The Fifth Circuit Provides a New Year’s Gift–Clear Guidance on Whether Covenants “Run with the Land”

Contributed by Charles Persons
The confluence of oil & gas law and bankruptcy law seldom results in simple, expected outcomes, and the intermingling of the two unusual areas of the law in the form of binding case law is somewhat sparse. One reason for the absence of significant appellate case law in this area is the complexity of these particular areas of the law. Indeed, one of these disciplines does not “play well” with other areas of the law and is a mixture of often convoluted nomenclature and occasionally inconsistent case law that functions to simultaneously protect and disregard contracted-for property rights through the distribution of finite resources. The other is oil & gas law.
Sometimes, however, the appellate courts gift professionals who practice in these legal disciplines with clear, controlling case law that helps harmonize areas of the law that typically mix like oil and water. The Fifth Circuit’s final published decision of 2013, In the Matter of Energytec, Inc., — F.3d –, Case No. 12-41162 (5th Cir. Dec. 31, 2013), is a New Year’s gift of just this sort. Energytec provides clear guidance to courts in evaluating whether a covenant “runs with the land” under Texas law. This fundamental distinction is frequently at issue in bankruptcies involving real property; especially oil and gas bankruptcies where real property conveyances are commonplace. Distinguishing real property covenants from typical contractual covenants is crucial—real property cannot be sold free and clear of covenants that “run with the land” in bankruptcy unless one of the five prongs of section 363(f) of the Bankruptcy Code is met. The Energytec holding, which also limits the protections to good faith purchasers under section 363(m) of the Bankruptcy Code where a court expressly carves out an issue for future adjudication in a sale order, settles on a black-letter framework for evaluating covenants under Texas law.
Several years prior to the bankruptcy filing, the original owner of a pipeline system in Texas conveyed the pipeline to the predecessor of Energytec. At the time of the conveyance, the original owner carved out a “Transportation Fee” for its affiliate, Newco, as well as a right to consent to future assignments of the pipeline. These covenants were carved out in a separate letter agreement (the “Letter Agreement”), entered into among Newco, the original owner, and the original pipeline purchaser. The Letter Agreement makes clear the covenants were considered partial consideration for the conveyance and were to “run with the land” and gave Newco a security interest and lien on the entire pipeline system to secure continuing payment of the Transportation Fee. A separate Assignment and Bill of Sale between the pipeline owner and purchaser contemporaneously conveyed the original owner’s legal interests in the pipeline “subject to the Transportation Fee and other terms and provisions” of the Letter Agreement. Both the Letter Agreement and Assignment and Bill of Sale were properly recorded. The pipeline was later conveyed to Energytec, which expressly agreed to assume the obligation to pay the Transportation Fee as part of the transaction.
Years later, Energytec filed for chapter 11 protection. In the course of its chapter 11 case, the debtor sought court approval to convey its interest in the pipeline to Red Water under section 363(b) of the Bankruptcy Code free and clear of any liens, claims, or encumbrances. Newco objected to the proposed sale, arguing the pipeline could not be sold free and clear of its lien or its property interests—the Transportation Fee and right to consent to any assignment of the pipeline.
The bankruptcy court was not prepared to make a determination at the time of the proposed sale as to whether Newco’s covenants were property interests that ran with the land, but allowed the sale of the pipeline to Red Water to go forward nonetheless. Importantly, recognizing the unresolved nature of the Newco lien issue, the sale order signed by the bankruptcy court’s order approving the sale provided that “the sale shall be free and clear of all liens, claims, interests and encumbrances . . . except for those liens granted to [Red Water pursuant to the DIP Financing Order] and including without limitation the rights, interest and lien rights claimed by Newco in certain obligations to pay transportation charges. . . pending later determination . . . .” Neither the debtor nor Red Water objected to this contingency. In reliance on the express carve-out, Newco did not seek to obtain a stay of the sale order or conveyance of the pipeline, as generally required to avoid mootness under 363(m).
Sixteen months after the sale of the pipeline to Red Water, the bankruptcy court ruled that Newco’s covenants did not run with the land, and consequently the sale of the pipeline to Red Water was free and clear of Newco’s lien, the obligation to pay the Transportation Fee, and Newco’s consent rights. The district court affirmed.
Issue 1 – Mootness under 363(m)
Newco appealed to the Fifth Circuit Court of Appeals. As a preliminary matter, Red Water and Energytec argued that Newco’s appeal was moot under section 363(m) of the Bankruptcy Code because Newco failed to obtain a stay following the sale. Section 363(m) gives finality to 363(b) sales by limiting the ability of appellate courts to modify or reverse a 363(b) sale unless the sale is stayed pending the appeal.
