covenants running with the land

Empty tomb with three crosses on a hill side.

Co-author Lydia Webb

One of the hottest issues from 2016 was whether an E&P debtor can reject, under section 365 of the Bankruptcy Code, an above-market midstream contract. Given the potential for a “no-win” situation, in all but one case where the issue arose E&P debtors and midstream companies were able to settle, often by entering into new midstream contracts upon mutually agreeable terms that take into account the changed market conditions since the downturn in commodity prices.

However, the bankruptcy judge in Sabine Oil and Gas Corp. held that an E&P debtor could reject its gas gathering agreements because its midstream counter-parties could not establish that their agreements were covenants running with the land under Texas law. The midstream companies appealed to the U. S. District Court for the Southern District of New York, hoping for a better answer. They did not get their wish.

Many were surprised by the opinions, given the billions of dollars invested in necessary midstream infrastructure that was built under the assumption that gathering, processing and transportation agreements would bind the producer’s successors. The Sabine court was unsympathetic, and last month affirmed the bankruptcy court’s rejection orders. The midstream companies’ primary argument was that the dedication language in the agreements were analogous to the conveyance of a royalty interest in minerals “produced and saved”.  Thus, Sabine’s dedication must have conveyed a real property interest. The district court was not impressed, and held that the gathering agreements were mere service contracts, and Texas law did not support a finding that they constituted a conveyance of mineral rights or otherwise burdened the underlying leases.

The debate will continue. Sabine is not the end of the argument that interests created by midstream oil and gas agreements are covenants running with the land that can survive a producer’s bankruptcy. Why?

  • A Texas court has not yet ruled on the issue, although at least one Houston bankruptcy judge has commented that he would love the opportunity to set the record straight for his New York colleagues. Given the complex issues of state law involved in the interpretation of these agreements, there is reason to believe that a Texas judge experienced in Texas property law would rule differently.
  • Energy companies continue to construct creative arguments that these agreements create real property interests that cannot be shed in bankruptcy. Most recently, in the Vanguard Natural Resources Corp. bankruptcy it has been argued that the right to drill and develop acreage assigned under a farmout agreement creates a covenant running with the land that burdens the entirety of the lessee/farmor’s undeveloped acreage (Caveat: This is not a midstream situation).

Stay tuned. Whether these arguments hold water, and in which contexts, is yet to be seen. What is clear is that midstream companies will continue to innovate in their effort to protect agreements in which they have invested millions of dollars, and the producers will respond.

It’s Holy Week, a time for musical interludes, one Jesusy but not churchy, one churchy. See you there.

I promise this will be the last post in a while on covenants running with the land. I think we all get it by now (This topic was discussed in my August 1 post).

The Result

A Joint Operating Agreement referenced in documents that is in a party’s chain of title and is, by its terms, binding on “ . . . the parties hereto and to their respective heirs, devisees, representatives, successors and assigns.” will bind that party, according to TransTexas Gas Corp. v. Forcenergy Onshore, Inc. That language establishes the agreement as a covenant running with the land.

What makes this rather mundane decision (mundane to you and me, probably not so to the parties) worthy of your attention is the focus on the JOA, letter agreements and a complicated series of assignments (of deep rights, shallow rights and other, deeper rights) at various times among a number of parties, most of which were entered into over 20 years ago.

The lesson

Keep your land files and records complete, accurate and in good order. Sometimes those who follow behind the original players are going to be put to the task of recreating a transaction, or the history of the parties’ performance of a transaction. The party without good land records is at a serious disadvantage.

A more obvious lesson

Don’t ask for relief in one suit by relying on the existence of a contract to which you are a party and then in another suit, deny that the contract burdens your interest. You can seldom have it both ways.

The Case

Trans Texas and Forcenergy owned interests in the same lease, and disagreed over the applicability of a non-consent provision of a JOA entered into by their assignors. TransTexas did not consent to Forcenergy’s drilling proposals, resulting in relinquishment of the working interest until 400% of costs had been recovered by the consenting parties. Trans Texas sued to determine if the non-consent relinquishment provisions applied. TransTexas’ argument was that the JOA wasn’t in its chain of title and therefore its interest was not subject to the JOA. The JOA and the letter agreement by the parties’ predecessors were mentioned in earlier assignments that were recorded in the official public records, establishing constructive notice of their contents. Also, TransTexas judicially admitted that the agreement applied to its interest by suing for a TRO in an earlier case in reliance on the JOA.

And there is something for the bankruptcy clients and their lawyers: TransTexas’s rejection of the JOA in bankruptcy had no effect on Forcenergy’s ownership of relinquished interests because relinquished interests are excluded from the debtor’s estate under the Bankruptcy Code.