Major Decision in Energy-Related Bankruptcies: Colorado Court in Monarch Midstream Case Departs from Sabine Oil and Finds Gathering Agreement Established a Covenant Running with the Land

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A Colorado bankruptcy court has departed from the widely reported holding in Sabine Oil that permitted a debtor to reject a certain midstream gathering agreement. On September 30, 2019, the United States Bankruptcy Court for the District of Colorado (Bankruptcy Court) rejected a debtor’s attempt to sell assets free and clear of a Gas Gathering and Processing Agreement (GPA) and Agreement for Disposal of Salt Water (SWDA), ruling that each constituted covenants running with the land that could not be rejected or eliminated pursuant to a sale of assets under Bankruptcy Code Section 363.[1] In so ruling, the court directly addressed the Sabine Oil & Gas Corp. v. Nordheim Eagle Ford Gathering, LLC decision, in which the Second Circuit, affirming the District Court and Bankruptcy Court for the Southern District of New York, held that a debtor could reject a certain midstream gathering agreement because it did not create a real covenant that ran with the land under Texas law. Given the departure from Sabine Oil, this new ruling sets forth new precedent that could yield a real benefit to midstream companies.[2]

Background

On August 11, 2017, Badlands Production Company, f/k/a Gasco Production Company, and Badlands Energy, Inc., f/k/a Gasco Energy, Inc. (collectively, “Badlands”) filed chapter 11 bankruptcy.

Prior to filing for bankruptcy, Badlands and Monarch Midstream, LLC f/k/a Monarch Natural Gas, LLC (collectively, “Monarch”) through their respective predecessors, executed an Asset Purchase Agreement whereby Monarch agreed to purchase gas gathering and salt water disposal systems in Uintah and Duchesne Counties from Badlands. Additionally, the parties, through their respective predecessors, entered into two agreements: (1) the GPA; and (2) the SWDA (together with the GPA, the “Agreements”).

On August 14, 2017, Badlands filed a motion to sell certain assets free and clear of liens, claims, encumbrances, and interests, as is typical in a sale under Section 363(f) of the Bankruptcy Code (Sale Motion). The proposed Purchase and Sale Agreement (PSA) between the proposed purchaser—Wapiti—and Badlands expressly provided that Wapiti would not assume any contracts with Monarch, including the GPA and SWDA, in connection with the purchase of the assets. As proposed, the sale would thus eradicate rights associated with the Agreements.

In tandem with the Sale Motion, Monarch initiated an adversary proceeding (Monarch Adversary), requesting the Court issue a declaratory judgment that Wapiti could not purchase the assets free and clear of the Agreements under section 363 of the Bankruptcy Code because the covenants in the Agreements ran with the land.

The Monarch Adversary

In the Monarch Adversary, the Bankruptcy Court found that the Agreements, which were governed by Utah law, created real covenants because they “touched and concerned” the land and met the requirements of vertical privity, mutual privity, and horizontal privity. Under Utah law, to be characterized as a covenant running with the land: (1) the covenant must touch and concern the land; (2) the covenanting parties must intend the covenant to run with the land; (3) there must be privity of estate; and (4) the covenant must be in writing. The Bankruptcy Court focused on the first and third elements of the test through its analysis—the same elements addressed in Sabine Oil.

Relying heavily on the Utah Supreme Court’s 1989 decision in Flying Diamond Oil Corp. v. Newton Sheep Co.,[3] the Bankruptcy Court recognized that “to touch and concern the land, a covenant must bear upon the use and enjoyment of the land and be of the kind that the owner of an estate or interest in land may make because of his ownership right.”[4] The “broad test” for the touch and concern requirements did not require a “physical effect upon the land” but rather, required the court to determine whether a covenant “enhances the land’s value [on the benefit side], and for the burden side, whether it diminishes the land’s value.” Because Badlands’ interests in the oil and gas leases were diminished by the Agreements and the burdens imposed by the Agreements consequently impacted Badlands’ use and enjoyment of its interests in the oil and gas leases, the Colorado Bankruptcy Court reasoned that the Agreements “touched and concerned” the land under Utah law. Additionally, provisions in both Agreements bound successors and assigns of the Agreements, as was the case in Flying Diamond.

In arguing that the Agreements did not touch and concern the land, Wapiti claimed that the dedication contained in the GPA was similar to the one found in Sabine Oil. The Bankruptcy Court disagreed, finding the ruling in Sabine Oil inapplicable—Sabine Oil’s dedication concerned personal property rather than real property under Texas law because it referred only to minerals extracted from the ground.[5] Unlike Sabine Oil, the GPA at issue encompassed real property because the dedication covered “non-extracted minerals.”[6]

In addition, the Bankruptcy Court rejected Wapiti’s argument that there must be a conveyance of a real property interest for a covenant to meet the “touch and concern” requirement under Utah law. The Bankruptcy Court agreed with Monarch that the dedicated interest in the oil and gas reserves, leases, and all other lands within the area of mutual interest sufficiently affected the use, value, and enjoyment of Badlands’ interest in the oil and gas leases subject to the GPA by limiting the right to possess, develop, and dispose of the minerals and salt water.

With respect to the third element—the most discussed in the Sabine Oil decision—the Bankruptcy Court noted that there are generally three types of privity: (1) vertical; (2) mutual; and (3) horizontal. The Bankruptcy Court easily found that vertical privity existed because Wapiti, as purchaser of the assets, was the successor to the estate of the original entity burdened. As for mutual and horizontal privity, the Bankruptcy Court noted that many courts, including Sabine Oil, have combined the two types of privity under the horizontal privity requirement, while others have found that mutual privity is not required. Although the Utah Supreme Court has yet to address whether mutual privity is required, the Bankruptcy Court found that the mutual privity requirement was satisfied pursuant to the simultaneous ownership interests of Badlands and Monarch within the oil and gas leases subject to the GPA. Finally, the Bankruptcy Court found that horizontal privity existed under Flying Diamond because the covenants set forth in the Agreements were created in connection with an asset purchase agreement executed by Badlands and Monarch that required execution of the Agreements as a condition to closing. Flying Diamond defined “horizontal privity” as existing “when the original covenanting parties create a covenant in connection with a simultaneous conveyance of an estate.”[7] Wapiti, relying on Sabine Oil, argued that horizontal privity was absent because no real property interests were conveyed under the Agreements. Again, the Bankruptcy Court distinguished Sabine Oil from the case at hand and found that there was in fact a conveyance (the gas gathering and saltwater disposal systems) related to the land that was burdened (Badlands’ oil and gas leases) by the applicable dedications.

[1] See 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, f/k/a Monarch Natural Gas, LLC v. Badlands Production Company f/k/a Gasco Production Company, et al., Adv. Case No. 17-01429-KHT (Bankr. D. Colo. Sept. 30, 2019), ECF No. 61.
[2] See 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).
[3] 776 P. 2d 618, 623 (Utah 1989).
[4] Quoting Flying Diamond, 776 F.2d at 623-24.
[5] Sabine Oil, 567 B.R. 869, 872 (the dedication was for “all [gas and condensate] produced and saved . . . from wells . . . located within the dedicated area”).
[6] The GPA dedication provided “the interest of [Badlands] in all Gas reserves in and under, and all Gas owned by [Badlands] and produced or delivered from (i) the Leases and (ii) other lands within the AMI . . . .”
[7] Flying Diamond, 776 P.2d at 628.

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