A recent bankruptcy court decision from the influential Southern District of New York permitted a debtor to reject executory contracts with midstream gathers as an exercise of sound business judgment. In In re Sabine Oil & Gas Corporation, the court issued an advisory ruling in which it determined that certain provisions of the rejected contracts were not covenants that ran with the land, and thus could be rejected thereby relieving the debtor of a financial hardship.

Prior to the bankruptcy case, Sabine – a company engaged in the acquisition, production, exploration and development of onshore oil and natural gas properties – had entered into agreements with midstream gatherers, essentially brokers situated between extraction companies (e.g., Sabine) and refining companies, which prepare mineral products for the commercial market. The agreements required Sabine to meet certain minimum delivery requirements or pay a deficiency payment.  The agreements also purported to “run with the land” in the same way an easement would burden real estate.  If the agreements did run with the land, rejecting them would not relieve the debtor of the deficiency payment obligations.

The court noted that the standard for rejecting an agreement is the “business judgment” test, which requires the court to look at whether rejecting the contract is beneficial to the bankruptcy estate. Typically, courts will approve a request to reject an agreement, unless the decision to reject is made in bad faith, on a whim or is the product of caprice.

Sabine sought to reject the midstream gather agreements because it was no longer financially viable for Sabine to make the required minimum deliveries and, absent rejection, Sabine would have to make significant deficiency payments that would pose a financial hardship. Sabine believed that after it rejected the agreements, it could enter into replacement agreements, perhaps with the same counterparties, on better economic terms.  The court agreed that rejection was appropriate, and also noted the counterparties to the agreements did not introduce any evidence of bad faith or caprice by Sabine.

In order to determine whether rejection would actually benefit Sabine, the court then turned to the question under Texas law of whether the agreements ran with the land such that even upon rejection Sabine would not be relieved of the financial burdens. Under Texas law, the language of an agreement provides the primary evidence of the intent of the parties, but is not dispositive.  Here, the court determined that a provision runs with the land when (i) it touches and concerns the land, (ii) it relates to a thing in existence or specifically binds the parties and their assigns, (iii) it is intended by the original parties to run with the land, and (iv) the successor to the burden has notice.

Focusing on the first prong, the court decided that the agreements did not “touch or concern” the land. The subject matter of the agreements involved minerals only after they had been extracted from the ground.  Minerals ceased to be real property and became personal property upon extraction.  Because Sabine’s obligations concerned only the extracted products (and not the real estate), the agreements did not constitute easements that ran with the land and did not continue to burden the debtor post-rejection.

The court’s ruling on the right to reject the agreements comports with well-established bankruptcy jurisprudence. However, in order to find that rejection benefited the debtor, the court had to explore Texas law on the issue of whether the agreements “ran with the land.”  The non-binding ruling that midstream agreements do not run with the land could have a significant impact on other oil and gas bankruptcy cases by either encouraging additional bankruptcy filings, or helping current debtors with negotiations with their midstream gathers, given that the leverage appears to now favor debtors.