (Bankr. W.D. Okla. June 20, 2019) [ECF 143]. In White Star, an involuntary petition was filed in the Western District of Oklahoma on May 24, 2019, and the debtor filed a voluntary petition in Delaware on May 28, 2019. Although the debtor filed several motions seeking to have the involuntary case dismissed or transferred to Delaware, after it became clear that those efforts would fail, the debtor eventually relented and consented to the case proceeding in the Western District of Oklahoma.

[17] On December 20, 2019, Judge Marvin Isgur issued an opinion holding that gathering agreements governed by Oklahoma law could not be rejected. See Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Resources, Inc.), No. 19-03609 (Bankr. S.D. Tex. Dec. 20, 2019) [ECF No. 236]. The Alta Mesa opinion will be discussed in a future Client Alert.