After about a one-year hiatus, bankruptcy courts in upstream company bankruptcies are again addressing the hotly contested issue of whether midstream contracts “run with the land” and therefore are not subject to rejection as executory contracts under Section 365 of the United States Bankruptcy Code^[1]  (the “Bankruptcy Code”).  On Monday, November 2, 2020, a Delaware bankruptcy court issued a bench ruling^[2]  (the “Extraction Bench Ruling”) in In re: Extraction Oil & Gas et al.^[3]  (“Extraction”)  in which Judge Sontchi found that the debtors’ midstream contracts could be rejected in bankruptcy even if the dedications^[4]  contained in those contracts constituted covenants running with the land. Further, the court addressed the issue of whether a gathering agreement that was subject to Federal Energy Regulatory Commission  (“FERC”) tariffs, could be rejected without FERC approval.  The court ruled that while FERC had the sole authority to abrogate or modify the rates set forth in FERC jurisdictional contracts, the bankruptcy courts have sole authority under the Bankruptcy Code to determine whether a midstream contract that was an executory contract could be rejected.

The Extraction Bench Ruling comes a little more than two weeks after the same court’s initial ruling in Extraction where Judge Sontchi granted the debtors’ motion to reject the midstream contracts that were also the subject of the Extraction Bench Ruling.  In that initial ruling he determined that these midstream contracts did not run with the land in spite of those midstream contracts containing express dedication language. The Extraction Bench Ruling also comes shortly after last Wednesday’s (October 28, 2020) ruling in ETC Texas Pipeline, Ltd. v. Chesapeake Energy Corporation, et al.^[5]  (“Chesapeake”) in which a Houston bankruptcy court granted the debtor’s motion to reject a gas purchase agreement despite express language purporting to create a covenant running with the land.  

Key Takeaways

(1) Extraction and Chesapeake illustrate that judges are considering, and, at least in the case of the Extraction Bench Ruling, willing, to reject midstream contracts even if they contain a valid covenant running with the land so long as they are executory (i.e., they include material obligations yet to be performed such as future minimum volume commitments).

(2) At least according to Chesapeake, contractual language matters with regards to whether dedications run with the land. Each situation is highly fact specific and, as shown by the Extraction Bench Ruling, there is no “silver bullet” language that will create a running covenant in every jurisdiction. The consequences of the contract language in each instance could be significant and the dedication language should be carefully reviewed, and then tailored, as much as possible, to each factual situation and the law of the applicable state.

(3) The Extraction Bench Ruling, on the one hand, and In re Alta Mesa Resources, Inc.^[6]  (“Alta Mesa”) and its progeny, on the other hand, present apparently contrasting analyses as to whether a covenant running with the land inoculates a midstream agreement against rejection as an executory contract.

(4) Per the Chesapeake case, dedication language that dedicates all of a party’s “right, title and interest” in the underlying real property interests—as opposed to just the hydrocarbons produced therefrom—may be more likely to be upheld as a dedication that runs with the land because it creates an encumbrance on the real property interest rather than on the hydrocarbons, that is the personal property, severed from the real property interest.  However, it is not clear whether that is the only consideration under the Chesapeake analysis.

(5) There do not appear to be any simple “magic words” that are sufficient to establish privity in dedication language. Additionally, Chesapeake suggests that “forward contract” language often found in midstream agreements may be counterproductive in that such language indicates an ongoing agreement to purchase personal property rather than a burden on real property that can be passed to a successor in interest.

(6) Midstream contracts that limit equitable remedies like specific performance and injunctive relief, but instead provide for liquidated damages or easily ascertainable contractual damages, may indicate that the parties did not intend for the contract to run with the land because such contractual remedies are purely related to personal property transactions. 

Midstream Contract Bankruptcy Litigation Background^[7] 

Many midstream companies rely on dedications of oil and gas leases, wells and the production therefrom as a form of credit support from producers to assure the future cash flows necessary to recover the significant capital expenditures incurred by such midstream companies to construct and maintain the gathering, transportation and processing assets built for such producers.

In 2016, the viability of such dedications was called into question when a New York bankruptcy court in In re Sabine Oil & Gas Corp.^[8]  (“Sabine”), held that, under Texas law, the “dedications” that were before the court failed to qualify as covenants running with the land. Thus, the court found that the gathering agreements secured by such dedications were simply executory contracts that could be rejected by the bankrupt producer under section 365 of the Bankruptcy Code. 

