Given the current state of oil and gas markets and the number of U.S. "upstream" operators that may need to restructure this year, investors in this sector should be aware of a number of recent cases addressing the ability of upstream operators to shed covenants made to midstream operators as part of a Chapter 11 restructuring. Recently, two bankruptcy courts (the U.S. Bankruptcy Court for the Southern District of Texas in Alta Mesa and the U.S. Bankruptcy Court for the District of Colorado in Badlands) issued opinions in favor of midstream operators that either distinguish or expressly disagree with the findings of the U.S. Court of Appeals for the Second Circuit's opinion in the Sabine. These decisions are discussed in detail below, along with a checklist of key questions investors should consider in determining the likelihood that an upstream operator will be able to shed covenants made to a midstream operator if the upstream operator commences a Chapter 11 case.

Gathering Agreements

In the oil and gas world, midstream operators provide a critical bridge between "upstream" exploration and production companies and "downstream" operators who handle marketing and delivery of the oil and gas extracted by the upstream operator. Under the typical "gathering agreement" documenting the relationship between upstream and midstream operators, the upstream operator will "dedicate," for the benefit of the "midstream operator," all oil and gas produced from certain designated sites. In return, the midstream operator will agree to gather and process the oil and gas received from the upstream operator and deliver the processed hydrocarbons to a downstream company or other specified location in exchange for minimum monthly or annual payments. In order to perform these services, the midstream operator generally incurs significant upfront expenses, including the cost of constructing pipeline systems, treatment facilities and other infrastructure.

To protect its significant upfront capital investment, the midstream operator will generally require that the gathering agreement identify the upstream operator's dedication and payment obligations as covenants that "run with the land." If properly structured, these real property covenants will be binding on future owners of the upstream operator's assets. The requirements necessary to create enforceable covenants that "run with the land" vary from state to state, but all applicable requirements must be satisfied in order to create an enforceable covenant.

Contract Rejection/Asset Sales

In recent Chapter 11 cases commenced by upstream operators, the debtors have attempted to shed certain off-market gathering agreements either through (1) §365 of the Bankruptcy Code, which provides a debtor wide latitude to reject executory contracts and unexpired leases, or (2) §363 of the Bankruptcy Code, which provides a debtor wide latitude to sell assets "free and clear" of existing claims against or interests in the assets. However, a properly structured covenant running with the land will survive rejection of a gathering agreement by an upstream operator under §365 (and remain binding on the reorganized company) or sale of an upstream operator's assets under §363 (and remain enforceable against the asset purchaser). As a result, upstream debtors seeking to utilize these provisions have been required to seek a determination from the bankruptcy court that one or more of the applicable state law requirements were not satisfied at the time the gathering agreement was executed. Armed with such a determination, the debtors could either reject the gathering agreement in its entirety or sell their assets free and clear of any obligation to the midstream operator, in each case limiting the midstream operator to an unsecured claim (and a pro rata share of the distribution to unsecured creditors).

Creating Enforceable Real Covenants

While the requirements for creating enforceable real property covenants (and the case law interpreting these requirements) vary by state, most states recognize that a covenant "runs with the land" when (1) it touches and concerns the land, (2) the original parties to the agreement intended for the covenant to run with the land, and (3) the successors in interest have notice of the covenant. Many states also require that "privity of estate," a real property term discussed in detail below, existed between the covenanting parties at the time of creation of the covenant. To date, the litigation between upstream and midstream operators on the enforceability of gathering agreement covenants has largely focused on the touch and concern and privity requirements.

'Sabine'

Shortly after filing for Chapter 11, Sabine sought to reject oil and gas gathering agreements with two different midstream operators. The agreements all contained explicit language labeling Sabine's dedication of all oil and gas "produced and saved" from certain well sites to the midstream operators as covenants that run with land. However, in seeking to reject the agreements, Sabine argued that neither the touch and concern nor privity requirements were satisfied at the time of creation of the covenants at issue.

Under Texas law, which governed the Sabine agreements, a covenant "touches and concerns" real property when it affects either "(1) the value of the real property or (2) the owner's interest in or use of the real property." See In Sabine Oil & Gas v. HPIP Gonzales Holdings (In re Sabine Oil & Gas), 550 B.R. 59, 66-68 (Bankr. S.D.N.Y. 2016). However, in Sabine both the bankruptcy court (and the U.S. District Court for the Southern District of New York (the district court) on appeal) found that the covenants at issue burdened personal property and not real property. Both courts noted that Texas law draws an important distinction between underground oil and gas reserves (which are treated as real property) and produced oil and gas (which is treated as personal property immediately upon extraction). Id. Critically, Nordheim's pipeline systems connected to Sabine's pipelines at above-ground "central delivery" points (and were not directly attached to Sabine's wells). As the dedication covenants at issue referred exclusively to oil and gas "produced and saved" from the specified wells, both the bankruptcy and district courts characterized the Sabine gathering agreements as personal property services agreements with covenants that did not have a "direct impact upon the real property" from which oil and gas was produced. Id. This deficiency alone was sufficient to defeat Nordheim's argument that Sabine's dedication and payment obligations were enforceable real property covenants.