The Fifth Circuit rejected the appellees’ mootness argument, finding that the sale was expressly contingent upon Newco’s unresolved claims. Had Newco sought a stay, what would have been stayed “was not a sale free and clear of Newco’s claims, but a sale not free and clear of those claims.” [Opinion at 8]. Further, the court held Red Water proceeded “in the face of whatever legal and financial risks it perceived . . . accepting the risk that Newco’s interests would survive.” [Id. at 6, 8]. Further explaining its decision, the Fifth Circuit held that the requirement of 363(m) to obtain a stay was to protect “later modification on appeal of authorized sales.” [Id. at 5]. Newco, rather than trying to modify the contingency in the sale, was in fact relying on that contingency. Under the circumstances, the court held that in order to rely on the protections afforded by 363(m), the burden was on Red Water and Energytec to object to the contingency in the sale order and litigate the issue to finality in advance of the conveyance.
Issue 2 – Do the Covenants Run with the Land?
The Fifth Circuit reversed the district court’s decision, holding that the Transportation Fee and consent rights were property rights that did run with the land. Recognizing that Texas case law contained variations on the specific requirements to determine whether a covenant runs with the land, the Fifth Circuit adopted a five-factor test as “controlling,” holding “a covenant runs with the land when it [1] touches and concerns the land; [2] relates to a thing in existence or specifically binds the parties and their assigns; [3] is intended by the original parties to run with the land; and [4] when the successor to the burden has notice” and [5] “privity of estate between the parties when the covenant was made.” [Id. at 9]. Recognizing that factors 2, 3, and 4 were indisputably met under the terms of the Letter Agreement, the court reviewed the covenants in the context of factors 1 and 5.
Turning first to the issue of privity, the Fifth Circuit recognized that vertical privity—the relationship between the original parties to a covenant and their successors-in-interest—was not at issue. Newco was the successor-in-interest to the original owner of the pipeline and Red Water, after a series of conveyances (including to Energytec), was the clear successor-in-interest to the pipeline’s original purchaser—Producers Pipeline Corporation. More difficult was whether horizontal privity—the relationship between the original parties to the covenant—was necessary for the establishment of real property covenants and if so, whether such privity existed at the time of the conveyance from the original owners to Producers.
Whether horizontal privity must exist between the beneficiary of the real property covenant and the property owner at the time the covenant is created has not been settled by the Texas Supreme Court. In a typical real property conveyance, the purchaser (Producers) would have granted the real property covenants to Newco in the document legally conveying the interests in the property—the Assignment and Bill of Sale. In this typical transaction, the notice and consent rationales underlying horizontal privity are met because the establishment of covenants that will continue to burden the conveyed real property occurs in concert with the conveyance itself. Atypically, the Transportation Fee and consent right in favor of Newco was created in the separate Letter Agreement, not in the Assignment and Sale Agreement between the original pipeline owner and Producers.
Without clear guidance from the Texas Supreme Court, the Fifth Circuit refused to go so far as to hold that horizontal privity was a strict requirement to establish a valid covenant that ran with the land. Nonetheless, noting the certain notice to and consent of Producers upon the creation of the Newco covenants, the Fifth Circuit concluded horizontal privity, whether or not it was a necessity under Texas law, was satisfied. In support of this conclusion, the court recognized the recording of the separate Letter Agreement and the Assignment and Bill of Sale, and additional indication that Producers (and subsequent purchasers) understood they took the pipeline subject to Newco’s interests.
Having found the required privity between Newco and Red Water, the final factor the Fifth Circuit addressed in its analysis of the Newco covenants was whether the Transportation Fee and consent rights were interests that touched and concerned the real property. Again, recognizing that variations on the requirements to establish such a finding existed under Texas law, the Fifth Circuit harmonized its earlier holdings, stating the test for “touch and concern” was not just whether the covenant affected the value of the land, but also that “even when a covenant impacts the value of land, it must still affect the owner’s interest in the property or its use in order to be a real covenant.” [Id. at 15].
Energytec and Red Water argued that the obligation to pay transportation costs was unrelated to their interest in the land because the payment was based solely on the volume of gas moving through the pipeline and therefore had no direct impact on the land. The Fifth Circuit disagreed. Comparing the gas pipeline system (a real property interest in Texas) to a “subsurface road for natural gas,” the court held Newco’s interest in transportation fees were for the use of real property. Stated another way, the court held that third-party consent rights and rights to transportation payments “impact the owner’s interest in the pipeline. Furthermore, as burdens on the property, they also impact the pipeline’s value in the eyes of prospective buyers.” [Id.]
Having met all five factors laid out by the Fifth Circuit, the court found the covenants did in fact run with the land, and the pipeline was not sold free and clear of those interests to Red Water.
Issue 3 — Is Newco Required to Accept a Monetary Satisfaction of its Interests under 363(f)(5)?
A final issue of interest to bankruptcy practitioners before the Fifth Circuit was whether Newco could be required to accept monetary satisfaction of its interests under section 363(f)(5) of the Bankruptcy Code. Unfortunately, because the lower courts determined Newco’s interests were not covenants running with the land, they had not addressed 365(f)(5). The Fifth Circuit remanded the issue for further proceedings in the bankruptcy court.
Though the outcome in Energytec was undoubtedly fact-specific, as would be any inquiry into covenants that purport to run with the land, the holding provides a framework for evaluating these covenants under Texas law going forward. Such clarity is a New Year’s gift for which all bankruptcy practitioners can be thankful.