The issue of whether gathering agreements are subject to rejection in bankruptcy as executory contracts and whether certain provisions of those agreements run with the land and survive rejection will impact ongoing bankruptcy proceedings of producers, as well as renegotiations of existing gathering agreements.
This article was published on April 22, 2016 in the Bankruptcy, Commercial Contracts, Energy, New York, Pennsylvania, Real Estate and Texas sections of Law360 under the title, "When a Contract 'Runs with the Land' — A Look at the Laws."
Since the beginning of 2015, approximately 50 exploration and production companies in the United States and Canada have filed for bankruptcy, with the combined debt of these companies approaching $20 billion. As the challenging commodity price environment continues to exert pressure on exploration and production companies and others in the production chain, understanding the possible rights and obligations that could be impacted or modified by a bankruptcy filing, or the threat of such a filing, is important for all parties involved. One such obligation at the heart of numerous ongoing energy industry bankruptcy proceedings, and at the center of the relationship between exploration and production and midstream companies, is the gathering and transportation agreement defining the terms and cost to flow oil and natural gas from wellhead to market.
In the ongoing bankruptcy proceedings of several exploration and production companies, this issue has taken center stage as the companies attempt to reduce costs by trying to reject what they deem are above market gathering and transportation agreements with their pipeline providers. These gathering agreements are typically for lengthy fixed terms and, outside of the financing that exploration and production companies obtain to run their drilling programs, are often one of the company’s largest long-term expenses. Therefore, in an effort to reorganize or sell their assets as part of a bankruptcy proceeding, exploration and production companies are motivated to reject these gathering agreements to reduce their costs and obligations going forward after reorganization, or to threaten such rejection to gain leverage in negotiating a lower rate.
The determination of whether a producer may avoid the burdens of a gathering agreement through rejection in a bankruptcy proceeding has boiled down to whether the agreement “runs with the land.” A contract establishing a covenant running with the land may not be susceptible to rejection under section 365 of the Bankruptcy Code, or may create property rights that survive rejection. As such, bankrupt exploration and production companies burdened with above-market gathering agreements contend that the agreements do not run with the land and are subject to rejection as executory, while midstream companies argue that the gathering agreements do run with the land and either cannot be rejected by producers in bankruptcy or create enforceable property rights that will survive rejection.
On March 8, 2016, the U.S. Bankruptcy Court for the Southern District of New York in the Sabine Oil & Gas bankruptcy case found that exploration and production company Sabine could reject three midstream agreements for gas and condensate gathering services as part of its bankruptcy proceeding. See In re Sabine Oil & Gas Corp., No. 1511835, Doc. No. 872 (Bankr. S.D.N.Y Mar. 8, 2016). The bankruptcy judge agreed with Sabine that its rejection of the contracts was a reasonable exercise of its business judgment and that Sabine satisfied the statutory standard for rejection. The court, however, for bankruptcy procedural reasons, did not officially decide the issue of whether the gathering agreements ran with the land pursuant to Texas law. After stating that it was not deciding the “running with the land issue,” the court then proceeded to issue a nonbinding analysis, concluding that the gathering agreements at issue did not run with the land under Texas law.
There has been litigation on this same issue in the bankruptcy cases of exploration and production companies Quicksilver Resources and Magnum Hunter. See In re Quicksilver Resources, Inc., No. 15-10585 (Bankr. D. Del.); In re Magnum Hunter, No. 15-12533 (Bankr. D. Del.). Because a key issue in all of these cases where a bankrupt exploration and production company seeks to avoid the burdens of a gathering agreement is whether the agreement runs with the land under relevant state law, this article analyzes the law in certain mineral-producing states regarding when an agreement runs with the land.
How the Issue Plays Out in Bankruptcy Court
What is and is not an executory contract subject to assumption and rejection can be the basis of litigation, as has occurred in the Sabine, Quicksilver and Magnum Hunter cases. A debtor’s assumption or rejection of executory contracts is governed by section 365(a) of the Bankruptcy Code. Section 365(a) provides that the debtor may assume or reject any executory contract or unexpired lease of the debtor, subject to the bankruptcy court’s approval. The Bankruptcy Code does not define what constitutes an executory contract, but it is generally accepted to mean a contract under which the obligations of both the bankrupt party and the other party are so far unperformed that the failure of either to complete performance would constitute a material breach, excusing the performance of the other.
With respect to covenants that run with the land, courts have found that express covenants that run with the land cannot be rejected under section 365 because they represent an interest in real property, as opposed to contract rights. See, e.g., Gouveia v. Tazbir, 37 F.3d 295, 299 (7th Cir. 1994). Midstream players therefore can be expected to assert that their gathering agreements include covenants that run with the land that either preclude rejection or would survive rejection.
