“Parties’ Words Matter” – New Houston Bankruptcy Court Decision in Chesapeake-ETC Dispute Provides Alternative Paths for Challenging Midstream Contracts

Jackson Walker

Over the past five years, bankruptcy courts have analyzed whether oil and gas producers’ contracts with midstream oil, gas, and produced water companies may be rejected if they create covenants running with the land. Through decisions in the Sabine Oil & Gas Corp.,[1] Badlands,[2] and Alta Mesa[3] cases, bankruptcy courts in New York, Colorado, and Texas have wrestled with whether midstream agreements burden real property interests, making them binding on the restructured debtor or a successor in interest after bankruptcy.

On October 28, 2020, Chief Bankruptcy Judge David R. Jones of the United States Bankruptcy Court for the Southern District of Texas issued a ruling that provides a new dimension to analyzing whether midstream contracts may be rejected. This decision will affect future rejection disputes (1) related to purchase and sale agreements concerning severed minerals or that contain forward sale provisions; and (2) contracts with “sole and exclusive remedy” provisions that provide for payment of formulaic damages.

In June 2020, Chesapeake Energy Corporation and its affiliates (Chesapeake) filed bankruptcy under Chapter 11 of the Bankruptcy Code and immediately filed a motion to reject a gas purchase agreement with ETC Texas Pipeline, Ltd. (ETC). The parties used a form of agreement published by the North American Energy Standards Board (NAESB) styled “Base Contract for Sale and Purchase of Natural Gas.” ETC asserted that the agreement contains a covenant running with the land and was not subject to rejection as an executory contract. Chesapeake responded that the agreement does not create a covenant running with the land and that rejection was appropriate notwithstanding the covenant running with the land issue in light of the parties’ agreed exclusive remedy provision.

In his Memorandum Opinion, Judge Jones first noted that the rejection of an executory contract constitutes a breach by the debtor of the contract[4] but does not itself terminate the contract or “vaporize” a counterparty’s rights.[5]

Next, Judge Jones analyzed and rejected ETC’s argument that a contract cannot be a rejectable executory contract if it contains a covenant running with the land. He noted that ETC did not cite any authority establishing that principle and that the particular language of an agreement may make an agreement both executory and a covenant running with the land. That is, a contract could establish the elements of a covenant running with the land but then undermine the otherwise continuing nature of the burden through contractual provisions allowing for termination and damages. Unlike the Chesapeake-ETC agreement, such provisions were not present or disputed in the Alta Mesa and Badlands decisions. Therefore, while contracts containing covenants running with the land generally cannot be rejected, Judge Jones emphasized that the parties’ contractual language will control the outcome.

Turning to the covenant running with the land analysis, the bankruptcy court noted that while the agreement recited that the obligation to sell gas would “run with the land,” the parties’ economic arrangement demonstrated that they did not intend to create a real property covenant. Chesapeake and ETC agreed that, in the event of any breach of the agreement, the “sole and exclusive remedy of the parties,” would be a payment of liquidated damages under a contractual formula instead of continuing with the purchase and sale of gas. By their words, the parties excluded specific performance, injunctive relief, and other remedies and instead provided the “exclusive” remedy of damages. Thus, the parties designed their contract to allow for damages and termination of sales obligations, so the language suggesting that the obligations would run with the land was an “ill-conceived attempt” to portray the agreement as a “horse of a different color” than their commercial terms created.

In addition to failing to satisfy the intent element, Judge Jones ruled that the Chesapeake-ETC agreement did not touch and concern the land. ETC did not obtain any interest in Chesapeake’s leases, and ETC agreed to buy produced gas, i.e. gas after it is severed from the mineral estate and becomes personal property under Texas law. In this respect, the bankrupcty court’s analysis of the dedication in the Chesapeake-ETC agreement was similar to the analysis in Sabine, and it is distinguishable from the analysis in the Alta Mesa and Badlands decisions because those cases addressed a dedication of unextracted minerals.[6] Since ETC failed to obtain any real property interest and Chesapeake’s ability to use and enjoy its property rights are unaffected, the parties’ contract did not touch and concern the land. Accordingly, the decision in this case confirms the importance of an appropriate dedication, and it highlights the distinctions made in prior cases between dedications of a real property interest in the mineral estate that generally do touch and concern the land and interests in severed personal property that do not touch and concern the land.

Finally, no horizontal privity of estate existed. ETC and Chesapeake never shared a simultaneous interest at the time they formed their agreement. To the contrary, they specified that their agreement constituted a “forward contract” for the sale of goods, belying any claim of a shared interest in real property. Under section 101 of the Bankruptcy Code, a forward contract concerns the future sale and purchase of commodities or rights. Based on the agreement, ETC obtained only a future right to buy a product rather than holding any interest in or burden on Chesapeake’s real property interests.

The October 28 ruling by Judge Jones provides an important new chapter in analyzing whether midstream contracts can be rejected. This decision points out the dangers of parties using a NAESB form of gas purchase and sale contract – that was designed for gas trading – in connection with wellhead sales of gas. The decision’s larger impact may be felt in other hydrocarbon sales contracts that have “sole and exclusive remedy” provisions that provide for payment of formulaic or liquidated damages upon breach or that contain forward sale provisions. Exclusive remedy provisions may undermine any recited intent for an obligation to run with the land or may make a contract that contains a covenant that would otherwise run with land become rejectable in bankruptcy. Exclusive remedy clauses constrain the non-debtor’s right to assert other remedies that would otherwise be available at law or in equity. Based on this decision, future bankruptcy courts may follow Judge Jones in declining to expand a counterparty’s rights when it has bound itself to one specific remedy.

[1] See Sabine Court Gives “Non-Binding” Ruling That Gathering Agreements Are Not Covenants Running with the Land Under Texas Law”; 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).
[2] See “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”; Monarch Midstream. LLC v. Badlands Prod. Co. (In re Badlands Energy, Inc.), 608 B.R. 854 (Bankr. D. Colo. 2019)
[3] See Texas Bankruptcy Court – Applying Oklahoma Law – Concludes That Gathering Agreements Created Covenants Running With the Land and Cannot be Rejected by the Alta Mesa Resources Debtors”; Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Res., Inc.), 613 B.R. 90 (Bankr. S.D. Tex. 2019).
[4] 11 U.S.C. § 365(g)(1); Wainer v. A.J. Equities, Ltd., 984 F.2d 679, 684 (5th Cir. 1993).
[5] Memorandum Opinion at *5 (citing Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652, 1658 (2019)).
[6] The dedication concerned oil and gas (in Alta Mesa) and gas (in Badlands) in the mineral estate and contained a promise to deliver those products once they were produced from the dedicated area.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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