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Bankruptcy Court Distinguishes Sabine and Holds That Midstream Agreements Are Covenants That Run with the Land

October 4, 2019

In an Order issued on September 30, 2019, the United States Bankruptcy Court for the District of Colorado, construing Utah law, held that a Gas Gathering and Processing Agreement and a Salt Water Disposal Agreement each constituted covenants that run with the land and could not be extinguished through a Section 363 bankruptcy sale.[1] In the Order, the bankruptcy court expressly distinguished the recent In re Sabine Oil & Gas Corp. decision[2] that sent shockwaves through the upstream and midstream segments of the oil and gas industry. As the first reported decision to test Sabine, this Order provides upstream and midstream companies as well as oil and gas and bankruptcy practitioners authority in contrast to Sabine that a midstream agreement which purports to burden hydrocarbon reserves or other real property (as opposed to simply burdening severed minerals) may be binding on successors in interest even after a “free and clear” bankruptcy sale.

Background

Badlands Energy, Inc., f/k/a Gasco Energy Inc., and certain related entities that owned and operated oil and gas assets in Utah (collectively, “Badlands”) filed for Chapter 11 bankruptcy in 2017. As part of the bankruptcy proceedings, Badlands auctioned and sold its oil and gas assets pursuant to Section 363 of the Bankruptcy Code. Following the auction, the bankruptcy court entered a “free and clear” sale order authorizing Badlands to sell a portion of its oil and gas assets known as the “Riverbend Assets” to Wapiti Utah, LLC (“Wapiti”).

Monarch Midstream, LLC (“Monarch”) owns and operates a gas gathering and salt water disposal system which services the Riverbend Assets. In 2010, Monarch acquired the then existing portions of this midstream infrastructure from Badlands, and in connection with the acquisition, Badlands and Monarch entered into a Gas Gathering and Processing Agreement (the “GGPA”) and an Agreement for Disposal of Salt Water (the “SWDA”). Under the terms of the GGPA, Badlands as Producer, dedicated and committed “. . . all Gas reserves in and under, and all Gas owned by Producer and produced from . . .” the leases and lands owned by Badlands within a defined geographic area (the “AMI”), whether now owned or thereafter acquired. The term of the GGPA runs until March 2025, and as to any wells connected to the gathering system, the GGPA would remain in effect so long thereafter as such wells were capable of producing in commercial quantities. Under the GGPA, Badlands was required to deliver a certain minimum volume of gas to Monarch each calendar quarter or else pay Monarch certain shortfall payments as liquidated damages.

Under the SWDA, Badlands committed to deliver all water requiring disposal from its operations within the AMI to Monarch’s disposal facilities. Both the GGPA and SWDA expressly stated that the dedication and commitment of gas or water, respectively, was a covenant running with the land.

As part of the Section 363 sale proceedings, Badlands rejected the GGPA and SWDA and therefore they were not assumed by, or assigned to, Wapiti. Monarch objected to the sale and filed an adversary proceeding seeking a declaratory judgment that the GGPA and SWDA could not be rejected because they constitute covenants running with the land. Monarch also asserted a breach of contract claim for $1.2 million in pre-petition fees due under the GGPA and SWDA. Pursuant to the Sale Order, Wapiti agreed to purchase the Riverbend Assets subject to the outcome of this adversary proceeding—provided, however, that if the bankruptcy court determined in the adversary proceeding that the Riverbend Assets could not be sold free and clear of the GGPA and SWDA, then such agreements would be deemed to be Permitted Encumbrances under the Asset Purchase Agreement and Wapiti, as buyer, would be responsible for the obligations under those agreements.[3]

Covenant Analysis Under Utah Law

Although the GGPA and SWDA are governed by Colorado law, the bankruptcy court ruled that, because property interests are created and defined by the law of the state in which the property is located, Utah law governed the determination of whether the GGPA and SWDA constitute covenants that run with the land.[4]

Applying Utah law, the bankruptcy court held that GGPA and SWDA are, in fact, covenants that run with the land. In order for a covenant to run with the land, it must possess four elements: (1) it must “touch and concern” the land, (2) the covenanting parties must intend for it to run with the land, (3) there must be privity of estate, and (4) the covenant must be in writing.[5] Both the GGPA and SWDA are in writing, so the bankruptcy court focused its analysis on the other three elements.

