Questions Remain After Two Bankruptcy Courts Hold Midstream Contracts May Not Be Rejected
OVERVIEW
Can a mineral producer reject a midstream agreement in bankruptcy? Midstream companies hope the answer to this question is "no." When a bankruptcy debtor rejects a contract, the bankruptcy debtor is relieved from future performance under that contract. To the relief of midstream companies (and the corresponding disappointment of mineral producers), two bankruptcy courts have recently held that certain midstream agreements constitute real property covenants under state law, thus precluding their rejection in bankruptcy.
On September 30, 2019, a bankruptcy court in Colorado held that a gas gathering and processing agreement and a saltwater disposal agreement "ran with the land" as real property covenants under Utah law.1 On December 20, 2019, a bankruptcy court in Texas applied Oklahoma law to reach a similar conclusion with regard to the effect of dedications in the gathering agreements at issue there.2 As a result, the agreements at issue in these cases could not be rejected by their respective bankruptcy debtors.
These two cases – Monarch and Alta Mesa – give new hope to midstream companies in the wake of Sabine Oil, a 2018 decision in which the United States Court of Appeals for the Second Circuit allowed a bankruptcy debtor to reject gas gathering agreements because those agreements did not run with the land under Texas law.3 Nevertheless, the cases may have limited applicability in Louisiana, where the question of whether gathering agreements create real property interests remains open.
MONARCH
In 2017, Colorado corporation Badlands Energy, Inc. and its wholly owned subsidiary, Badlands Production Company (collectively, "Badlands"), filed for bankruptcy. Badlands owned oil and gas assets in the Uintah Basin in Utah (the "Uintah Basin Assets").
Several years prior to the bankruptcy proceedings, Monarch Midstream LLC purchased a set of systems from Badlands' predecessor for the gathering and processing of natural gas and the disposal of saltwater in the Uintah Basin. As consideration for Monarch's purchase of these systems, Badlands' predecessor (the "Producer") entered into midstream gas gathering/processing and saltwater disposal contracts with Monarch (the "GPA" and "SWDA", respectively), under which the Producer dedicated minerals and saltwater produced from the Uintah Basin Assets to these systems. Badlands eventually became bound as the Producer under the GPA and SWDA.
In October 2017, in connection with Bandlands' bankruptcy proceedings, the bankruptcy court authorized Badlands to sell the Uintah Basin Assets to Wapiti Utah. The Uintah Basin Assets were to be sold free and clear of all liens, claims, encumbrances and interests pursuant to Sections 363(b) and (f) of the Bankruptcy Code. In other words, the Uintah Basin Assets were to be transferred to Wapiti Utah free and clear of, among other things, any obligations under the GPA and the SWDA. Monarch objected to the free and clear sale of the Uintah Basin Assets, asserting that the GPA and SWDA could not be rejected because they form covenants running with the land.
The terms of the GPA and the SWDA specified that Colorado law was to govern the contracts. Because the Uintah Basin Assets are located in Utah, however, the Monarch court applied Utah property law to determine whether the GPA and SWDA constitute real covenants running with the land. Under Utah law, a covenant runs with the land if: (1) the covenant touches and concerns the land; (2) the covenanting parties intended the covenant to run with the land; (3) privity of estate exists; and (4) the covenant is in writing.
While the Monarch court gave ample consideration to each of these four elements, the pertinent portions here are the court's analysis of the touch and concern element. On that issue, the Monarch court articulated the following rule: a covenant touches and concerns real property if it enhances the property's value on the benefit side, and on the burden side, if it diminishes the property's value.
The Monarch court distinguished the dedication at issue in Sabine Oil from those involved in Monarch. In Sabine Oil, the dedication pertained to gas and condensate extracted from a specified area. Under Texas law, extracted minerals are personal property, not real property. Thus, the “touch and concern” element was not met. By contrast, the midstream agreements at issue in Monarch dedicated the Producer's interests in unextracted minerals to Monarch's systems. Unextracted minerals constitute real property rights under Utah law. Because the GPA and the SWDA limited the Producer's use and enjoyment of these unextracted minerals for the benefit of Monarch's systems, the agreements satisfied Utah's touch and concern element.
ALTA MESA
Bankruptcy debtors Alta Mesa Holdings, LP and its wholly owned subsidiary, Oklahoma Energy Acquisitions, LP (collectively, "Alta Mesa"), are onshore oil and gas producers. Alta Mesa holds several mineral leases in the STACK formation in Oklahoma. Prior to filing for bankruptcy, Alta Mesa entered into two gathering agreements with gathering system developer Kingfisher Midstream, LLC ("Kingfisher"). In these agreements, Alta Mesa promised to deliver its produced oil and gas to Kingfisher's systems in exchange for Kingfisher's promise to deliver Alta Mesa's product to market for set gathering fees. Alta Mesa sought to either reject or avoid these gathering agreements in bankruptcy court in order to avoid the high gathering fees.
The bankruptcy court focused its analysis on Alta Mesa's claims relating to rejection. A contract creating a real property covenant is not subject to rejection in bankruptcy. Because Alta Mesa's leases are located in Oklahoma, the court began by determining whether the gathering agreements form real property covenants under Oklahoma law. Under Oklahoma law, a contract forms a real property covenant if: (1) the covenant touches and concerns the land, (2) the parties to the covenant are in privity of estate, and (3) the parties intended to bind their successors. The court found that Alta Mesa's gathering agreements with Kingfisher met all three of these elements.
In its analysis of the touch and concern element, the court articulated the following rule: if the value of the owner’s real property interest is affected by the covenant, either positively or negatively, the covenant touches and concerns the land. In Alta Mesa, the gathering agreements negatively affected Alta Mesa's interests in its mineral leases (which constitute real property rights under Oklahoma law) by restricting Alta Mesa's right to use different gathering systems to deliver minerals produced from its leases. The agreements required Alta Mesa to deliver produced minerals exclusively through the Kingfisher systems. The Alta Mesa court relied on this fact, among others, to determine that the gathering agreements created real property covenants affecting Alta Mesa's mineral leases.
KEY TAKEAWAY
To date, no court has addressed whether gathering agreements constitute real property rights under Louisiana law. As such, whether Louisiana gathering agreements constitute real rights immune from rejection in bankruptcy remains an open question, even in light of Monarch and Alta Mesa. The key takeaway from these cases is that companies dealing with Louisiana gathering agreements should work with competent Louisiana counsel to protect their interests.
1 Monarch Midstream LLC v. Badlands Production Co., No. 17-17465 KHT, 2019 WL 5549463 (Bankr. D. Colo. Sept. 30, 2019).
2 Alta Mesa Holdings LP v. Kingfisher Midstream LLC, 19-03609, Dkt. No. 236 (Bankr. S.D. Tex. Dec. 20, 2019).
3 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. 869 (S.D.N.Y. 2017); aff’d, 734 Fed. Appx. 64 (2d Cir. 2018).