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Nov 18, 2020

Additional Guidance for Drafting Dedications: Delaware Bankruptcy Court Rejects Southland Dedication

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ADDITIONAL GUIDANCE FOR DRAFTING DEDICATIONS: DELAWARE BANKRUPTCY COURT REJECTS SOUTHLAND DEDICATION

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 In re Sabine Oil & Gas Corp.[1] bankruptcy case held that, under Texas law, the dedication language in the applicable midstream contract did not create a covenant running with the land, but instead amounted only to a right involving personal property that could be separately assumed or rejected in a bankruptcy case.

Since the Sabine decision, there has been a developing split between bankruptcy courts regarding the enforceability of gathering agreements as real property covenants. The United States Bankruptcy Court for the District of Colorado, applying Utah law, held in In re Badlands Energy, Inc.[2] that certain midstream gas gathering and processing and saltwater disposal contracts constituted covenants running with the land.[3] The Bankruptcy Court for the Southern District of Texas reached different results in two subsequent cases, holding in In re Alta Mesa Resources, Inc.[4] that certain dedications in gathering agreements created covenants that run with the land, while reaching the opposite conclusion in In re Chesapeake Energy Corp. based on the unique language in that agreement.[5] Not to be left out, the Delaware Bankruptcy Court, in Extraction Oil and Gas, Inc.,[6] determined that certain oil, gas and water gathering agreements did not create covenants running with the land under Colorado law. Most recently, on November 13, 2020, Delaware Bankruptcy Court Judge Karen B. Owens held that a certain gas gathering agreement did not create a covenant running with the land under Wyoming law. As this landscape develops, midstream companies are being required to adjust and evolve their approach to dedications in order to get the best possible treatment in the event of a producer bankruptcy.

Background

Southland Royalty Company (“Southland”) is a Texas-based independent oil and gas exploration and production company focused on developing plays in Wyoming, Utah, Colorado and New Mexico. Prior to the recent collapse in energy prices, Southland planned to increase production of its natural gas assets in Wyoming through horizontal drilling. A midstream company affiliated with The Williams Companies (“Williams”) provided exclusive gathering services in connection with Southland’s Wyoming assets, and, in 2018, the parties entered a new gas gathering agreement under which Williams agreed to expand its pipeline system to accommodate the anticipated increase in volumes (the “Agreement”). Among other obligations, the Agreement included long-term minimum volume commitments requiring Southland to transport fixed quantities of gas on Williams’ pipelines or make deficiency payments. As is common in such midstream agreements, the contract contained a provision in which Southland “dedicated” its mineral interests within a specified geographic area to the performance of the Agreement.

In January 2020, Southland filed for chapter 11 protection and in March 2020, it filed an adversary proceeding against Williams seeking a ruling that the Agreement could be rejected under Section 365 of the Bankruptcy Code and that the properties could be sold free and clear of Williams’ dedication. Williams argued that, as a real property covenant, the Agreement could not be rejected and was thus binding on any subsequent purchaser. 

Decision

The Bankruptcy Court looked to Wyoming law to determine that the Agreement did not contain a real property covenant and that, even if it did, it could be rejected under the Bankruptcy Code and sold free and clear of Williams’ interests. Under Wyoming law, covenants running with the land must satisfy four elements: (i) the original covenant must be enforceable; (ii) the parties must intend that the covenant run with the land; (iii) the covenant must touch and concern the land; and (iv) there must be privity of estate between the parties. The first element was not at issue in the case, but the Bankruptcy Court found that the dedication failed to satisfy each of the other three elements.

Intent of the Parties

To determine the intent of the parties, the Bankruptcy Court looked to the specific language of the Agreement and also considered extensive testimony from the parties over a week-long trial. The Agreement provided: “This Dedication shall be a covenant running with the land under applicable law and binding on the respective successors and assigns of the interests of the Shipper and its Affiliates in and to the Dedicated Properties and Dedicated Gas.” The Court’s opinion focused on the absence of this language in other parts of the Agreement—including the minimum volume commitment section—and also drew on conflicting testimony about whether parties thought the MVC was intended to be a part of the dedication.

The Bankruptcy Court found that, based on the absence of evidence or witness testimony that Southland intended the entire Agreement, and not just the dedication, to run with the land, that element was not satisfied.

The Covenant Must Touch and Concern the Land

To analyze whether the covenant touched and concerned the land, the Bankruptcy Court examined whether the dedication alters Southland’s legal rights in its real property. It found that even though the Agreement “dedicates” or commits Southland’s “Dedicated Properties” and “Dedicated Gas” to Williams, the covenant merely gives Williams an exclusive right to “Gather, Process, Dehydrate and treat [Southland’s] Produced Dedicated Gas.” The Agreement does not convey any right, title or interest in the “Dedicated Gas” or “Dedicated Properties” to Williams, and it places no restrictions or any other burden on such property.

