Running with the Land: Texas Bankruptcy Court’s Alta Mesa Decision Undercuts Sabine, Holding That Gathering Agreements Cannot Be Rejected

In a significant recent decision in the Alta Mesa chapter 11 case,[1] Bankruptcy Judge Marvin Isgur of the United States Bankruptcy Court for the Southern District of Texas (the “Bankruptcy Court”) held that the debtors’ midstream oil and gas gathering agreements constituted real property covenants “running with the land” under Oklahoma law and, therefore, could not be rejected as executory contracts under § 365 of the Bankruptcy Code. The Bankruptcy Court distinguished the 2016 bankruptcy case of In re Sabine Oil & Gas Corp.,[2] in which the United States Bankruptcy Court for the Southern District of New York, interpreting Texas law, held that the midstream gathering agreements at issue in that case were not covenants running with the land and, thus, could be rejected.

Factual Background

The debtor plaintiffs[3] were Texas limited partnerships doing business in Oklahoma. Alta Mesa contracted with its defendant affiliate, Kingfisher Midstream, LLC (“Kingfisher”), to transport Alta Mesa’s oil and gas over gathering systems to be constructed by Kingfisher.[4] Pursuant to gathering agreements governed by Oklahoma law, Kingfisher built a gas gathering system linking Alta Mesa’s wells to central collection points. In exchange, Alta Mesa promised to deliver substantially all of its hydrocarbons to Kingfisher for fixed gathering fees.[5] Because the fixed fees proved to be expensive, Alta Mesa filed an adversary proceeding seeking, among other things, a declaratory judgment that the gathering agreements were not real property covenants, but instead executory contracts subject to rejection under § 365 of the Bankruptcy Code.[6]

The Gathering Agreements Created Covenants Running with the Land

Because the real property at issue was situated in Oklahoma, the Bankruptcy Court applied Oklahoma law to determine how real property covenants are formed and the real property status of Alta Mesa’s hydrocarbons.[7] Oklahoma treats hydrocarbons as real property while in the ground, but personal property once extracted.[8] In Oklahoma, three elements are required to form a real property covenant: (1) the burden or benefit much “touch and concern” the land; (2) privity of estate must be present; and (3) the parties must intend for the burden to pass to successors.[9] The Bankruptcy Court held that the gathering agreements satisfied all three elements.

First, the gathering agreements “touch[ed] and concern[ed]” the land because the benefits and the burdens were logically connected to Alta Mesa’s leasehold interest in real property.[10] The modern gathering system built by Kingfisher benefited the leases by facilitating the collection of produced reserves and increasing the value of the unproduced reserves. The gathering agreements burdened the leases by (1) granting a surface easement to Kingfisher (thus limiting Alta Mesa’s possessory interest), (2) restricting Alta Mesa’s ability to seek a different gatherer or build its own gathering system (thus restricting the use of Alta Mesa’s reserves) and (3) establishing a fixed fee system that, particularly in a low-price environment, negatively impacted the value of Alta Mesa’s reserves.[11]

Second, the Bankruptcy Court held that the parties were in privity of estate. Vertical privity, which relates to the relationship between the present owner of the land and the original parties to the covenant, was irrelevant because Alta Mesa and Kingfisher had not transferred their interests.[12] Under Oklahoma law, horizontal privity arises when the covenant is created in connection with the conveyance of an estate in property.[13] The conveyance of a surface easement to Kingfisher was sufficient to create horizontal privity with respect to the gathering agreements.[14]

Third, the language of the gathering agreements, which (1) stated that they created covenants running with the land, (2) required recordation and (3) contained language requiring the parties to obtain an affirmation that a transferee would uphold the transferor’s obligations under the agreement, evidenced the parties’ intention to create a covenant running with the land.[15]

Distinguishing Sabine

In reaching its decision, the Bankruptcy Court distinguished Sabine. First, the covenants in Alta Mesa concerned Alta Mesa’s leasehold interests, whereas the bankruptcy court in Sabine focused its inquiry on rights to the debtor’s mineral estate (not its surface estate). The bankruptcy court in Sabine found that a surface easement did not touch and concern the mineral estate because the surface and mineral estates consist of separate bundles of rights.[16] Without explicitly rejecting Sabine, the court in Alta Mesa found that “in the context of an oil and gas lease, the surface easement is integral to the lessee’s ability to realize the value of its mineral reserves. Without the surface easement, the lessee cannot capture reserve hydrocarbons.”[17] Second, focusing its analysis on the mineral estate, the bankruptcy court in Sabine found that the gatherers’ surface easement did not create horizontal privity with respect to the producer’s mineral estate.[18] In contrast, the Bankruptcy Court in Alta Mesa held that, “[b]ecause a surface easement is a crucial component of an oil and gas lease, the Court does not view this conveyance as creating privity only with respect to the surface estate.”[19]

Notably, the Bankruptcy Court stated that “[t]he requirements to form a real property covenant in Texas mirror those in Oklahoma,”[20] suggesting its discomfort with the Sabine decision. Further, the Bankruptcy Court cited with approval a September 2019 decision from the bankruptcy court in Colorado in Badlands Energy, which also distinguished Sabine in holding that a gathering agreement governed by Utah law created a real property covenant running with the land, and thus could not be rejected as an executory contract.[21] The bankruptcy court in Badlands Energy expressly disagreed with Sabine’s privity analysis, and found that the grant of a surface easement to a gatherer is a conveyance creating privity with an oil and gas lessee.[22]

Conclusion

Because § 365 of the Bankruptcy Code cannot be used to reject a covenant running with the land, the classification of a gathering agreement has a critical impact on chapter 11 reorganizations of oil and gas companies and on pre-bankruptcy negotiating leverage. If a gathering agreement is an executory contract, a debtor may reject it as a burdensome agreement, thus facilitating a § 363 sale or plan of reorganization. If not, the land and minerals subject to the gathering agreement will be burdened by the gathering agreement even after a sale or reorganization. Moreover, the likely outcome of bankruptcy court litigation will affect leverage in out-of-court negotiations, as a distressed oil and gas company may find it easier to negotiate modifications of a gathering agreement if it can credibly threaten rejection if it files for bankruptcy.

Alta Mesa does not directly reject Sabine. Moreover, it concerns gathering agreements with different contractual terms and governed by different law from those at issue in Sabine. However, Alta Mesa’s reasoning and its pointed affirmation that Texas law and Oklahoma law have identical requirements to create real property covenants significantly undermine the holding in Sabine. Bankruptcy court judges in Texas have previously expressed skepticism about Sabine, with Chief Judge David Jones, who also sits in the Southern District of Texas, stating that “he has been looking for an opportunity to correct the state of New York….”[23] Given the large number of oil and gas bankruptcies currently being, and expected to be, filed in Texas, that opportunity may come soon, which may have a potentially significant impact on both producers and midstream companies.