Last year, the Second Circuit Court of Appeals affirmed the decisions by the bankruptcy court and the district court in the Southern District of New York to permit Sabine Oil & Gas Corporation’s rejection of its gas gathering and processing agreements with Nordheim Eagle Ford Gathering LLC and HPIP Gonzalez Holdings LLC as executory contracts, rather than to assume that the agreements are real covenants “running with the land.”1 Prior to the Second Circuit’s decision, it was commonly held that these agreements would withstand rejection under Section 365 of the Bankruptcy Code and survive a bankruptcy.2 The issues presented in Sabine are all legal issues of Texas state law and, as of today, there is still no binding decision from a Texas court.3 The immediate effect of the Second Circuit’s interpretation of Texas law is that parties (and their attorneys) are deliberately considering how to draft these types of agreements by, for instance, including certain dedication language that makes clear that the gatherer will have rights against the mineral interests instead of the production from such interests, by determining the pricing for taking on additional risk, and by adding guarantees or credit support, just to name a few.4
It is also interesting to observe how other courts in other jurisdictions will decide cases with similar legal issues to those that were presented in Sabine. In fact, the first reported decision to test Sabine was recently handed down by Judge Kimberley Tyson in the United States Bankruptcy Court for the District of Colorado.5 Whereas Sabine featured a New York bankruptcy court interpreting Texas law, Monarch featured a Colorado bankruptcy court interpreting Utah law.6 Also contrary to Sabine, the bankruptcy court determined that the midstream agreements at issue in Monarch could not be rejected under Section 365 of the Bankruptcy Code because the agreements were covenants that ran with the land.7 While the Monarch decision distinguishes itself from Sabine, the disparate rulings are likely to yield uncertainty within the oil and gas industries.
Brief Historical Background
In 2014, Sabine Oil & Gas Corp. (hereinafter referred to as “Sabine”) became a party to several midstream agreements whereby Sabine agreed to dedicate and deliver all of the oil and gas it produced within an area in exchange for, among other things, the construction and operation of gathering facilities to provide certain services with respect to the products delivered by Sabine.8 After filing for bankruptcy a year later, Sabine sought authorization from the bankruptcy court to reject certain gas gathering contracts pursuant to Section 365 of the Bankruptcy Code, but was met with resistance from the gas gathering companies to whom Sabine had contractual obligations under gas gathering and processing agreements.9 Both of those midstream service providers anticipated Sabine’s contractual obligations to survive its bankruptcy and argued that certain dedications in those midstream agreements constituted covenants running with the land.10
In October 2017, the Colorado bankruptcy court in Monarch authorized Badlands Production Co., f/k/a Gasco Production Co. (collectively referred to herein as “Badlands”) to sell its oil and gas assets located in the Uintah Basin, Utah as part of a Section 363 sale (the “Riverbend Assets”) to Wapiti Utah, L.L.C., f/k/a Wapiti Newco, L.L.C. (collectively referred to herein as “Wapiti Utah”).11 Monarch Midstream, LLC, f/k/a Monarch Natural Gas, LLC (collectively referred to herein as “Monarch”) “objected to the sale of the Riverbend Assets to Wapiti Utah” on the grounds that it had midstream gas gathering and processing contracts and saltwater disposal contracts with Badlands, and asserted that those contracts could not be rejected as a result of Badlands’ bankruptcy because those contracts “constitute[d] covenants running with the land.”12 Pursuant to a certain gas processing agreement, Badlands dedicated and committed its “Dedicated Reserves” — oil and gas that is not produced and not yet extracted — to the gas gatherer.
Covenants Running with the Land
As a preliminary matter, Sabine does not stand for the global proposition that gathering agreements are not covenants running with the land. Judge Chapman’s decision in the Sabine case concluded that the particular gathering agreements at issue did not meet the requirements under Texas law to constitute covenants running with the land.13
In Texas, a covenant runs with the land when it (1) touches and concerns the land, (2) relates to a thing in existence or specifically binds the parties and their assigns, (3) is intended by the original parties to run with the land, (4) the successor to the burden has notice,14 and (5) while vertical privity of estate is also required, some courts have also required horizontal privity of estate as well.15 That is, the original parties who burdened the land had a sufficient relationship: either the burden or restriction was created in a deed that passed from one party to the next, or both parties had some interest in the land to begin with.16 In its analysis, the court in Sabine determined that two of the five elements had not been met: the covenants did not touch and concern the land and they lacked privity of estate.17
In Utah, a covenant runs with the land when it (1) touches and concerns the land, (2) it is intended by the original parties to run with the land, (3) must be in writing so as to satisfy the Statute of Frauds, and (4) have privity of estate.18 Like in Sabine, the Colorado bankruptcy court focused its analysis on whether the covenants touched and concerned the land and whether there was privity of estate.