The Bankruptcy Court went on to explain that Southland is free to do what it likes with its unproduced gas reserves, including decreasing or ceasing further exploration, drilling and production, and that Williams has no right to enter the underlying area and access or control Southland’s unproduced reserves. The Dedication, in fact, does not take effect, and the property was not benefited or burdened by the dedication, until the gas is produced. At the point the gas is produced, such property is personal property and not real property.

The Bankruptcy Court therefore concluded that the Agreement does not touch and concern the real property.

Privity of Estate

The Bankruptcy Court found that under Wyoming law, privity of estate can only be created in connection with a grant of “the land sought to be charged, or an estate therein, or the equivalent thereof.” Even though Southland granted Williams a floating easement on the surface estate along with various other easements to facilitate the midstream operations, the Bankruptcy Court concluded that these did not sufficiently establish privity in the mineral estate. The Bankruptcy Court found that “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] - Southland’s mineral interests.” The Bankruptcy Court distinguished between the mineral estate (which was the estate burdened by the dedication) and the surface estate (which was unburdened). Southland’s contemporaneous grant of an interest in the surface estate (through easements) was insufficient to satisfy the privity requirement at the burdened mineral estate.

Rejection of Real Covenant

Breaking new ground, the Bankruptcy Court held that, even if the dedication under the Agreement were a real covenant, Southland could still reject the agreement as an executory contract, relieving Southland of future performance. The Bankruptcy Court explained that the relevant inquiry is whether the Agreement is an executory contract (i.e., whether there are material unperformed obligations by both Southland and Williams), including with respect to the dedication. Finding that both parties have material unperformed obligations, the Bankruptcy Court found that even if real covenants exist, nothing in the Bankruptcy Code prevents rejection of the Agreement. Going even further, the Bankruptcy Court reasoned that Williams’ exclusivity portion of the covenant would continue to burden the land in that scenario, but that the minimum volume commitment would not burden either Southland or any successor. Instead, Williams may file a prepetition claim for damages resulting from Southland’s rejection of the agreement, and Williams would be prohibited from enforcing the MVC obligations against future owners on principles of equity and fairness. The harsh reality that Williams would collect only a fraction of its damages from Southland was not relevant to the Court’s analysis.

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 if certain elements are satisfied. The Bankruptcy Court held that, even if the dedication under the Agreement were a real covenant, it could still be rejected by Southland under Section 363(f)(1) and (5) of the Bankruptcy Code. The Bankruptcy Court found that Section 363(f)(1) allows a sale free and clear of even enforceable dedications where the debtor’s RBL lenders perfected their liens before the midstream company received its dedications. Additionally, the Bankruptcy Court found that Section 363(f)(5) allows the sale free and clear because the Agreement included a payoff clause with respect to the MVC, thereby satisfying one of the scenarios where bankruptcy can compel a sale free and clear of interests.

Discussion

The Bankruptcy Court openly acknowledged that a split is developing regarding the enforceability of gathering agreements as real property covenants. Though only some of the recent holdings offer precedent for the proposition that dedication covenants run with the land under applicable state law, they all provide valuable insight into how to best craft dedication provisions that are most likely to be enforceable in bankruptcy.

While recent decisions trend against enforcing midstream agreements as covenants that run with the land, these agreements can still be improved upon to avoid the problems cited by the courts. For example, midstream companies need to search for existing liens and negotiate for non-disturbance agreements with the producer’s lenders. In addition, parties need to find creative and commercial solutions to (i) create horizontal privity at the mineral estate (e.g., a capped ORRI), (ii) satisfy the touch and concern element (e.g., limited specific performance right) and (iii) evidence intent more clearly. Midstream transporters and service providers are well advised to take note of this decision and the decisions that have come before it. They offer guidance on how to structure dedication covenants to avoid the pitfalls.

We are available to assist clients in crafting solutions that cater to applicable state law and to the particulars of a specific contract.

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) (applying Texas law to find that the certain covenants within a gas gathering agreement were neither covenants running with the land nor equitable servitudes), aff’d, 567 B.R. 869 (S.D.N.Y. 2017), aff’d, 734 Fed. App’x 64 (2d Cir. 2018).
[2]  Midlands Midstream, LLC v. Badlands Energy, Inc. (In re Badlands Energy, Inc.), 608 B.R. 854, 869 (Bankr. D. Colo. 2019).
[3]  Midstream Companies Have Renewed Hope: Running-with-the-Land Oil and Gas Dedication Survives a Bankruptcy Challenge, Offering Precedent in Contra to Sabine.
[4]  Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Res., Inc.), 613 B.R. 90, 96 (Bankr. S.D. Tex. 2019).
[5]  In re Chesapeake Energy Corp., No. 20-33233, docket no. 27 (Bankr. S.D. Tex. Oct. 28, 2020).
[6]  See, e.g., Extraction Oil & Gas, Inc. v. Platte River Midstream, LLC (In re Extraction Oil & Gas, Inc.), No. 20-50833, slip op. at 19-44 (Bankr. D. Del. Oct. 14, 2020); In re Extraction Oil & Gas, No. 20-11548, 2020 WL 6389252, at *7 & n.34-36 (Bankr. D. Del. Nov. 2, 2020).

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