Power & Pipes

FERC, CFTC, and State Energy Law Developments

Is a midstream contract treated the same as other executory contracts in bankruptcy, subject to assumption and rejection pursuant to the US Bankruptcy Code? An executory contract is any contract of the debtor where both the debtor and the contract counterparty have ongoing performance obligations on the date of the bankruptcy filing. A midstream contract, if considered by the court to be an executory contract, may be assumed or rejected under 11 USC § 365.

If a debtor assumes the contract, it will “ride through” the bankruptcy and if the debtor rejects it, the contract is treated as if it were breached by the debtor, and the counterparty to the contract is left with a general unsecured claim for damages. The standard to reject an executory contract is low; the debtor simply has to show a valid business reason. Unless there is bad faith, a bankruptcy court will typically defer to the debtor’s determination that rejection is in the best interest of the estate.

Covenants ‘Running with the Land’

While many midstream contracts are indeed executory, certain courts have found that contracts containing real property covenants, also referred to as a covenant that “runs with the land,” are not executory and, therefore, cannot be rejected in bankruptcy. However, certain recent cases dealing with midstream agreements have found that even if the contract contains a real property covenant, rejection may be possible and the debtor’s obligations under the covenant are satisfied through the bankruptcy claim process.

In the bankruptcy of Sabine Oil & Gas Corp., a New York bankruptcy court, interpreting Texas law, found that certain gas gathering agreements did not contain real property covenants and could be rejected by the debtor, a holding that was subsequently affirmed by the US Court of Appeals for the Second Circuit. In re Sabine Oil & Gas Corp., 547 B.R. 66 (Bankr. S.D.N.Y. 2016); Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC, 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).

Subsequently, in the bankruptcy cases of Badlands Energy, Inc. (Colorado bankruptcy court, Utah law) and Alta Mesa Resources, Inc. (Texas bankruptcy court, Oklahoma law), the bankruptcy courts found that the gas gathering agreements at issue did contain real property covenants and, therefore, could not be rejected. In re Badlands Energy, Inc., 608 B.R. 854 (Bankr. D. Colo. 2019); In re Alta Mesa Resources, Inc., 2019 WL 7580122 (Bankr. S.D. Tex. Dec. 20, 2019).

While the above cases each apply different state laws, the basic analysis to determine whether the agreements contain covenants running with the land is the same and focuses primarily on three issues: (1) whether the covenants in the agreements “touch and concern” a real property interest; (2) where there was “privity” between the parties when the agreements were entered into (horizontal and vertical privity); and (3) whether the parties intended to create a real property covenant, i.e., that the agreements would “run with the land.” If all three of these elements are present, then the court will find that the agreement contains a real property covenant.

Following these cases, a trio of cases decided in 2020 more narrowly construed what constitutes a covenant running with the land and either suggested or found that even if a midstream contract does contain a covenant running with the land, it can still be rejected.

In the bankruptcy of Chesapeake Energy Corp., the court found that Chesapeake’s gas purchase agreement with the ETC Texas Pipeline did not contain a covenant running with the land under Texas law. Despite having express language that the parties agreed there was a “covenant running with the land,” the court found that there were other provisions indicating that the parties intended the contract to be personal in nature, including a liquidated damages provision providing for monetary damages and a provision acknowledging that the contract was a forward contract for the sale of gas. In re Chesapeake Energy Corp., 2020 WL 6325535 (Bankr. S.D. Tx. Oct. 28, 2020). In dicta, the Chesapeake court (Jones, J.) also suggested that even if the contract did contain a covenant running with the land, it was not clear that this would preclude rejection.

In the Extraction Oil & Gas bankruptcy, a Delaware bankruptcy court found that certain transportation services agreements could be rejected even if they contained covenants running with the land, and that the rights of counterparties under those covenants would be satisfied through the claims process—thereby extinguishing any rights the counterparty had to enforce the covenants against the debtor or subsequent owners of the property to which the covenants attached. In re Extraction Oil & Gas, 622 B.R. 608 (Bankr. D. Del. Nov. 2, 2020).

In the Southland Royalty Co. LLC bankruptcy, another Delaware bankruptcy court (applying Wyoming law) found that a gas gathering agreement did not contain a covenant running with the land because the agreement related to “produced” gas and therefore did not “touch and concern” the land. Southland Royalty Co. LLC v. Wamsutter LLC, 2020 Bankr. LEXIS 3185 (Bankr. D. Del. Nov. 13, 2020). The Southland court also followed the decision in Extraction, finding that even if the agreement contained a covenant running with the land, the contract could still be rejected.

In practice, these recent cases suggest that bankruptcy courts are trending toward a more narrow view of what constitutes a real property covenant and, even if a contract contains such a covenant, the court may still find that the contract can be rejected by a debtor in bankruptcy.