Touch and Concern the Land
In Monarch, the “touch and concern” elements were met under Utah law, but the elements under Texas law were not met in Sabine.
The court in Monarch found that the dedication was very different than the dedication in Sabine in that Sabine held that the dedications constituted personal property under Texas law, whereas the dedications under the midstream contracts between Badlands and Monarch concerned real property interests.
Despite the fact that some Texas courts have established that a conveyance of an interest in gas that is “produced and saved” constitutes a royalty interest and thus is considered a real property interest, under Texas law, once minerals are extracted from the ground, such minerals cease to be real property and instead become personal property.19 This is one of the distinguishing factors from Monarch in that the Sabine court believed that the dedications of certain products between Sabine and its service providers only concerned Sabine’s interests in the produced products and the service providers’ performance of the contracted-for services, rather than attach as an ongoing burden to the land.20 Accordingly, the transportation fees and dedications did not touch and concern the land; rather, they just affected personal property.21 By contrast to Sabine, the Dedicated Reserves under the gas processing agreement at issue in Monarch were held to constitute interests in real property instead of personal property.22
Texas jurisprudence recognizes two tests for establishing the “touch and concern” element in the determination of whether covenants run with the land: (1) whether the covenant affected the nature, quality or value of the thing demised, independently of collateral circumstances, or if it affected the mode of enjoying it, and (2) whether the promisor’s legal interest as owner is rendered less valuable by the promise. However, the Sabine court explained that, regardless of which test applied, the agreements could not touch and concern the land because they pertained to produced minerals and thus, to personal property.
Under Utah law though, meeting the “touch and concern” element does not require the dedication to attach directly to real property. Rather, a covenant must “be of such character that its performance or non-performance will so affect the use, value or enjoyment of the land itself that it must be regarded as an integral part of the property.”23 The court in Monarch agreed with Monarch that by requiring producers to dedicate their interest in the Dedicated Reserves under the leases and lands within the area of mutual interest, the agreements certainly affected the use, value or enjoyment of the producers’ interest in the leases by limiting the right to possess, develop, and dispose of the minerals and salt water therefrom, and therefore, the court concluded that the touch and concern element was met.24
Privity of Estate
Horizontal Privity in Texas
Ultimately, the court in Sabine determined that horizontal privity of estate did not exist because the covenants did not arise through a real property conveyance.25 Sabine merely contracted with the service providers to perform certain services rather than sell the property (or any other real property interest) and reserve an interest for their benefit. The underlying basis for this assertion was that the subject matter of the Agreements (the provision of service in connection with oil and gas already extracted from the ground) constituted personal property rather than real property.26
However, it is unclear whether horizontal privity is a requirement under Texas law. While horizontal privity has been required by a minority of lower courts, the issue has yet to be settled by the Texas Supreme Court.27 Outside of Texas law, the horizontal privity requirement is a much-criticized doctrine that has been explicitly rejected by the latest Restatement of Property.28 Even if horizontal privity is a requirement under Texas law, there is no indication that it must arise in the context of a real property conveyance, although that is most often the circumstance under which horizontal privity arises. Interestingly, while the court in Sabine heavily relied on a handful of cases in determining that horizontal privity was required, it neglected to address other cases in which horizontal privity existed despite no transfer of real property. There are a number of cases in which covenants were held to run with the land, despite not being created in such a context.29
Mutual Privity in Utah
