Background
Southland and Wamsutter LLC, an affiliate of The Williams Companies, Inc. (“Wamsutter”) were parties to two midstream agreements, the L60 and L63 agreements. After the parties had entered into the L60 agreement, Southland enhanced its drilling program to include horizontal wells that required an expansion and update to the Wamsutter gathering system. To accommodate this expansion and update, the parties entered into the L63 agreement. The area covered by the L63 agreement was located within the area covered by the L60 agreement, but it served different receipt points. Both agreements included MVCs, but the L63 agreement contained the more onerous of the two, with an estimated net present value between $413 and 568 million.
Southland filed chapter 11 on January 27, 2020 after Wamsutter made a $6.9 million adequate assurance request on the cash-strained operator. Citibank is the debtor’s lead administrative agent to a lending syndicate with $540 million outstanding as of the bankruptcy. The bank agreed to a sale process that the debtor kicked off shortly after the filing. But the sale process came to a grinding halt when it became clear that the parties had widely divergent views on go-forward gathering and processing terms for Wamsutter’s services, thereby dashing away the chapter 11 parties’ hope of a speedy sale.
Southland subsequently initiated an adversary proceeding against Wamsutter seeking a declaration from the bankruptcy court that it could (i) reject the L63 agreement, (ii) sell its assets free and clear of Wamsutter’s interest under section 363(f) of the Bankruptcy Code, (iii) sever out the terms of the minimum volume commitment (“MVC”) under the L63 agreement under a variety of theories, and (iv) unilaterally transfer all gathering and processing services from the L63 agreement to the L60 agreement, thereby avoiding the L63 MVC obligations.
Bankruptcy case law momentum favored Wamsutter at the time of the Southland trial. Bankruptcy courts in Badlands3 and Alta Mesa4 had concluded that the midstream agreements in those cases contained covenants that ran with the land and created real property interests, or real covenants, that could not be rejected in a bankruptcy case. These two courts had reached an outcome different from the Sabine5 case, where the New York court held that the covenant running with the land language in the agreement did not create real property interests. The pendulum swung even further with the Delaware court’s decision in Extraction, which the court issued after the Southland trial concluded but before Judge Owens’ decision. Indeed, in Judge Owens’ decision in Southland, she acknowledged the case law split.6
Wins for the E&P company
The elements to create a real covenant under Wyoming law are similar to the elements in the state laws analyzed in Sabine, Badlands, Alta Mesa, and Extraction: the parties must intend to create a real covenant, the covenant must touch and concern the land, and there must be privity of estate between the parties.7
Judge Owens found that the parties unquestionably intended for the dedication provision in the L63 agreement to run with the land. But the court was unwilling to “bootstrap” the clear intent in the dedication provision to the remainder of the L63 agreement. The court also found that Southland’s commitment to Wamsutter did not touch and concern the land. Southland had dominion over its unproduced gas reserves and unfettered control over its exploration, drilling, and production activity. Southland’s produced gas was the only property directly benefited and burdened by the L63, which once severed, is “personal property”. The court reasoned that “[a]t bottom, the L63 is a contract for Wamsutter’s services in the [dedication area] so that Southland can monetize its production.”8
The court also disposed of Wamsutter’s argument concerning the privity of the estate requirement, determining that Southland’s easement conveyances were of surface rights, not of an interest in the mineral estate.
Judge Owens also held that Southland could sell its assets free and clear of Wamsutter’s interest. Wyoming law permits a mortgagee like Citibank (the RBL lender) to foreclose and extinguish later-created real property covenants. Thus, Wamsutter’s interest could be sold free and clear under section 363(f)(1) of the Bankruptcy Code, which permits free and clear sales when non-bankruptcy law permits the property to be sold free and clear. The court also held that section 363(f)(5)—permitting free and clear sales when the entity could be compelled to accept a money satisfaction—applied because Wyoming law gives broad discretion to a court to select appropriate remedies to enforce covenants. Importantly, Judge Owens noted that the L63 agreement does not exclude monetary damages as a remedy to address breaches.
Wins for the midstream company
Southland won the rejection battle, but not the war. Judge Owens denied Southland’s request to sever the MVC from the L63 gathering agreement. The agreement’s structure and language convinced Judge Owens that the MVC was intertwined with the gathering and processing services. Wamsutter’s witnesses testified that the MVC was part-and-parcel with Wamsutter’s agreement to expend significant capital to construct the gathering system.
Judge Owens also held that Southland could not flow gas serviced by the L63 agreement under the overlapping L60 agreement. Wamsutter persuaded the court that the agreements dealt with different receipt points, which is supported by the interplay between the two gathering agreements as well as their structure. Ultimately, the court declined Southland’s request to force Wamsutter to accept gas through the L60 notwithstanding the L63 rejection.
Practical implications
The Southland decision highlights the inherent problem that many E&P operators face when addressing out-of-market or onerous midstream agreements through chapter 11. While the debtor may successfully use bankruptcy to reject a gas gathering agreement, the result may ring hollow if the debtor does not have a viable alternative. Indeed, in Southland, the Delaware court did not award Southland with its desired home run, permitting it to reject the agreement, sever the MVC, and force the midstream company to accept terms that the parties did not originally contemplate in their agreements.
On the other hand, the midstream company should consider the economic reality of the operator-debtor’s failure. It is unclear whether acquisition of Southland’s assets is economically attractive to potential bidders given Wamsutter’s prevailing points in the Southland decision. If the sale process does not attract a suitor, the debtor may be forced to liquidate, with the secured creditor benefitting from any scraps realized from a piecemeal sale in a down market. Wamsutter’s best hope for recovering its investment may be to work through a commercial arrangement with potential bidders, or to bid on the assets itself to take advantage of the synergies created by the joint ownership of the upstream and midstream assets. Alternatively, bidders may seek other solutions for gathering and processing gas now that Southland’s assets may be sold free and clear of Wamsutter’s interests, although there are no apparent existing service alternatives.
Unsecured creditors also should be wary of the Southland case. The creditors’ best outcome was rejection of the Wamsutter agreements and a ruling that the MVC damages were unenforceable under Wyoming law. But Judge Owens ruled that Wamsutter was entitled to a claim for all damages arising from the rejection, including the MVC. Thus, the Southland unsecured creditors must share pro rata with Wamsutter, whose MVC claim will greatly exceed the existing unsecured creditors pool, diluting expected recoveries.
- www.reedsmith.com
- Southland Royalty Co. LLC v. Wamsutter LLC (In re Southland Royalty Co. LLC), Nos. 20-10158 (KBO), 20-50551 (KBO), 2020 Bankr. LEXIS 3185 (Bankr. D. Del. 2020).
- Monarch Midstream, LLC v. Badlands Prod. Co. (In re Badlands Energy, Inc.), 608 B.R. 854 (Bankr. D. Colo. 2019) (interpreting Utah law).
- Alta Mesa Holdings, LP v. Kingfisher Midstream, LLC (In re Alta Mesa Res., Inc.), 613 B.R. 90 (Bankr. S.D. Tex. 2019) (interpreting Oklahoma law).
- Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC (In re Sabine Oil & Gas Corp.), 550 B.R. 59 (Bankr. S.D.N.Y. 2016) (interpreting Texas law), aff’d, 567 B.R. 869 (S.D.N.Y. 2017), aff’d, 734 Fed. Appx. 64 (2d Cir. 2018).
- Southland Royalty Co. LLC, 2020 Bankr. LEXIS 3185, at *23-24.
- Id., at *25.
- Id., at *33.
Client Alert 2020-597