Quoting extensively from Flying Diamond, the bankruptcy court held that the test for the “touch and concern” element does not require a physical effect upon the land but instead asks simply “ . . . whether a covenant enhances the land’s value [on the benefit side], and for the burden side, whether it diminishes the land’s value.”[6] Moreover, all that must be shown is that the covenant “ . . . be of such character that its performance or nonperformance will so affect the use, value, or enjoyment of the land itself that it must be regarded as an integral part of the property.”[7] The bankruptcy court found that the “touch and concern” element was met since the dedication and commitments in the GGPA and SWDA directly affect the Producer’s use and enjoyment of the leases and lands covered thereby. Furthermore, the purpose of the commercial terms of the GGPA and SWDA are to compensate Monarch for the cost and expense of installing and operating the gathering and disposal systems which are located on the producer’s lands and leases and connected to the producer’s wells.

In determining that the GGPA and SWDA touch and concern the land, the bankruptcy court distinguished Sabine. The bankruptcy court reasoned that the gas dedication in question in Sabine covered all gas and condensate that were produced and saved from wells located within a defined geographic area. Since under Texas law extracted minerals are personal property—not real property—the Sabine court held that the “touch and concern” element was not met. Under Utah law, extracted minerals are also considered to be personal property and not real property. However, the bankruptcy court noted that the term “dedicated reserves” was broadly defined in the GGPA as “the interest of Producer in all Gas reserves in and under, and all Gas owned by Producer and produced or delivered from” the leases and other lands within the AMI.[8] Since the dedication and commitment under the GGPA covered the gas reserves, not merely the produced gas, the bankruptcy court held that the dedication did in fact cover a real property interest. In addition, the bankruptcy court held that, unlike under Texas law in Sabine, a conveyance of real property is not required under Utah law to meet the “touch and concern” element in any event.[9]

In discussing the intent element, the bankruptcy court cited Flying Diamond for the proposition that “an express statement in the document creating the covenant that the parties intend to create a covenant running with the land is usually dispositive of the intent issue.”[10] Since both the GGPA and SWDA, along with the Memorandum of the GGPA, contain several express statements to that effect, the bankruptcy court held that the intent element was met. Interestingly, the Memorandum of the GGPA was never filed in the county records in the counties where the Riverbend Assets were located, and Wapiti argued that the failure to record the Memorandum was evidence that the parties did not intend for the GGPA to be a covenant that runs with the land. The bankruptcy court rejected that argument, noting that failure to record the Memorandum merely implicates notice, not intent, and there was no dispute that Wapiti had actual notice of the GGPA.[11]

Regarding the privity element, the bankruptcy court noted that traditionally, there are three types of privity: (1) vertical, (2) mutual, and (3) horizontal. Under Flying Diamond, vertical privity “arises when the person presently claiming the benefit, or being subject to the burden, is a successor to the estate of the original person so benefited or burdened.”[12] The bankruptcy court held that vertical privity clearly exists in this case, since by its acquisition of the Riverbend Assets, Wapiti is the successor to Badlands as an original party to the GGPA and SWDA.[13]

Mutual privity exists when the parties have a continuing and simultaneous interest in the same property. However, the bankruptcy court observed that Utah has never adopted the requirement that mutual privity be shown, and that the Utah Supreme Court has noted that with respect to privity, substance should prevail over form.[14] Although the bankruptcy court acknowledged that the fact scenario in Badlands “. . . is not identical to the traditional paradigm . . . [which] involves a property owner reserving by covenant, either for itself or another beneficiary, a certain interest out of the conveyance of the property burdened by the covenant . . .” the bankruptcy court concluded that the simultaneous interests of producer and gatherer in the lands and leases within the AMI satisfies mutual privity to the extent it is required under Utah law.[15]