Another provision of the Bankruptcy Code that may implicate the contract rights of the parties to gathering agreements is section 363, which governs the use, sale or lease of the debtor’s property. Section 363(b) permits the debtor to use, sell or lease property of the debtor’s estate outside the ordinary course of business after notice and a hearing. Section 363(f) provides that the trustee may sell property free and clear of any interest in the property if any one of five conditions are met: (1) applicable non-bankruptcy law permits the sale of the property free and clear of such interest; (2) the entity consents; (3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property; (4) such interest is in bona fide dispute; or (5) such entity could be compelled, in a legal or equitable proceeding, to accept money satisfaction of the interest.
In addition to the substantive provisions of the Bankruptcy Code that may impact the contractual rights of the parties, one procedural issue is also noteworthy. As noted above, the Sabine court did not make a binding determination as to whether the covenants under the gathering agreements at issue run with the land. The court found that it could not make a binding determination on the issue because — although Rules 6006 and 9014 of the Federal Rules of Bankruptcy Procedure provide that a proceeding to reject an executory contract is a contested matter — Second Circuit precedent holds that contract rejection proceedings are summary proceedings and should not be used for the prolonged adjudication of disputed legal and factual issues. The Sabine court therefore found that it could not make a binding determination as to whether the covenants at issue run with the land, but did offer nonbinding analysis that they do not. Although the court did not offer express guidance as to the next steps the midstream companies or the debtors would need to take on the issue, it did suggest that an adversary proceeding or a separate contested matter would be required to determine the substantive legal dispute.
The debtor in Magnum Hunter appears to have heeded the Sabine court’s procedural warning by very recently filing both a motion to reject a gas purchasing agreement and an adversary complaint seeking a declaratory judgment that certain covenants contained in the agreement do not run with the land.
Common Terms in Gathering Agreements
The terms of each agreement governing the gathering, processing and transportation of oil and natural gas between the exploration and production company and the pipeline company will determine whether the agreement itself is an executory contract subject to rejection in bankruptcy. The terms of each such agreement will, of course, be different and will require analysis by all parties long before a bankruptcy filing is imminent or threatened. Nevertheless, there are certain terms that are typical of such agreements, as demonstrated by the terms of the gathering agreements in Sabine.
In Sabine, at issue were three gathering agreements with two pipeline companies, all with similar terms. The gathering agreements provided that Sabine would dedicate all gas produced in a designated area and deliver that gas to the pipeline company, which agreed to construct, at its cost, a gathering system to provide the necessary transportation services. The gathering agreements contemplated a separate and subsequent conveyance from Sabine to the pipeline company of a mutually agreed tract of land in connection with its construction and operation of the gathering system. Sabine also agreed to deliver a certain minimum amount of gas. If Sabine failed to deliver the minimum amount of gas, it was subject to a deficiency payment. The gathering agreements had 10-year terms and were governed by Texas law, and memoranda of the gathering agreements were recorded in the relevant counties. Lastly, the agreements contained a clause stating that they were covenants running with the land within the designated areas and that they were enforceable against affiliates, successors and assigns.
Law in Mineral-Producing States When a Contract 'Runs with the Land'
Bankruptcy courts deciding the issue of whether gathering agreements run with the land will be interpreting state law to do so. The applicable state law will be determined by choice-of-law provisions in the gathering agreements or by choice-of-law principles focused, mostly, on the location of the gathering pipelines at issue. The following are factors that courts in various mineral-producing states analyze in determining whether an obligation runs with the land, an inquiry that will be the focus of bankruptcy courts facing this issue. Although many of the states have similar ways to determine if an agreement runs with the land, it is not uniform by any means.
Texas
In Texas, a covenant will run with the land where 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 and (4) when the successor to the burden has notice. Inwood North Homeowners’ Ass’n v. Harris, 736 S.W.2d 632, 635 (Tex. 1987). But a covenant that does not technically run with the land can still bind successors to the burdened land as an equitable servitude if (1) the successor to the burdened land took its interest with notice of the restriction, (2) the covenant limits the use of the burdened land and (3) the covenant benefits the land of the party seeking to enforce it. Reagan Nat’l Adver. of Austin v. Capital Outdoors, 96 S.W.3d 490, 495 (Tex. Ct. App. 2002). The intent of a covenant to run with the land may be implied where the benefit of the covenant was intended to be more than transitory in nature. Musgrave v. Brookhaven Lake Prop. Owners Ass’n, 990 S.W.2d 386 (Tex. Ct. App. 1999).
