United States: Midstream Companies Have Renewed Hope: Running-With-The-Land Oil And Gas Dedication Survives A Bankruptcy Challenge, Offering Precedent In Contra To Sabine

The oil and gas industry in the United States is highly dependent upon an intricate set of agreements that allow oil and gas to be gathered from privately owned land. Historically, the dedication language in oil and gas gathering agreements — through which the rights to the oil or gas in specified land are dedicated — was viewed as being a covenant that ran with the land. That view was put to the test during the wave of oil and gas exploration company bankruptcies that began in 2014. A shockwave was sent through the oil and gas industry in 2016, when the United States Bankruptcy Court for the Southern District of New York in the Sabine bankruptcy case1 held that under Texas law a dedication in the applicable midstream contract did not create a covenant running with the land, but instead was a right involving personal property that could be separately assumed or rejected in a bankruptcy case. On September 30, 2019, the United States Bankruptcy Court for the District of Colorado, applying Utah law, issued a decision holding that certain midstream gas/gathering processing and saltwater disposal contracts did constitute covenants running with the land. In reaching its decision, the court in Badlands both distinguished Utah and Texas law, but also the language at issue from the dedication language in Sabine.

Background

Badlands Production Company and Badlands Energy, Inc. (together, "Badlands") was a consolidated natural gas and petroleum exploration, development and production company. On January 29, 2010, Monarch Midstream, LLC ("Monarch"), the owner/operator of natural gas gathering and processing and salt water disposal systems in Utah, executed an agreement to purchase the systems from Badlands Energy, Inc.'s predecessor. Badlands (through a predecessor in interest) and Monarch were parties to a Gas Gathering and Processing Agreement (the "GPA")2 as well as an Agreement for Disposal of Salt Water effective February 26, 2010 (the "SWDA," and together with the GPA, the "Agreements").

On August 11, 2017, Badlands and certain of its affiliates filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. On August 14, 2017, Badlands filed a sale motion, identifying Wapiti Utah, LLC as the stalking horse bidder and potential purchaser of Badlands' oil and gas assets located in the Uintah Basin, Utah (the "Riverbend Assets"). On October 26, 2017, the Bankruptcy Court authorized Badlands to sell the Riverbend Assets to Wapiti Utah free and clear of liens, claims and encumbrances pursuant to sections 363(b) and (f) of the Bankruptcy Code. The sale motion provided that Badlands would not assume and assign the Agreements to Wapiti Utah. Badlands subsequently rejected the Agreements under its confirmed chapter 11 plan.

Monarch objected to the sale, arguing that the debtors could not reject the Agreements because they constitute covenants running with the land. Prior to the sale hearing, Monarch filed an adversary proceeding requesting a declaratory judgment that the Agreements burden the Riverbend Assets as covenants running with the land and, consequently, that Wapiti Utah could not purchase the Riverbend Assets free and clear of the Agreements. Monarch also asserted a claim for breach of contract for over $1.2 million in unpaid prepetition fees under the Agreements. Wapiti Utah agreed to purchase the Riverbend Assets subject to the outcome of the adversary proceeding.

Decision

The Bankruptcy Court looked to Utah law3 to determine whether the Agreements constitute covenants that run with the land and bind successive owners of the burdened or benefitted land. Under Utah law, covenants running with the land must have four attributes: (i) they must "touch and concern" the land; (ii) the covenanting parties must intend the covenant to run with the land; (iii) there must be privity of estate; and (iv) the covenant must be in writing.[4] The Bankruptcy Court found that because both Agreements were in writing, the fourth requirement was satisfied. The Bankruptcy Court then analyzed the remaining three requirements.

The Covenant Must Touch and Concern the Land

The Bankruptcy Court found that under Utah law, the touch-and-concern requirement mandates that the burdens and benefits created must relate to the land and the ownership of an interest in the land (as opposed to the personal duties or rights of the parties to a covenant that exist independently from the ownership of an interest in the land).5 Wapiti Utah argued that because one of the objectives was the gathering, processing and disposal of "produced gas" and water — which are not real property interests under Utah law — the Agreements do not touch and concern the land. The Bankruptcy Court did not find that argument to be persuasive, because Utah law does not require the conveyance of a real property interest for a covenant to "touch and concern," as "[t]he question is not what is conveyed by the covenant, but does the performance or nonperformance of it affect the use, value or enjoyment of the land itself."6

The Bankruptcy Code found that the underlying objective of the Agreements was to compensate for the burdens imposed by and upon the mineral and surface estates' property interest for the production of natural gas. As a result, the Bankruptcy Court concluded that the burdens imposed under the Agreements directly affected Badlands' use and enjoyment of its interests in the leases, and as a result, that both Agreements satisfied the touch-and-concern requirement.  

Intent

To determine the intent of the parties, the Bankruptcy Court looked to the specific language of the relevant contracts. The GPA provided that "[Badlands] agrees to cause any existing or future Affiliates of [Badlands] holding Dedicated Reserves to be bound by, and to execute and join as a party, this Agreement. The dedication and commitment made by [Badlands] under this Agreement is a covenant running with the land." Similarly, the SWDA provided that "[Badlands] further agrees to cause any assignee of [Badlands'] now-existing leasehold to be bound by this Agreement. The commitment made by [Badlands] hereunder is a covenant running with the land." The Bankruptcy Court found that the language of both Agreements clearly expressed the intent that the Agreements run with the land.