“Horizontal privity exists when the original covenanting parties create a covenant in connection with a simultaneous conveyance of an estate.”[16] Wapiti argued that, under Sabine, horizontal privity requires “. . . conveyance of an interest in property that itself is being burdened with the relevant covenant.” Since neither the GGPA nor the SWDA convey any real property interest in the mineral estate to Monarch, but rather conveyed only easements burdening the surface estate, Wapiti argued that horizontal privity was not met.[17] However, the bankruptcy court held that, unlike Sabine, the commitment and dedication under the GGPA burdening the gas reserves, the conveyance of the then existing gathering and disposal infrastructure from Badlands to Monarch in connection with the execution of the GGPA and SWDA, and the grant of easements under the GGPA and SWDA each constitute a conveyance of real property, which all simultaneously burden the same leases and lands within the AMI.

As a result, the bankruptcy court concluded that all of the four elements were met and therefore that the GGPA and SWDA were covenants that run with the land comprising the Riverbend Assets.

Bankruptcy Law Analysis

Turning to application of the Bankruptcy Code, the bankruptcy court next held that covenants that run with the land, such as the GGPA and SWDA, are not “an interest” of which the Riverbend Assets could be sold free and clear of under Section 363(f).[18] Under Utah law, the nature of a covenant that runs with the land is such that is must be regarded as an integral part of the property and binding upon successive owners of the burdened or benefitted land. Therefore, the GGPA and SWDA “. . . are part of the bundle of sticks that Wapiti acquired when it purchased the Riverbend Assets, and they are not subject to elimination utilizing Section 363(f).”[19] Accordingly, Section 363(f)(1) cannot be relied on to enable Wapiti to acquire the Riverbend Assets free and clear of the GGPA and SWDA since it is not permitted by “applicable nonbankruptcy law” (i.e., Utah law). Section 363(f)(5) cannot be relied on either because “. . . Monarch could not be compelled . . . to accept money satisfaction of such interest because the interests of Monarch are part of the Riverbend Assets themselves.”[20]

Similarly, the bankruptcy court held that, because the GGPA and SWDA are covenants that run with the land under Utah law, they cannot be rejected under Section 365. Here, the bankruptcy court relied on Sabine in ruling that, under Section 365, “. . . it is not possible for a debtor to reject a covenant that runs with the land since such a covenant creates a property interest that is not extinguished through bankruptcy.”[21]

Not every aspect of the GGPA and SWDA survived the bankruptcy sale, however. Monarch sought to hold Wapiti liable for more than $1.2 million in fees incurred pre-petition under the GGPA and SWDA. The bankruptcy court disagreed. Assumption of executory contracts and the requirement to pay any attendant cure costs under such contracts are purely creatures of Section 365. Because Section 365 is not applicable to the GGPA and SWDA, there was no mechanism to require Wapiti to pay those prepetition amounts. Thus, a subsequent owner of land burdened by a real covenant takes subject to the covenant but is not liable for his predecessor’s breach.[22] In other words, “while a covenant may run with the land, damages arising from broken covenants do not.” Accordingly, the bankruptcy court held that Monarch’s $1.2 million claim for pre-petition default is an unsecured claim against the bankruptcy estate for which Wapiti is not liable.[23]

Conclusion

Given the stakes at issue, the bankruptcy court’s decision will likely be appealed. Depressed commodity prices and other economic factors impacting the oil and gas industry are likely to result in additional oil and gas operators filing for bankruptcy. Debtors will continue to argue that these sorts of midstream agreements are simply executory contracts that do not create property interests that burden their assets; meanwhile, midstream providers will continue to argue that the obligations under the agreements do run with the land and that any conveyance will be subject to these covenants. Clearly, this issue will continue to arise and be further litigated.

While the bankruptcy court did not directly reject Sabine, this decision provides upstream and midstream companies as well as oil and gas and bankruptcy practitioners authority in contrast to Sabine that a midstream agreement which purports to burden hydrocarbon reserves or other real property (as opposed to simply burdening severed minerals) may be binding on successors in interest even after a “free and clear” bankruptcy sale.

If you have any questions relating to this decision or how it may affect your business, please contact Lamont Larsen, Chris Richardson, or Kyler Burgi.

