Yes, Gathering Agreements Can Be Rejected as Executory Contracts (At Least Under One Court’s Interpretation of Texas Law)

Reuters recently reported that “the rout in crude prices is snowballing into one of the biggest avalanches in the history of corporate America, with 59 oil and gas companies now bankrupt[.]” In March, we described how surging energy bankruptcies may affect midstream pipeline operators. We wrote about one particular nonbinding decision that hinted at the authorized rejection of gathering agreements: In re Sabine Oil & Gas Corp., 547 B.R. 66 (Bankr. S.D.N.Y. 2016) [hereinafter “Sabine I”]. On May 3, 2016, the Sabine I court issued a second decision that reaffirmed its prior reasoning − this time with binding effect.

In Sabine I, the court considered whether gathering agreements were covenants that ran with the land under Texas law (and therefore could not be rejected, even if onerous). Notable for questioning the common belief that gathering agreements convey an interest in real property, Sabine I was remarkable for its lack of effect: The parties’ dispute arose in the context of a motion to reject, so Second Circuit law prohibited a determination of their substantive rights.

To obtain that determination, the debtors filed adversary proceedings against their midstream pipeline operators soon after Sabine I issued. Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC; Sabine Oil & Gas Corp. v. Nordheim Eagle Ford Gathering, LLC [hereinafter, collectively, “Sabine II”]. The Sabine II suits sought declaratory judgments that the debtors’ gathering agreements are executory contracts, not covenants that run with the land.

Thus presented with a procedural vehicle for doing so, in Sabine II the court expanded upon and made binding its earlier reasoning. As the court stated, a covenant runs with the land under Texas law when: (1) it touches and concerns the land; (2) it relates to a thing in existence or specifically binds the parties and their assigns; (3) it is intended by the original parties to run with the land; and (4) the successor to the burden has notice. In addition, a number of Texas authorities require that horizontal privity of estate exist between covenanting parties.

In Sabine II, the court found that the gathering agreements before it could not surmount even the first hurdle. Among other factors, the court distinguished between minerals produced and saved, and minerals that remain in situ. It determined that Texas law considers only the latter category to touch and concern real property, whereas extracted minerals are personal property. Because the court concluded that the gathering agreements conveyed an interest in produced minerals, it found them to be executory contracts and granted summary judgment to the debtors.

As described in Sabine I, that decision allows the debtors to negotiate new gathering agreements “with any party, likely obtaining better terms than the existing agreements provide.” The debtors did so, and on May 17, 2016, the court granted their request to enter into an alternative pipeline agreement with a new midstream operator. The debtors believe that the agreement will save them $200,000 a month.

The midstream operators whose agreements were rejected, on the other hand, have appealed the Sabine decisions. They requested a direct appeal to the Second Circuit − so that it can certify questions to the Texas Supreme Court, as only a federal appellate court can do under the Texas Rules of Appellate Procedure. That is, the midstream operators believe that the Sabine decisions rest upon unsettled questions of Texas law. Because the questions broadly affect the oil and gas industry, the operators believe they should be posed to the Texas Supreme Court.

As we stated upon the release of Sabine ISabine II serves as a cautionary tale to midstream pipeline operators. Now, more than ever, operators would be well-advised to scrutinize their agreements − with the assistance of experienced counsel − to assess the risks presented by the potential bankruptcy of a counterparty. By drafting or amending documents to touch and concern or convey an interest in real property, midstream pipeline operators can prevent bankrupt producers from rejecting their gathering agreements. The Sabine decisions provide guidance on how to do so.

To read the previous installment in this series, please see “R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 1” and "R&I Update: Hot Topics in Oil and Gas Restructurings, Volume 2."