Texas Court Undercuts Sabine, Holding Gathering Agreements Cannot Be Rejected

Background

On September 11, 2019, contemporaneously with filing its bankruptcy case, Alta Mesa initiated an adversary proceeding against, among others, Kingfisher Midstream (“Kingfisher”) seeking authority to reject under section 365 of the Bankruptcy Code certain “above-market” Kingfisher gathering agreements (the Agreements). The Agreements provided that Kingfisher would gather and transport the hydrocarbons that Alta Mesa produced, and in exchange Kingfisher would receive service fees based on the amount of hydrocarbons that Alta Mesa delivered to Kingfisher. Alta Mesa contends that the Alta Mesa owners agreed to pay Kingfisher — a commonly owned affiliate — exorbitant gathering fees and that the Agreements do not “touch and concern the land” (the extracted oil and gas constitutes personal property as opposed to real property). Alta Mesa also sought to avoid the Agreements as preferences, fraudulent transfers and byproducts of the insiders’ alleged breach of fiduciary duties — all theories that were not summarily decided by Judge Isgur in his opinion. 

Recognizing that the uncertainty created by the underlying litigation dynamics could chill bidding relating to Alta Mesa’s sale process, Judge Isgur ruled from the bench on December 6, 2019, holding that the Agreements were covenants running with the land that could not be rejected. Notwithstanding the oral ruling, Alta Mesa pressed on by seeking to rescind the Agreements under alternative theories. At Judge Isgur’s recommendation, the parties agreed to improve the joint sales process through a stay of the litigation, and Judge Isgur issued his written opinion one week later.

Gathering Agreements Are Covenants Running With the Land Under Oklahoma Law

Real property covenants are those that are so connected to the underlying land that the benefit and burden pass to successors by operation of law. For the Agreements to be considered covenants that run with the land under Oklahoma law, Kingfisher had to establish the following factors: (1) The Agreements must touch and concern the real property, (2) there must be privity of estate between the parties and (3) the original parties to the Agreements intended to bind successors. In finding that the Agreements satisfied all three factors, Judge Isgur’s analysis primarily focused on the connection between the Agreements and Alta Mesa’s leasehold interest as opposed to their mineral estate interest — an important deviation from Judge Shelley Chapman’s analysis in Sabine (explaining that “[t]he Court assumes that unique facts in Sabine led to that court’s conclusions. To the extent that the pronouncements in Sabine were intended to be generalized, this Court must reject them”). 

The Agreements Touch and Concern the Land

In deciding whether a gathering agreement touches and concerns the land, the court asked “whether the covenantor’s legal interest with respect to the land is rendered more or less valuable by the covenant.” The court embarked on an analysis to determine whether Alta Mesa’s interest in the leasehold was affected, either positively or negatively, by the Agreements and identified at least four relevant covenants in the original Agreements that “touch and concern” Alta Mesa’s leasehold interest: (1) the dedication of all of Alta Mesa’s produced hydrocarbons for delivery to Kingfisher, which restricts Alta Mesa’s use of its reserves; (2) the inclusion of sections titled “Covenants Running With Land,” which required recordation and required transferees to affirm the agreements; (3) the creation of surface easements allowing Kingfisher to build and maintain the gathering system, thus realizing the value of Alta Mesa’s reserves; and (4) fixed gathering fees, which diminished the value of the reserves in a depressed oil and gas market and which ultimately precipitated Alta Mesa’s desire to reject the Agreements in the first place.⁴ As a result, the court found a “logical connection between both the burden and benefit of the covenants and Alta Mesa’s real property” even though Kingfisher was not entitled to possession of the hydrocarbons until after they were extracted.  

There Is Both Vertical and Horizontal Privity

The court next addressed the issue of whether there was privity of estate, which essentially requires that Alta Mesa and Kingfisher have a mutual or successive relation to the same right in the leasehold estate. There are two types of privity: vertical privity, which refers to the relationship between the present owner of the land and the original parties to the covenant, and horizontal privity, which is present if the original covenanting parties created the covenant in connection with a conveyance of an estate from one to the other. Judge Isgur emphasized that Alta Mesa and Kingfisher were the original covenanting parties, and because the interests in the gathering agreements were properly recorded, subsequent transferees would have notice and would be bound to the covenants.

With respect to horizontal privity, Kingfisher argued that it was not required under Oklahoma law, but even if it was, horizontal privity existed between Alta Mesa and Kingfisher.  The court declined to answer definitively whether horizontal privity must be shown under Oklahoma law and instead found that “[i]f horizontal privity is required, it exists under the facts of this case.”

Judge Isgur again distinguished the Sabine decision, which centered its analysis on fee mineral estates, and instead focused on the oil and gas leaseholds at issue. According to Judge Isgur, the easements conveyed to Kingfisher a possessory interest in Alta Mesa’s leasehold estate. The surface easements were an essential component to the oil and gas lease, the conveyance of which from Alta Mesa to Kingfisher was sufficient to show horizontal privity with respect to the gathering Agreements. Further, because Alta Mesa’s surface easements spring directly from its leasehold mineral interests, Judge Isgur found that the surface easement is a crucial component on an oil and gas lease.  

The court’s emphasis on the easements in the lease was a critical distinction from the mineral interest owner analysis in Sabine. Judge Isgur continuously underscored his emphasis on the lessee (Kingfisher) having surface easements and implied that the record demonstrated these leases involved actual grants of surface easements to Kingfisher, which raises critical bankruptcy questions and practical issues for midstream and upstream companies in future energy transactions.  

Finally, the court found that the record sufficiently established that Alta Mesa and Kingfisher intended the covenant to run with the land.⁵ 

Conclusion

Having satisfied all three elements necessary to conclude that the covenants run with the land, the court granted summary judgment determining that the Agreements could not be rejected. For the remaining claims, such as alleged breaches of fiduciary duty, the court found fact issues remaining that would require a trial on the merits. This ruling has ample policy implications for both midstream and upstream companies, especially producers with burdensome gathering agreements contemplating bankruptcy. Although Sabine interpreted Texas law, it was never binding on courts outside of the Second Circuit, and Judge Isgur’s opinion in Alta Mesa only further casts doubt on Sabine’s reach. 

¹ Alta Mesa Holdings, LP, et al. v. Kingfisher Midstream, LLC, et al., Case No. 19-03609.
² See generally Midlands Midstream, LLC v. Badlands Energy, Inc., 2019 WL 5549463, No. 17-01429, at *15 (Bankr. D. Colo. Sept. 30, 2019) (holding under Utah law that gathering agreements formed real property covenants and therefore could not be rejected pursuant to section 365 of the Bankruptcy Code).
³ Critically, the issues in Sabine were governed by Texas law pursuant to choice-of-law provisions in the contracts, whereas Judge Isgur’s analysis in Alta Mesa was premised on Oklahoma law due to the location of the leases.  
⁴ Additionally, the court explained that the Agreements carve out a portion of Alta Mesa’s lease easements and grant those portions to Kingfisher. These carveouts restricted Alta Mesa’s use of the surface land for drilling or exploration and ultimately reduced Alta Mesa’s real property interest, thereby “burden[ing] Alta Mesa’s interest in the reserves” and further underscored the touch and concern element.
⁵ Each of the Agreements stated that it was “a covenant running with the land.” This alone would not create a real property covenant, the court explained, but rather demonstrated the parties’ “intent to bind successors to real covenants.” Accordingly, parties must be cognizant in drafting gathering agreements that include language that the “covenant runs with the land,” as it may indicate an intent to create a real property covenant.