In Utah, mutual privity exists when the parties have a continuing and simultaneous interest in the same property.30 Meanwhile, horizontal privity exists when the original covenanting parties create a covenant in connection with a simultaneous conveyance of an estate.31 Whereas the court in Flying Diamond listed mutual and horizontal privity separately, some courts, including the Sabine court, combine the two under the same horizontal privity requirement, which the court in Sabine says requires a “conveyance of an interest in property that itself is being burdened with the relevant covenant.”32 The Monarch court explained that the parties shared simultaneous interests in the Dedicated Reserves; thus, mutual privity is satisfied.33 The court also determined that horizontal privity is established under the facts of the case and under the definition set forth in Flying Diamond.34 Badlands and Monarch created the covenants at issue in connection with a simultaneous conveyance of an estate from Badlands to Monarch: the gathering and saltwater disposal systems.35 The Monarch court further distinguishes its facts from those presented in Sabine by noting that the covenants burdened real property interests (the Dedicated Reserves and Badlands’ interests in the leases) in the context of a simultaneous conveyance of real property interests (the gathering and saltwater disposal systems) to Monarch, both of which are located in the same area of mutual interest.36
Equitable Servitudes
Regardless of whether the courts in Sabine or Monarch determined that the covenants ran with the land, it would still be possible to enforce those agreements against subsequent parties as equitable servitudes. Generally, an equitable servitude is similar to a real covenant, however it contains two key distinctions: (1) a party seeking enforcement of an equitable servitude does not need to demonstrate horizontal privity,37 and (2) a party seeking enforcement for a real covenant may obtain monetary remedies, whereas a party seeking enforcement of an equitable servitude is limited to specific performance.38 Enforcement of equitable servitudes tends to be more common than real covenants, particularly in a bankruptcy context.39 In order to demonstrate that an equitable servitude runs with the land, the party seeking enforcement must demonstrate (i) notice,40 (ii) that the equitable servitude limits the use of real property, and (iii) that the equitable servitude benefits the party seeking enforcement.41 Accordingly, an equitable servitude does not require horizontal privity of estate, and instead, just the “touch and concern”, “intent”, and “notice” elements are necessary to bind subsequent purchasers and in effect, run with the land.42
However, despite arguments from the parties seeking enforcement of the agreements as equitable servitudes in both Sabine and in Monarch, neither court explored these matters in depth as the courts’ analyses focused on real covenants.43 Future courts may look to utilize an equitable servitude inquiry in determining whether certain oil and gas contracts run with the land.
Conclusion
These issues promise to play a prevalent role in future litigation as more oil and gas companies file for bankruptcy due to depressed commodity prices and other economic factors facing the energy industry. While debtors will contend that certain agreements are executory contracts that can be rejected rather than covenants that run with the land, midstream service providers will assert that these agreements burden the land and that subsequent conveyances are subject to such covenants therein.
Even though Monarch was decided in a jurisdiction that does not directly affect the holding in Sabine, and the holding in Monarch merely distinguishes its facts from those presented in Sabine, the ruling in Monarch is significant because it is the first reported decision to challenge Sabine by providing a basis for the contention that a midstream agreement which purports to burden hydrocarbon reserves, as opposed to produced minerals, may be binding on successors-in-interest irrespective of a Section 363 bankruptcy sale in which assets are customarily conveyed “free and clear” of all liens, claims, encumbrances and interests.
“[G]iven the magnitude of the investments involved in the oil and gas industry by midstream companies and their respective lenders, along with the absolute need to move natural gas to market,”44 Texas courts will likely scrutinize the Sabine decision, the Monarch decision, and any other attempts to reject or divest midstream pipeline agreements and their related obligations. In fact, Chief Judge David Jones of the U.S. Bankruptcy Court for the Southern District of Texas has already noted that he might reconsider the Sabine decision if the case were properly presented.45 As time evolves, the oil and gas industry will eventually find out if a similar case lands in Judge Jones’ court.
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1 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 F. App’x 64 (2d Cir. 2018).
2 Mark W. Wege, Oscar N. Pinkas & Lauren Macksoud, Does the Second Circuit in Sabine Have the Final Word on Texas Law?, 37-AUGug Am. Bankr. Inst. J. 24 (2018).
3 Id. at 79.
4 Id. at 78-79.
5 Order on Wapiti Utah, L.L.C.’s Motion for Judgment on the Pleadings and Monarch Natural Gas, LLC’s Motion for Summary Judgment, Monarch Midstream, LLC v. Badlands Production Co. (In re Badlands Energy, Inc.), No. 17-01429-KHT (Bankr.Colo. Sept. 30, 2019) [hereinafter Monarch].
6 Id.
7 Id.
8 In re Sabine, 547 B.R. at 70.
9 Id. at 70-73.
10 Id.
11 Case No. 17-17465 KHT, docket #223, Order (A) Approving the Asset Purchase Agreement 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.