Wapiti Utah argued that the true intent of the parties could be discerned not just from the contract language, but by Monarch's failure to record the documents in local land offices. The Bankruptcy Court disagreed, finding that the failure to record implicates notice (which Wapiti Utah actually had), and not intent. As a result, the Bankruptcy Court found that the intent element was satisfied.

Privity

To determine whether the privity requirement was satisfied, the Bankruptcy Court cited to Flying Diamond in stating that traditionally there were three types of privity — vertical, mutual, and horizontal. Vertical privity arises when the benefitting or burdened party is a successor to the estate of the original party so benefitted or burdened, and exists in almost all covenant situations. Mutual privity exists where parties have a continuing and simultaneous interest in the same property. And finally, horizontal privity exists when the original covenanting parties create a covenant in connection with a simultaneous conveyance of an estate. The Bankruptcy Court found that all three types of privity were satisfied. Vertical privity existed by virtue of Wapiti Utah's acquisition of the Riverbend Assets. Mutual privity (which the Bankruptcy Court noted may not be required in Utah) was satisfied by virtue of the simultaneous property interests of Badlands and Monarch in the area of mutual interest. And horizontal privity was established because the covenants at issue were created in connection with a simultaneous conveyance of an estate from Badlands to Monarch.

Application of Sections 363(f)

Under section 363(f) of the Bankruptcy Code, assets can be purchased from a debtor free and clear of all liens, claims and interests relating to the assets. The Bankruptcy Court found that under Utah law, a covenant that runs with the land is an integral part of the property, and that a sale could not be made free and clear of that covenant, even under section 363(f) of the Bankruptcy Code. In reaching its decision, the Bankruptcy Court referenced its prior holding7 that restrictions that run with the land are not "interests" to which section 363 applies. Moreover, under Utah law, covenants that run with the land bind successive owners of the burdened or benefitted land. As a result, section 363(f) would permit the sale of the property free and clear of the dedication covenants in the Agreements.

Wapiti Utah is Not Liable for Badlands' Prepetition Default

Finally, the Bankruptcy Court held that Wapiti Utah is not liable for $1.2 million in unpaid fees owing to Monarch that arose during the time that Badlands operated the Riverbend Assets prepetition. The Bankruptcy Court found that assumption or rejection of a liability only occurs under section 365 of the Bankruptcy Code. The Bankruptcy Court concluded that because the Agreements are covenants that run with the land under Utah law, Wapiti Utah did not assume them under section 363 of the Bankruptcy Code, and is not responsible for curing Badlands' prepetition breach. A subsequent owner of land burdened by a real covenant (i.e., Wapiti Utah) takes subject to the covenant, but is not liable for its predecessor's (i.e., Badlands') breach. Monarch thus had to look to the bankruptcy estate for any recovery on account of its unsecured monetary claim resulting from Badlands' prior breaches.

Discussion

The Bankruptcy Court distinguished the SDNY Bankruptcy Court's holding in Sabine Oil, which involved the application of Texas law to what the Colorado Bankruptcy Court called "a very different dedication than the one made [in Badlands]." The Sabine Court held that the covenant at issue there, which purported to dedicate all gas and condensate produced and saved from wells located within the designated area, did not create a covenant running with the land because it concerned only minerals extracted from the ground. Under Texas law, severed hydrocarbons are personal property and not real property. In contrast, in Badlands the dedicated reserves in question (i.e., non-extracted minerals) were held to be interests in real property under Utah law.

The Bankruptcy Court also distinguished the SDNY Bankruptcy Court's finding in Sabine that horizontal privity was not satisfied, because there, such privity only existed with respect to property separate from the property burdened by the covenant at issue. In Badlands, the Bankruptcy Court found that the language in the Agreements did effectively burden Badlands' real property interest in the context of a simultaneous conveyance of real property interests to Monarch, both of which are located in the same area of mutual interest.

While decided with the backdrop of a different state law, Badlands arguably is precedent in contra to Sabine. Midstream transporters and service providers dealing with a distressed counterparty and the potential rejection of their agreements in a bankruptcy are well advised to take note of this decision. It offers precedent for the proposition that dedication covenants found to run with the land under applicable state law, and of such obligations being forced on a buyer under section 363 of the Bankruptcy Code.

Footnotes

1 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).

2 Wapiti Oil & Gas II, LLC ("Wapiti Oil & Gas") acquired a 50% interest in Badlands' oil and gas leases subject to the GOA.

3 Although the Agreements, by their terms, are governed by the laws of the state of Colorado, the Bankruptcy Court found that since property interests are created and defined by state law, and the Riverbend Assets are located in Utah, Utah law controls.

4 The Bankruptcy Court cited heavily to the Utah Supreme Court's decision in Flying Diamond Oil Corp. v. Newton Sheep Co., 776 P.2d 618 (Utah 1989) ("Flying Diamond") in its analysis.

5 The Bankruptcy Court relied on Flying Diamond in ruling that for a covenant to run with the land, it must be of such character that its performance or nonperformance will so affect the use, value or enjoyment of the land itself that constitutes an integral part of the property. Id. at 624 (internal quotations omitted).

6 Id.

7 In re Lonesome Pine Holdings, LLC, Case No. 10-34560 HRT (Bankr. D. Colo. Sept. 9, 2011).

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