Decision establishes framework for future rulings that covenants in midstream agreements do not run with the land.

On March 8, Judge Shelley C. Chapman of the US Bankruptcy Court for the Southern District of New York issued an order determining that Sabine Oil & Gas Corp. (Sabine), an exploration and production (E&P) company in the natural gas and condensate sector, is permitted to reject three midstream gas and condensate gathering agreements. Although Judge Chapman’s opinion that the agreements do not contain covenants that “run with the land” under Texas law is not binding, the ruling may well reverberate throughout the midstream pipeline and shipping industry for the considerable future, and could ultimately lead to additional upstream bankruptcy filings by companies eager to either shed or renegotiate existing midstream agreements.

Background

Sabine filed for bankruptcy in July 2015. At the time of filing, Sabine was a party to three gathering agreements with two separate counterparties.

Under two of the gathering agreements with one counterparty, Sabine committed to flow natural gas or condensate through certain dedicated areas on its counterparty’s applicable gathering systems and to pay gathering fees. Sabine’s gas would flow on its counterparty’s gathering system to downstream pipelines and subsequently to market centers. Both agreements required Sabine to deliver a minimum annual volume of gas or condensate per year or else it would have to make deficiency payment to cover underdelivery.

Under the third gathering agreement with the other counterparty, Sabine was obligated to drill at least one well per year until 2017 and use the gathering system of its counterparty, which was still in the development phase. If Sabine failed to drill one well per year as required, the agreement provided for Sabine to purchase the gathering system at a contractually determined price.

Each agreement at issue is governed by Texas law and contains specific language indicating that the underlying properties are dedicated to the agreement, and that the agreement is intended to constitute a covenant running with the land. One of the counterparties also filed memoranda with respect to its agreements in the real property records of Texas.

As natural gas and oil prices continued to decline, the mandatory volume minimum and commitment obligations to which Sabine agreed were viewed by Sabine as uneconomical. As a result, Sabine sought bankruptcy court approval to “reject” the contracts under section 365 of the Bankruptcy Code, arguing that relief from the mandatory volume and drilling commitments would allow Sabine to negotiate new agreements with alternative providers and save over $100 million.

One of the counterparties opposed rejection on the grounds that the underlying agreements, or, at a minimum, the covenants in the agreements governing dedication and the gathering fee, were real property interests that “run with the land” under Texas law and therefore could not be rejected.

Decision

In the ruling, which cited to the US Court of Appeals for the Second Circuit’s opinion in Orion Pictures Corp. v. Showtime Networks (In re Orion Pictures Corp.), 4 F.3d 1095(2d Cir. 1993), Judge Chapman found that she could not issue a binding decision concerning whether the covenants at issue run with the land because there was not consensus among the parties as to whether that issue was “properly joined on the substantive legal issues presented by the [rejection] Motion.” She did, however, approve rejection of the contracts as a whole on the basis that the Debtors’ decision to reject the agreements was reasonable whether or not certain of the covenants run with the land.

The court also included in its decision an extensive “non-binding analysis” discussing whether the covenants relating to dedication and the gathering fee run with the land. If they do, Sabine would remain bound by those covenants even after rejection. If the covenants do not run with the land, then Sabine would not continue to be bound, and the contract counterparties can only assert prepetition claims for damages against the bankruptcy estate based upon breach of the covenants.

In its non-binding analysis, the court concluded that, under Texas law, the covenants relating to dedication and the gathering fee do not run with the land and therefore do not constitute real property covenants that can survive rejection. The court noted that the covenants at issue did not satisfy at least two of the requirements necessary under Texas law for a covenant to run with the land: (1) there was no horizontal privity of estate between the parties to the covenants and (2) the covenants did not “touch and concern the land.”

The court determined that there was no horizontal privity because the covenants at issue were not reserved for the contract counterparties in the context of real property conveyance; rather, they were simply included in a contract for services. Additionally, the covenants related only to the right to transport and gather product, which is not one of the five real property rights that comprise a mineral estate under Texas law (those being the rights to develop, lease, receive bonus payments, receive delay rentals, and receive royalty payments). Therefore, Sabine had not transferred any portion of its real property interest to the counterparties.

The covenants also did not “touch and concern the land” because they concerned product only after it was produced and, under Texas Law, once minerals are extracted from the ground, they become personal property.

The court distinguished the facts of this case from the facts in In re Energytech, Inc., 739 F.3d 215 (5th Cir. 2013). In Energytech, the US Court of Appeals for the Fifth Circuit found that a “transportation fee” reserved for the affiliate of the owner of a pipeline when the owner sold the pipeline to a third party was a covenant that ran with the land and, therefore, the pipeline could not subsequently be sold in a bankruptcy “free and clear” of the obligation to pay the fee. Judge Chapman distinguished Energytech on the basis that the covenant there was reserved in the context of a broader real property conveyance (the original sale of the pipeline), therefore establishing the necessary horizontal privity. Additionally, because the fee was associated with use of the pipeline—and the pipeline constitutes the real property of the party paying the fee—and because the fee was secured by a lien on the pipeline, it was a covenant that “touched and concerned” real property, unlike the covenants at issue in Sabine.

Implications

While it is non-binding, Judge Chapman’s thorough and detailed analysis in Sabine may serve as a model for future decisions regarding the ability of E&P companies to reject or otherwise shed existing contractual obligations. Similar motions to reject midstream agreements are pending in the bankruptcy case of Quicksilver Resources, Inc. in Delaware. If the decision in that case follows the reasoning in the Sabine decision, there may be few midstream contracts that are immune from rejection in bankruptcy.

For upstream companies, the ability to reject above-market midstream agreements (especially ones with minimum volume commitments) could lead to additional bankruptcy filings. The Sabine decision also establishes a framework for analyzing the ability to reject other contractual obligations that purport to “run with the land.”

For midstream companies, gathering agreements such as those at issue in the Sabine proceeding arise out of the gatherer’s financial commitment to outlay substantial capital cost for development of a gathering system for which the costs will be recouped over a period of years through the gathering fees provided for by the agreement. Changes in the applicable fees or rates, or wholesale switches to alternative midstream service providers via bankruptcy, will disrupt the economic models of the midstream companies that own and operate these systems.