12 Monarch at 3.
13 In re Sabine, 547 B.R.at 74-79.
14 Inwood N. Homeowners’ Ass’n, Inc. v. Harris, 736 S.W.2d 632, 635 (Tex. 1987).
15 Westland Oil Dev. Corp. v. Gulf Oil Corp., 637 S.W.2d 903, 910-11 (Tex. 1982); Blasser v. Cass, 158 Tex. 560, 314 S.W.2d 807 (1958); Rolling Lands Invs., L.C. v. Nw. Airport Mgmt., L.P., 111 S.W.3d 187 (Tex. App. 2003)); Tarrant Appraisal Dist. v. Colonial Country Club, 767 S.W.2d 230 (Tex. App. 1989); Wayne Harwell Props. v. Pan Am. Logistics Ctr., Inc., 945 S.W.2d 216 (Tex. App. 1997).
16 Id.
17 In re Sabine, 547 B.R. at 75-76.
18 Flying Diamond Oil Corp. v. Newton Sheep Co., 776 P.2d 618, 623 (Utah 1989).
19 See, e.g., Sabine Prod. Co. v. Frost Nat’l Bank of San Antonio, 596 S.W.2d 271, 276 (Tex. Civ. App. 1980); Colo. Interstate Gas Co. v. Hunt Energy Corp., 47 S.W.3d 1, 10 (Tex. App. 2000); Riley v. Riley, 972 S.W.2d 149, 155 (Tex. App. 1998); Phillips Petroleum Co. v. Adams, 513 F.2d 355, 363 (5th Cir. 1975).
20 In re Sabine, 547 B.R. at 77-78.
22 Monarch at 15.
23 Flying Diamond, 776 P.2d at 624 (quoting Lundeberg v. Dastrup, 28 Utah 2d 28, 31 (1972)) (1989) (footnote omitted).
24 Monarch at 15.
25 In re Sabine, 547 B.R. at 77-78.
26 Id.
27 Newco Energy v. Energytec, Inc. (In re Energytec, Inc.), 739 F.3d 215, 222 (5th Cir. 2013).
28 Restatement (Third) of Prop.: Servitudes § 2.4 (2000).
29 See Wimberly v. Lone Star Gas Co., 818 S.W.2d 868, 870 (Tex. App. 1991) (contract to purchase water for a gas compressor station) (declaration within the contract held to be a covenant running with the land despite no conveyance of real property); Prochemco, Inc. v. Clajon Gas Co., 555 S.W.2d 189, 191 (Tex. Civ. App. 1977) (contract to purchase gas for irrigation purposes) (declaration within the contract held to be a covenant running with the land despite no conveyance of real property).
30 Flying Diamond Oil Corp. v. Newton Sheep Co., 776 P.2d 618, 628 (Utah 1989). (citing Margot Rau, Note, Covenants Running with the Land: Viable Doctrine or Common-Law Relic?, 7 Hofstra L. Rev. 139, 145 (1978); Berger, A Policy Analysis of Promises Respecting the Use of Land, 55 Minn. L. Rev. 167, 180 (1970)).
32 In re Sabine, 550 B.R. at 69.
33 Monarch at 20.
34 Id.
35 Id.
36 Id. at 21.
37 Wayne Harwell Props. v. Pan Am. Logistics Ctr., Inc., 945 S.W.2d 216, 218 (Tex. App. 1997). It should be noted there is some discrepancy as to whether an equitable servitude technically “runs with the land”. Regardless, an enforceable equitable servitude is binding against subsequent purchasers and thus in practical effect, runs with the land.
38 J. Dukeminier et al., Property 236-264 (7th ed. 2010).
39 Id.
40 Both the Nordheim and HPIP Agreements were filed in the appropriate county land records and thus the notice element would very likely be met.
41 James N. Johnson, In General—Types of Enforceable Restrictions, 4 Texas Practice Guide Real Estate Transactions § 24:7 (2019).
42 Flying Diamond Oil Corp. v. Newton Sheep Co., 776 P.2d 618, 623 n.6 (Utah 1989).
43 In re Sabine, 550 B.R. at 65-71; Monarch at 11-21.
44 Mark W. Wege, Oscar N. Pinkas & Lauren Macksoud, Does the Second Circuit in Sabine Have the Final Word on Texas Law?, 37-Aug. Am. Bankr. Inst. J. 24, 79 (2018).
45 Mark W. Wege & Kwame N. Cain, Will Texas Courts Upend Recent Decisions Applying Texas Law and Striking Down Midstream Contracts, Texas Lawyer (Sept. 27, 2016), http://www.texaslawyer.com/id=1202768648682/Will-Texas-Courts-Upend-Recent-Decisions-Applying-Texas-Law-and-Striking-Down-Midstream-Contracts.