Lamont Larsen

Mr. Larsen is a partner and the head of the Energy Group at Davis Graham & Stubbs LLP. His practice focuses on upstream and midstream transactional matters for the oil and gas industry. In particular, in recent years he has assisted several clients in acquiring oil and gas assets out of bankruptcy in Chapter 11 Section 363 auctions. He is licensed to practice in Colorado, Utah, Wyoming, North Dakota and Texas.

Chris Richardson

Mr. Richardson is a partner in the Finance & Acquisitions Department of Davis Graham & Stubbs LLP. His practice has an emphasis on mergers, acquisitions and corporate financing and restructuring work. Mr. Richardson has worked with secured and unsecured creditors, debtors, and creditors’ committees in numerous Chapter 11 proceedings. He has assisted clients and debtors in buying and selling companies out of Chapter 11, as well as reorganizing or liquidating debtor companies. He has also represented purchasers of oil and gas assets in Chapter 11 Section 363 auctions in bankruptcy proceeding in Wyoming, Colorado, Utah, North Dakota, and Delaware.

Kyler Burgi

Mr. Burgi is an associate in the Trial Department of Davis Graham & Stubbs LLP. His practice focuses primarily on complex commercial litigation, and bankruptcy & creditors’ rights.

[1] Monarch Midstream, LLC v. Badlands Production Co., f/k/a Gasco Production Co., Badlands Energy, Inc., f/k/a Gasco Energy, Inc., and Wapiti Utah, LLC, f/k/a Wapiti Newco, LLC (In re Badlands Energy, Inc.), United States Bankruptcy Court for the District of Colorado, Adv. Proc. No. 17-01429-KHT (hereafter, “Monarch v. Wapiti”).

[2] In re Sabine Oil & Gas Corp., 547 B.R. 66 (Bankr. S.D.N.Y. 2016); affirmed in In re Sabine Oil & Gas Corp., 567 B.R. 869 (S.D.N.Y. 2017) and In re Sabine Oil & Gas Corp., 734 Fed.Appx. 64 (2nd Cir. 2018).

[3] See Order (A) Approving the Asset Purchase Agreement Between Debtor Badlands Production Company and Wapiti Utah, L.L.C.,(B) Authorizing the Sale of Substantially All of the Debtor’s Assets Free and Clear of All Liens, Claims, Encumbrances and Interests, (C) Authorizing the Assumption and Assignment of Contracts, and (D) Granting Related Relief, Docket No. 223, para. 39, In re Badlands Energy, Inc., et. al. Case No. 17-17465-KHT.

[4] Monarch v. Wapiti at 11.

[5] Id. at 12 (citing Flying Diamond Oil Corp. v. Newton Sheep Co., 776 P.2d 618, 624 (Utah 1989)).

[6] Id at 13.

[7] Id.

[8] Id. at 15 (emphasis in original)

[9] Id. at 14-15.

[10] Id. at 16.

[11] Id. at 17.

[12] Flying Diamond at 628.

[13] Monarch v. Wapiti at 17-18.

[14] Id. at 18-19.

[15] Id. at 20.

[16] Flying Diamond at 628.

[17] Monarch v. Wapiti at 21.

[18] Section 363 (f)(1) states that a debtor may sell property free and clear of an interest only if “applicable nonbankruptcy law permits sale of such property free and clear of such interest.”

[19] Monarch v. Wapiti at 22.

[20] Id. at 22-23.

[21] Id. at 23; Sabine, 567 B.R. 869, 874.

[22] In a somewhat curious provision, at the bottom of page 24 of the opinion, the bankruptcy court states that Wapiti took the Riverbend Assets free and clear of Monarch’s pre-petition claim because Monarch “could be compelled, in a legal or equitable proceeding, to accept money satisfaction of such interest.” Monarch v. Wapiti at 24. On page 22, the bankruptcy court held that Section 363 (f)(5) could not be used with respect to the covenant itself though apparently it can be used for claims that arise out of failure to comply with the covenant.

[23] Monarch v. Wapiti at 23-24.

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