Last year, in Alta Mesa, a Houston bankruptcy court, interpreting Oklahoma real property law (which it found to be similar to Texas law in this regard) reached an opposite result.  That court held that a midstream service provider's rights under its agreements to gather and transport production in the Oklahoma STACK formation could not be rejected in bankruptcy because those rights were covenants running with the land under Oklahoma law. Similarly, a Colorado bankruptcy court interpreting Utah real property law in Monarch Midstream, LLC v. Badlands Production Co.^[9]  (“Badlands”) found that a producer had dedicated an interest in its real property to the performance of a gas gathering agreement by dedicating “reserves” in the ground. 

More recently, two bankruptcy cases distinguished Alta Mesa and Badlands by finding that a dedication constituted a commitment of personal property rather than a burden on real property. In Extraction, a Delaware bankruptcy court interpreting Colorado real property law determined that a suite of midstream contracts failed to “touch and concern” the land. 

Last Wednesday, in Chesapeake, the bankruptcy court for the Southern District of Texas applied the rule set forth in Alta Mesa and allowed the debtors to reject a midstream contract under Texas real property law. Despite express language attempting to create a covenant running with the land, the court found that the parties lacked actual intent to establish a burden on real property. The court also determined that the contract did not “touch and concern” a real property interest and that the parties lacked privity of estate.

In both of these decisions, the bankruptcy judges discussed in dicta, but did not decide, whether a midstream contract that included covenants running with the land (e.g., a valid dedication clause), could be rejected anyway as an executory contract under Section 365 of the Bankruptcy Code. Then on November 2, Judge Sontchi followed up his ruling in Extraction, with the Extraction Bench Ruling, in which he held that, even if a dedication constituted a covenant running with the land, a midstream contract was an executory contract and subject to rejection so long as there were material obligations that had not yet been performed, which is true of essentially all gathering agreements. 

The November 2 Decision: In re Extraction Oil & Gas

In the Extraction Bench Ruling, the bankruptcy court took up the issue of whether four transportation service agreements (the “TSAs”) could be rejected as executory contracts while the issue of the existence of covenants running with the land was pending appeal. In a previous holding on summary judgment, the court had determined that the TSAs did not contain covenants running with the land. However, in the Extraction Bench Ruling, the court held that, regardless of the outcome of the appeal, the fact that the alleged covenants running with the land called for future performance made them executory contracts that could be rejected.

The court reasoned that covenants running with the land are “fundamentally creatures of contract” that impose a burden on the owner of land rather than on the land itself. Thus, a midstream agreement can be an executory contract even if it contains such covenants. To support its reasoning, the court cited both Colorado case law^[10] and federal bankruptcy law^[11], making a broad argument that a party’s future performance obligations are inherently subject to rejection, regardless of whether those obligations stem from real property covenants. 

Furthermore, the fact that the TSAs provided for money damages in lieu of specific performance in the event of a breach further supported the court’s determination that the covenants were contractual in nature rather than burdens on real property. Upon rejection, consistent with the treatment provided by the Bankruptcy Code, the midstream companies would be entitled to an unsecured claim for money damages.

Addressing the effect of rejection on the debtor and its property, the court noted that once the midstream companies had been granted unsecured claims for damages as part of the bankruptcy process, such claims (although not paid in full) would nevertheless be deemed “fully satisfied and incapable of subsequent enforcement against the Debtors and its assigns through either privity of contract or privity of estate.”  As such, “the Rejection Counterparties cannot seek duplicative recovery for the breached covenants by using privity of estate as justification for suing successors to the Debtors’ real property interests for a breach of the fully satisfied covenants.”^[12]  

The Extraction Bench Ruling stands in contrast to Alta Mesa, in which the case turned on whether gas dedications constituted covenants running with the land. Having found that the requisite elements of a covenant running with the land under applicable state law were satisfied, the court held that the gathering agreements were not executory contracts susceptible of rejection.

Some of the midstream companies in Extraction had also argued that the TSAs were subject to FERC jurisdiction and, therefore, FERC must hold a proceeding to determine whether the court could reject the TSAs. In the Extraction Bench Ruling, the court rejected this argument because FERC and the bankruptcy courts had “parallel exclusive jurisdiction” over the separate issues of rates, on the one hand, and rejection of the applicable agreement, on the other. Accordingly, the court concluded that midstream contracts could be rejected without affecting the FERC tariffs and that, while FERC had the sole authority to abrogate or modify the rates set forth in FERC jurisdictional contracts, the bankruptcy courts have sole authority under the Bankruptcy Code to determine whether a midstream contract that was an executory contract that could be rejected.

