Delaware Bankruptcy Court Rules That Midstream Gathering Agreements Failed to Create Covenants Running With the Land

On October 14, 2020, the honorable Christopher Sontchi, Chief Judge of the Delaware Bankruptcy Court, issued an opinion in the Extraction Oil and Gas bankruptcy case finding that certain oil, gas and water gathering agreements (the “Agreements”) did not create covenants running with the land under Colorado law and are thus subject to rejection in Extraction’s chapter 11 proceedings.

The Extraction decision is the Delaware Bankruptcy Court’s first published foray into a recent thicket of gathering agreement litigation that was reignited in 2016 with the Bankruptcy Court for the Southern District of New York authorizing the rejection of certain gathering agreements in the Sabine Oil & Gas bankruptcy case. Following Sabine, various oil and gas producers in chapter 11 attempted to use Sabine as a basis for invalidating dedications and shedding minimum volume and other commitments in their own gathering agreements. Such efforts were rebuffed in 2019 by the Colorado Bankruptcy Court in Badlands and by the Bankruptcy Court for the Southern District of Texas in Alta Mesa, each of which found that the agreements at issue created valid real property covenants under applicable state law and were thus not executory contracts that could be rejected in bankruptcy. 

Background

Extraction is an oil and gas producer based in Colorado that filed for chapter 11 protection on June 14, 2020. Prior to the bankruptcy, Extraction entered into the Agreements to transport hydrocarbons directly to market in Oklahoma and dispose of produced water generated in connection with its operations. During the bankruptcy case and in connection with an asset sale of substantially all of its assets, Extraction filed a motion in the Delaware Bankruptcy Court seeking to reject the Agreements pursuant to Section 365 of the Bankruptcy Code and commenced adversary proceedings against the various midstream counterparties seeking declaratory judgments that the Agreements did not create covenants that run with the land under Colorado law. 

Covenant Analysis

Although certain of the Agreements intended to create covenants running with the land, according to Judge Sontchi, the “central issue” before the Court was whether the dedications in the Agreements actually touched and concerned the relevant land.  Judge Sontchi analyzed the gathering services provided under the Agreements and the related dedications and ultimately concluded that the commodity produced by Extraction and gathered under the Agreements did not constitute a real property interest in Extraction’s mineral estate; it concerned only personal property and did not affect the physical use of real property or closely relate to real property. In contrast to the courts in Alta Mesa and Badlands, which found that a gathering system can touch and concern the relevant land given that it enhances the value of the relevant mineral interest, in Extraction the Delaware Bankruptcy Court echoed Sabine in finding that the primary effect of a dedication is on the use and enjoyment of personal property (the produced commodity) rather than real property.   

The Delaware Bankruptcy Court also found that the dedications in the Agreements did not run with the land because they were not created in conjunction with the conveyance of an independent real property interest in the relevant mineral estate, a condition known as horizontal privity. The issue of whether state law requires horizontal privity to create a real covenant is a common feature of litigation. In Extraction, Judge Sontchi found that horizontal privity applied and was not present because even though Extraction conveyed easements and other property rights to the relevant counterparties, the rights constitute interests in a severed surface estate rather than in Extraction’s mineral estates. In this respect, Extraction adopted an interpretation of horizontal privity that closely mirrors the reasoning in Sabine.    

After further analysis, the Delaware Bankruptcy Court ruled that the Agreements did not satisfy state law requirements for creating covenants running with the land and were thus executory contracts that could be rejected in Extraction’s bankruptcy proceeding. In the long-term, the effect of decisions like Sabine and Extraction is not clear. It may well create a greater reluctance of gatherers to accept poor producer credit where the gathering agreement requires significant capital outlays, and in such circumstances gatherers may be less willing to accept only long-term minimum volume commitments as security for recovering such capital expenditures. Moreover, the application of varying state law and the current divergence of results among jurisdictions provides no clear path to a national consensus for these continuing rejection disputes.