Additionally, the bankruptcy court in Sabine, and the district court and U.S. Court of Appeals for the Second Circuit on appeal, all found that "horizontal privity" was both required to created enforceable real property covenants under Texas law and not present at the time of creation of the Sabine covenants. In re Sabine Oil & Gas, 734 Fed.Appx. 64, 66-69 (2d. Cir 2018). Horizontal privity requires that, at the time a covenant is agreed upon, the covenanting parties share some existing interest in the burdened real property independent of the covenant (most commonly as purchaser and seller). Id. For example, assume that the deed transferring title to a parcel of land contains a covenant requiring the purchaser to refrain from taking certain actions in respect of the land (such as a restriction on the height of any future buildings). In this example, because the seller and the purchaser share an interest in the land as a result of the sale, horizontal privity exists between them. Id.

In Sabine, the midstream operators stressed that they received both an easement over the land on which its pipelines would run and title to the parcel of land on which it built its gas treatment facility under the gathering agreements. However, the Second Circuit stressed that in order to create horizontal privity, the covenanting parties must convey an interest in the real property that is the "subject" of the covenant. In Sabine, the covenants at issue burdened gas extracted from specified wells, which was personal property under Texas law at the time it was delivered to Nordheim. Transfer of title to and receipt of an easement over land that was distinct from, even if related to, the burdened personal property did not create horizontal privity in the view of the Second Circuit. Id.

'Badlands'

Last September, the U.S. Bankruptcy Court for the District of Colorado issued an opinion distinguishing Sabine and refused to permit an upstream operator to sell assets free and clear of covenants made to a midstream operator. In interpreting Utah law in Badlands, the court first noted the dedication covenants in the gathering agreements at issue were significantly broader than the dedication covenants in Sabine and pledged the debtors' interests in "all Gas reserves in and under, and all Gas owned by Producer and produced or delivered from" certain oil and gas leases and related real property interests. As the covenants clearly burdened oil and gas prior to extraction (and not just oil and gas produced from certain well sites), the court found that the covenants clearly touched and concerned real property.

Similarly, the court held that the granting of an easement to the midstream operator for the construction of pipelines and transfer of title to the land on which a treatment facility was built was sufficient to create horizontal privity between the debtors and the midstream operators. In reaching this conclusion, the court relied exclusively on the broad drafting of the dedication provision to conclude that an in interest in same real property burdened by dedication covenant was transferred to the midstream operator. Midlands Midstream v. Badlands Energy (In re Badlands Energy), 608 B.R. 854 (Bankr. D. Colo. 2019).

'Alta Mesa'

At the end of December, the U.S. Bankruptcy Court for the South District of Texas also issued an opinion in favor of a midstream operator in Alta Mesa's Chapter 11 cases. However, unlike Badlands, where a broadly drafted dedication provision allowed the court to easily distinguish Sabine, the dedications covenants at issue in Alta Mesa closely resembled the Sabine covenants and referenced oil and gas produced and saved by the debtors.

In finding that the covenants at issue touched and concerned real property, the court expressly disagreed with the Sabine opinions that concluded that a gathering agreement covenant must burden a subsurface mineral estate in order to touch and concern real property. In reaching this conclusion, the court stressed that "the gathering agreements impose costs and delivery restrictions on produced hydrocarbons, which diminish the value of Alta Mesa's unproduced reserves" and by extension the oil and gas leases referenced in the gathering agreements. Similarly, the court found that the easements granted to the midstream operator restricted the debtors "use of the surface land for drilling or exploration" and therefore reduced the debtors' "real property interest under the leases." By focusing its analysis on the impact of the covenants on the debtors' oil and gas leases (as opposed to their subsurface mineral estates), the court was able to identify several real property burdens that "persisted" even though the midstream operator was "not entitled to possession until after the hydrocarbons become personal property." In re Alta Mesa Resources, 2019 WL 7580122 (S.D. Tex 2019).

For the same reasons, the court also concluded that privity existed at the time of execution of the gathering agreements as a result of the easement rights granted to the midstream operator. Further contradicting the Sabine opinions, the court stressed that "a surface easement is a crucial component on an oil and gas lease" and therefore "the Court does not view this conveyance as creating privity only with respect to the surface estate." Id.

Conclusion

The recent opinions in Badlands and Alta Mesa will undoubtedly create uncertainty surrounding the ability of upstream operators to shed gathering agreement covenants in future Chapter 11 cases. While the answer to this question will ultimately be dependent on both the applicable law governing the gathering agreements at issue and the venue in which the Chapter 11 case is filed, there are a number of questions that investors should consider in evaluating the continuing enforceability of gathering agreement covenants. These questions include:

• How broadly are the dedications covenants drafted? Do they simply reference produced and saved oil and gas or do they include language similar to the Badlands covenants summarized above?

• Does the midstream operator's infrastructure attach at above ground delivery points or directly to the upstream operator's wells?

• Is privity required to create enforceable covenants under the state law governing the gathering agreements? As noted in Sabine, there is a growing trend across the country toward removing this requirement.

• If privity is required, what interests were transferred to the midstream operator and can such interests be easily characterized as real property interests under applicable law?

• And, although secondary issues under the discussed cases, (1) do the agreements clearly state that the parties intended to create enforceable real covenants; and (2) were the gathering agreements properly recorded to provide proper notice of the covenants?

Finally, even if the answers to these questions suggests that gathering agreements can be rejected in Chapter 11, a debtor must either be able to shutter the wells covered by the gathering agreements or have access to an alternative midstream provider (or the ability to move produced oil and gas by truck or rail) in order to actually capture value from shedding these agreements. Given these complexities, working with experienced counsel is essential to evaluating whether rejection of midstream agreements can form part of any sound restructuring or investment strategy for a distressed oil and gas company.

John J. Rapisardi is a partner and chair of the corporate restructuring practice of O'Melveny & Myers. Joseph Zujkowski is a partner in the restructuring practice.