Looking to Texas law, in a nonbinding analysis, the Sabine court largely adopted Sabine’s arguments that the gathering agreements did not create covenants running with the land. The court concluded that Sabine’s dedications to the pipeline companies, as well as the covenant to pay gathering fees, were not covenants running with the land or equitable servitudes. While noting that there was no “applicable binding decision of the Texas Supreme Court on all aspects of the question,” the court applied the long-standing four-part test and analyzed whether horizontal privity existed to determine that the gathering agreements do not run with the land.
Lastly, the Sabine court examined whether the gathering agreements represented a conveyance of real property interests from Sabine to the pipeline companies. The court recognized that, under Texas law, “five sticks” exist: (1) the right to develop (the right of ingress and egress), (2) the right to lease, (3) the right to receive bonus payments, (4) the right to receive delay rentals and (5) the right to receive royalty payments. The court concluded that, because the right to transport or gather produced gas was not listed, the gathering agreements were not real estate conveyances under Texas law and, as such, did not run with the land. Of course, the Texas Supreme Court could reach a different decision on the issue if it comes before it in the future (including, potentially, on a federal appellate court’s certification of the issue to the Texas Supreme Court), which would provide direction to bankruptcy courts confronting the issue.
Pennsylvania
Pennsylvania law provides that a real covenant is one that runs with the land and is enforceable against whomever holds title to the real property. Real covenants are those so closely connected with the realty that their benefits or burdens pass with it to subsequent owners. See DeSanno v. Earle, 117 A. 200, 202 (Pa. 1922). The test for whether a covenant runs with the land is governed by the intention of the parties, as ascertained from the words of the covenant read in the light of the surroundings of the parties and the subject of the grant. See Philadelphia Fresh Food Terminal Corp. v. M. Levin & Co., 361 A.2d 886, 890 (Pa. Super. Ct. 1976). The requirements for a covenant running with the land are that the covenant touch and concern the land itself, that it be certain and definite, that it is for the benefit of the dominant estate and must have been intended as such, and that there must be privity of estate. See Elec. City Land & Improv. Co. v. W. Ridge Coal Co., 41 A. 458, 500 (Pa. 1898).
No formal or specific technical language is required to set forth a covenant running with the land in Pennsylvania, nor is it required that the covenant be expressed as such. Typically, a covenant creating an easement, lien or charge generally runs with the land. See Birchwood Lakes Cmty. Assocs. v. Comis, 442 A.2d 304, 307 (Pa. Super. Ct. 1982) (covenant providing for an annual homeowners’ association charge is binding on successors to the title); Muzzarelli v. Hulshizer, 30 A. 291 (Pa. 1894) (a covenant concerning light and air restrictions runs with the land).
Oklahoma
Covenants restricting the use of property are generally held to be covenants running with the land, and such covenants are binding on the successors in interest to the parties, although there was no privity of interest between such successors and the original parties. The portion of the restricted agreement would be as binding on subsequent owners as on the original parties to the agreement. O’Neil v. Vose, 145 P.2d 411, 417 (Okla. 1944). Oklahoma courts consider three factors to decide whether a covenant runs with the land: (a) there must be privity of estate between the party claiming the benefit and the party on whom the burden rests, (b) the burden or benefit must “touch and concern” the land, and (c) the original parties must have intended for the burden or benefit to pass to successors. Noyes v. McDonnell, 398 P.2d 838, 840 (Okla. 1965). Oklahoma’s prevailing real covenant standard provides:
[a] real covenant is one which is so connected with the underlying realty that either the right to enforce the covenant’s performance (the benefit) or the duty to perform the covenant’s obligation (the burden), or both, passes to the heirs or grantees of one or both of the original covenanting parties by operation of law without express assignment or delegation. A real covenant benefits or burdens remote parties simply because they acquire an interest in land that carries the benefit or burden along with it, . . . provided the covenant meets certain conditions imposed by law.
Beattie v. Grand River Dam Auth., 41 P.3d 377, 385-87 (Okla. 2002) (J. Opala, concurring) (emphasis in original).
Privity of estate may include horizontal privity, where a relationship exists between the original covenantor and covenantee, or vertical privity, where a relationship exists between the present owner/occupier and the original covenanting parties. Id. at 388. While Oklahoma’s Supreme Court never expressly dispensed with the need for horizontal privity for the running of a real covenant, the few Oklahoma decisions related to the running of real covenants only identify the vertical aspect of privity. Cason v. Conoco Pipeline Co., 280 F.Supp.2d 1309, 1319 (N.D. Okla. 2003) (citing Beattie, 41 P.2d at 388).
North Dakota
North Dakota law defines covenants running with the land as:
Certain covenants contained in grants of estates in real property are appurtenant to such estates and pass with them so as to bind the assigns of the covenantor and to vest in the assigns of the covenantee in the same manner as if they personally had entered into them. Such covenants are said to run with the land.
