On December 20, 2019, Judge Marvin Isgur in the U.S. Bankruptcy Court for the Southern District of Texas (Houston Division) entered a memorandum opinion which held that debtors' midstream gathering agreements formed real property covenants "running with the land" under Oklahoma law - and such agreements could not be subject to rejection under section 365 of the Bankruptcy Code. See 11 U.S.C. section 365(a) (allowing a debtor-in-possession, "subject to the court's approval," to "assume or reject any executory contract.").
This decision appears to contravene directly the seminal holding in 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) (Sabine), which held that the gathering agreements in question did not create covenants running with the land and thus could be rejected under Texas law. The Alta Mesa Bankruptcy Court noted that the "requirements to form a real property covenant in Texas mirror those in Oklahoma," but "[t]he Court assumes that unique facts in Sabine led to that court's conclusions [to the contrary]." Alta Mesa Holdings LP v. Kingfisher Midstream LLC (In re Alta Mesa Res., Inc.), No. 19-03609, 2019 Bankr. LEXIS 3859, at *21 (Bankr. S.D. Tex. Dec. 20, 2019). Judge Isgur went on to state, however, that 2[t]o the extent that the pronouncements in Sabine were intended to be generalized, this Court must reject them." Id.
On September 12, 2019, Debtors Alta Mesa Resources, Inc. and Oklahoma Energy Acquisitions, LP (the Debtors or Alta Mesa) initiated an adversary proceeding against Defendants Kingfisher Midstream, LLC and Oklahoma Produced Water Solutions, LLC (together, Kingfisher), seeking, in part, a declaratory judgment that the gathering agreements may be rejected as executory contracts under section 365 of the Bankruptcy Code.
Judge Isgur found that all three elements required to form a real property covenant under Oklahoma law were satisfied: "First, the covenant must touch and concern real property. Second, there must be privity of estate. Third, the original parties to the covenant must have intended to bind successors." Id. at *14.
(1) The midstream agreements "touched and concerned" the Debtors' oil and gas leases.
As to the first element, Judge Isgur found that gathering agreements "touch and concern" the oil and gas leases because "both the benefits and burdens of the covenants affect the value of Alta Mesa’s real property." Id. at *22. Judge Isgur writes that: "Unlike in Sabine, where the court focused its inquiry on a fee mineral estate, the relevant starting point here is Alta Mesa’s leasehold interests." Id. at *25 (emphasis added).1 According to Judge Isgur, "[a]n oil and gas lease is distinguishable from a fee simple mineral estate. Although overlapping in many respects, a fee mineral estate contains a separate collection of rights." Id. at *24.2 Unlike a fee mineral estate, "[a]ll of the property interests associated with an oil and gas lease are necessary for the lessee to successfully explore and produce his reserves." Id. (emphasis added).
Accordingly, the surface easements granted pursuant to the gathering agreements3 directly affect the lessee's underlying mineral interest. In Alta Mesa, Judge Isgur explained that, "[t]he Sabine court found that a surface easement does not touch and concern the mineral estate because the surface and mineral estates consist of separate bundles of sticks." Id. at *28–29.4 However, "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." Id. at *28–29. Moreover, the surface easements "directly burden Alta Mesa's interest" because it restricts the Debtors' "use of the surface land for drilling or exploration." Id. at *29. Thus, there is a logical connection between both the burden and benefit of the covenants and Alta Mesa's real property. Id.
In addition to the surface easements, Judge Isgur also found that three (3) other covenants touched and concerned the Debtors' oil and gas leases:
- First, the agreements dedicated all of Alta Mesa's produced hydrocarbons for delivery to Kingfisher. Id. at *26.
- Second, the agreements included sections titled "Covenants Running With Land" which required recordation and required transferees to affirm the agreements. Id.
- Finally, "the agreements set out the fixed gathering fees." Id.
(2) The Parties were in "privity of estate."
The second element required to form a real property covenant in Oklahoma is privity of estate. Citing to Oklahoma law, "[t]wo types of privity of estate are recognized at common law: vertical and horizontal." Id. at *31. "Vertical privity relates to the relationship between the present owner of the land and the original parties to the covenant." Id. Vertical privity was irrelevant in this case because Alta Mesa and Kingfisher had not transferred their interest. Id.
Conversely, "[h]orizontal privity existed only if the covenanter and covenantee created the covenant in connection with a conveyance of an estate from one to the other." Id. at *31–32 (emphasis added). Here, Judge Isgur found that horizontal privity existed:
Although less than a fee simple estate, the easements conveyed to Kingfisher a possessory interest in the leasehold estate. The surface easement is integrally tied to the purpose of an oil and gas lease. The conveyance of the easements to Kingfisher is enough to show horizontal privity with respect to the gathering agreements. . . . [T]he covenants were created alongside the conveyance of a property interest in Alta Mesa's leasehold estates.
Id. at *33 (internal citations omitted). As such, the second element was also satisfied.
(3) The Parties intended for the agreements to bind successors.
Judge Isgur found that, "[b]ased upon the language of the gathering agreements, original and as amended, the parties expressed the intent to bind successors":
Each of the agreements states that it is "a covenant running with the land." On their own, those recitations do not create real property covenants; however, the provisions memorialize the parties' intent to bind successors to real covenants. Additionally, those provisions require that the dedications be recorded. Recording puts subsequent purchasers on notice of real property covenants. . . . Finally, the gathering agreements also contain language requiring the parties to obtain affirmation that a transferee will uphold the party's obligations under the agreements.
Id. at *34–35 (internal citations omitted). In sum, Judge Isgur concluded that, "[t]hese provisions show a clear intent to bind successors to the covenants of the gathering agreements." Id.
Alta Mesa sheds light on the importance of drafting and structuring a midstream gathering agreement that will withstand rejection under section 365(a) of the Bankruptcy Code – particularly since, under its analysis, the surface easement aspects of an oil and gas lease, on which the gatherer relies, is an integral component of the covenant "running with the land" and establishes the "privity of estate" requirement. Moreover, midstream gathering agreements should also clearly stipulate the parties' intent to create a real property covenant. In Alta Mesa, each agreement expressly stated that it is "a covenant running with the land," and required that the dedications be recorded.
Perhaps of even greater importance to the midstream company, Alta Mesa appears to recognize the fundamental economic proposition that the midstream company’s agreement "connects" to the leasehold estate's hydrocarbons (and their removal) to create the embedded economic value of those hydrocarbons. The Sabine court seems to ignore the capital outlay required by the midstream company to get the hydrocarbons to a market. In the Sabine court's mind, the insolvent producer gets to keep the value of the hydrocarbons (as connected to a market) without the burdens that created the connection. In the Sabine scenario, once the producer has rejected the contract – meaning, rejected the rate under the contract that is tied to the capital outlay – it may turn right around and sign the same contract at a lower rate, and it is reconnected to the intrinsic value of market-attached hydrocarbons. In this context, the midstreamer eats the capital outlay which the old rate serviced.
Alta Mesa gives renewed hope to midstream service providers that gathering agreements, if properly crafted, may not be rejected. Sabine of course, remains alive and well, and taken together, the two cases represent opposite outcomes on essentially the same set of industry circumstances.