Continuing low oil and natural gas commodity prices have led to bargain prices at the pump, but also high tension in many boardrooms. This strain on the industry has resulted in many exploration and production, or “E&P,” companies seeking relief from high debt and reduced revenue in bankruptcy. In recent cases, those E&P companies have sought to reject their midstream gathering agreements, which they deem onerous and unprofitable. E&P companies Sabine Oil and Gas Corp. and Magnum Hunter Resources Corp. have been getting quite a bit of attention for their attempts to do just that, presenting potential road maps for how other such companies may choose to proceed during their reorganizations.

The ability to reject an executory contract or unexpired lease is a powerful reorganizational tool given to a bankrupt company by the Bankruptcy Code. With limited exception, under 11 U.S.C. § 365, debtors can reject such executory contracts over the objection of their counterparty. One such limited exception – that contracts creating covenants, which run with the title to real property, cannot be rejected under § 365 – has taken center stage in recent attempts by E&P debtors to reject midstream gathering agreements.

For the unacquainted, a midstream gathering agreement is a contract that governs the midstream company’s service of delivering oil or natural gas from the wellhead to market. Whether it does so using a pipeline, truck or crude oil transported by rail, these contracts can be extremely costly, largely because they are so vital to the business model of a continuing E&P venture.

The first shot across the bow came in March 2016, when a bankruptcy judge in the Southern District of New York held that Sabine had the right to reject two of its gathering agreements, with Nordheim and HPIP, under Section 365. In re Sabine, No. 15-11835 (Bankr. S.D.N.Y. Mar. 8, 2016), slip op. at 4. The midstream companies argued that portions of their midstream gathering agreements contained covenants that ran with the title to the property and, therefore, could not be rejected.

Ultimately, the Sabine court held that both midstream gathering agreements could be rejected. For procedural reasons, the Sabine court avoided substantively addressing whether the agreements did run with the land. Id. at 8. The court instead simply held that the debtor’s decision satisfied the business judgment test (a very deferential standard) by concluding that rejection of the midstream gathering agreements was appropriate even if the covenants run with the land:

If it is ultimately determined that the covenants at issue in the Agreements do not run with the land, as the Debtors argue and the Court believes to be the case, the Debtors will be free to negotiate new gas gathering agreements with any party, likely obtaining better terms than the existing agreements provide. If, however, the covenants are ultimately determined to run with the land, the Debtors will likely need to pursue alternative arrangements with Nordheim and HPIP consistent with the covenants by which the Debtors would remain bound. In either scenario, the Debtors’ conclusion that they are better off rejecting the Nordheim and HPIP Agreements is a reasonable exercise of their business judgment.

Id.

Fast on the heels of Sabine, Magnum recently moved to reject its midstream contract in its own Chapter 11 proceeding. Magnum’s motion is paired with an adversary proceeding asking the court to rule that the agreement did not “run with the land.” In re Magnum, No. 15-12533 (Bankr. D. Del. Mar. 18, 2016) Doc. Nos. 842, 843. (The Sabine court held that an adversary proceeding was required to reach the merits of whether the midstream gathering agreements ran with the land).

On May 3, 2016, the Sabine court entered a follow-up decision for publication, reinforcing its prior ruling, while specifically holding that the covenants do not run with the land.

In authorizing the rejection of the Nordheim Agreements and the HPIP Agreements, the Court provided its non-binding analysis on the “running with the land” issue, but noted that further proceedings would be necessary in order to enable the Court to render a binding ruling on the issue. The Debtors then commenced these adversary proceedings against Nordheim and HPIP seeking a declaratory judgment that the covenants contained in the Nordheim Agreements and the HPIP Agreements do not run with the land.

For the reasons stated in [the court’s prior decision, it] finds that the covenants at issue do not run with the land either as real covenants or as equitable servitudes, and therefore it denies the Defendant Motions and grants the [Debtor’s summary judgment motions against Nordheim and HPIP].

In re Sabine, No. 16-01042 (Bankr. S.D.N.Y. May 3, 2016) at 2.

The Sabine decisions have garnered much attention and concern that other bankruptcy courts would permit rejection of midstream contracts. It remains to be seen the full extent of the impact of the Sabine decisions. For now, though, the practical implication of Sabine is to increase an E&P company’s leverage to renegotiate its midstream gathering agreements in Chapter 11. For example, in April, Magnum withdrew its motion to reject its midstream gathering agreement – but only after it negotiated new terms for that agreement. The bankruptcy court subsequently approved Magnum’s plan of reorganization, with these new contract terms included.

We will continue to monitor developments in this area.