The only covenants which run with the land are those specified in this chapter and those which are incidental thereto.
N. D. Cent. C. § 47-04-25.
Section 47-04-26 of the North Dakota Century Code identifies specific covenants running with the land:
All covenants contained in a grant of an estate in real property, which are made for the direct benefit of the property or some part of it then in existence, run with the land. Such covenants include covenants:
1. Of warranty;
2. For quiet enjoyment;
3. For further assurance on the part of a grantor; or
4. For the payment of rent, taxes, or assessments upon the land on the part of a grantee.
Id.
If the covenant does not touch or concern the occupation or enjoyment of the land, it is the collateral and personal obligation of the grantor or lessor and does not run with the land. Beeter v. Sawyer Disposal LLC, 771 N.W.2d 282, 286-87 (N.D. 2009). If a covenant or deed restriction benefits the grantor personally and serves no real benefit to the land, then the covenant is personal in nature and does not “run with the land” upon a subsequent sale of the property. Id. at 287. Thus, if a covenant contained in a deed does not directly benefit the land as required by North Dakota Century Code section 47-04-26, it is personal and is enforceable only between the original parties to the deed. Id.
Ohio
In Ohio, the determination of whether the covenant runs with the land depends on whether the covenant is real or personal. A covenant is determined to run with the land when the liability to perform it or the right to take advantage of it passes to the assignee of the land. Lone Star Steakhouse Saloon of Ohio v. Quaranta, 2002 Ohio App. LEXIS 7282 (Ohio Ct. App. 2002) (citing 35 Ohio Jurisprudence 3d (1982)). A three-part test exists to determine whether a covenant runs with the land in Ohio: (1) the intent of the original grantor and grantee must have been that the covenant run with the land; (2) the covenant must either “affect” or “touch and concern” the land in question; (3) there must be privity of estate between the party claiming the benefit of the covenant and the party who is called on to fulfill it. See LuMac Dev. Corp. v. Buck Point Ltd. P’ship, 573 N.E.2d 681, 683 (Ohio Ct. App. 1988).
In determining whether the restriction “affects” or “touches and concerns” the land in question, Ohio courts must determine if the property was made more useful or valuable by the covenant. LuMac Dev. Corp. 573 N.E.2d at 684. A personal covenant can still be enforceable against a subsequent purchaser and valid in equity on a purchaser taking the estate with notice. See Counts v. Baltimore & O S.R.R. Co.,177 N.E.2d 606, 609 (Ohio Ct. App. 1961). The covenant is not binding on a successor merely because he stands as an assignee of the party who made the agreement, but because he has taken the estate with notice of a valid agreement concerning it, which he cannot equitably refuse to perform. Id.
New York
In New York, every instrument creating, transferring, assigning or surrendering an estate or interest in real property must be construed according to the intent of the parties, so far as such intent can be gathered from the whole instrument and is consistent with the rules of law. Real Prop. Law § 240(3). The statute guides us in determining whether, in a deed, the parties have, or have not, created covenants running with the land. See Neponsit Prop. Owners’ Assn. v. Emigrant Indus. Sav. Bank, 15 N.E.2d 793 (N.Y. 1938).
New York courts have held that a party claiming the benefit of a covenant could only enforce its rights against a successive purchaser where (1) the original grantee and grantor intended that the covenant run with the land, (2) there was privity of estate between the party claiming the benefit of the covenant and the right to enforce it and the party upon whom the burden of the covenant is to be imposed and (3) the covenant “touches and concerns” the land. Id. at 795. In ascertaining intent at the time that the covenant was created, New York courts first look to the language of the deed. See Brody v. St. Onge, 563 N.Y.S.2d 251, 252 (N.Y. App. Div. 1990). “[A] covenant should be held to touch or concern the land, to run with the land, if it affects ‘the legal relations — the advantages and the burdens — of the parties to the covenant, as owners of particular parcels of land and not merely as members of the community in general, such as taxpayers or owners of other land.” Neponsit at 796. Significantly, “whether a particular covenant is sufficiently connected with the use of the land to run with the land, must be in many cases a question of degree.” Id.
Conclusion
The issue of whether gathering agreements are subject to rejection in bankruptcy as executory contracts and whether certain provisions of those agreements run with the land and survive rejection will not only impact the ongoing bankruptcy proceedings of producers, but it will impact negotiations of financially challenged producers that may attempt to use the Sabine and related rulings as a sword in order to renegotiate existing gathering agreements. Importantly, the applicable state requirement of when an agreement runs with the land will not only determine these bankruptcy disputes, but will also inform the negotiation of future gathering agreements, including what language and requirements companies will want to include in those agreements to afford the greatest level of protection in any future bankruptcy proceeding.