The October 28th Decision: In re Chesapeake Energy Corporation

In February 2016, ETC and Chesapeake entered into a Base Contract for the Sale and Purchase of Natural Gas (commonly known as a NAESB form), a Transaction Confirmation that modified certain terms of the Base Contract, and a recorded Memorandum (collectively, the “Agreement”).  In the Transaction Confirmation, Chesapeake (a) agreed to “tender all of [Chesapeake’s] Gas to [ETC] at the Delivery Point(s)” and (b) dedicated “all of the Gas owned or controlled by [Chesapeake] or an Affiliate of [Chesapeake] that is produced from the oil and gas leases described in Exhibit ‘C’”. The Transaction Confirmation went on to state that the dedication was “a covenant running with the land” and required Buyer to file a Memorandum of the Agreement in the real property records. The Transaction Confirmation also explicitly provided that the Agreement was a “forward contract” under the Bankruptcy Code. Finally, the parties agreed that the sole and exclusive remedy for Chesapeake’s failure to deliver gas was for Chesapeake to pay liquidated damages calculated pursuant to the terms of the Transaction Confirmation.

As described in more detail below, the court found that the contract failed to show three of the requisite elements of a covenant running with the land, namely, (1) intent to create a covenant running with the land, (2) a covenant that “touches and concerns” Chesapeake’s real property and (3) privity of estate.

1. Intent that Obligation Run with the Land

The court noted that, generally, express intent for a covenant to run with the land is sufficient.  However, in Chesapeake, Judge Jones stated that further analysis was necessary because, as with the TSAs discussed in the Extraction Bench Ruling, the Agreement explicitly excluded specific performance, injunctive relief and other equitable remedies. Instead, the Agreement provided for liquidated damages as the exclusive remedy for a breach of the obligation to deliver or purchase a specified quantity of gas. The court found that this express economic provision, which is personal in nature and unrelated to any real property interest held by Chesapeake, better expressed the parties’ true intent and there was no intent to create an interest running with the land.

2. “Touch and Concern”

The court found that the Agreement’s gas dedication was not a specific interest in Chesapeake’s oil and gas leases, but rather was a dedication of produced gas. “Produced gas” means gas severed from the mineral estate and collected at the wellhead and therefore, is considered personal property under Texas law. The court further reasoned that the parties’ agreement was for any gas produced by Chesapeake to be delivered to ETC’s receipt point. Under the Agreement, ETC had no right of access or control over Chesapeake’s real property interests, and Chesapeake’s ability to use and enjoy its real property rights remained unaffected. Therefore, the court found the language of the Agreement insufficient to create a covenant that “touches and concerns” Chesapeake’s land.  However, in a telling footnote, Judge Jones noted that had the Agreement included a dedication of all of Chesapeake’s “right, title and interest in and to the leases”, the court’s analysis might have been profoundly different.

3. Privity

To qualify as a covenant running with the land, there must be vertical privity of estate between the parties, meaning that there must be a mutual or successive relationship to the same real property right. The court found the “privity of estate” element to be lacking because the Agreement only contained a specific dedication of gas unrelated to Chesapeake’s real property rights. Moreover, the parties expressly agreed that the Agreement was a “forward contract” under the Bankruptcy Code, which is indicative of an ongoing purchase and sale of personal property—not the burdening of a real property interest. Thus, the court found that there was no vertical privity because there was no real property interest burdened by the Agreement. This determination rendered the court’s consideration of whether horizontal privity existed moot, although the court noted that horizontal privity may not be required under Texas law.

4. Executory Contracts and Covenants that Run with the Land

In dicta, Judge Jones stated that, in his view, executory contracts and covenants running with the land are not mutually exclusive. The point was moot because Judge Jones found that no covenant running with the land had been established, but his statement aligns with the Extraction Bench Ruling in signaling that midstream agreements may still be rejected even if all of the elements of a covenant running with the land are successfully established.

Ruling to Watch For

Litigation related to rejection of certain gas gathering agreements and a development agreement stemming from the bankruptcy of Sanchez Energy Corporation and its affiliates also bears watching.^[13]  This litigation is before Judge Isgur, the same judge who decided Alta Mesa, and involves disputes around dedications and covenants running with the land under Texas real property law. A decision in this case is expected soon. The outcome of this latest case will likely build on the growing case law around the enforceability of midstream agreements as covenants running with the land and whether they may be rejected notwithstanding such a determination.  

 

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