Bad news for midstream counterparties of bankrupt oil & gas producers: you may not be able to rely (as much as you might have expected) on covenants “running with the land” to save your contracts from rejection in bankruptcy.

One strategy commonly used by midstream counterparties of oil & gas producers to mitigate upstream risk has been to craft their contractual entitlements as covenants that “run with the land,” generally expecting that these covenants are immune from rejection in bankruptcy. As with most things, however, the devil is in the details. After having heard argument on February 2, 2016, and considering the evidence presented, on March 8, 2016, Judge Shelley Chapman of the U.S. Bankruptcy Court for the Southern District of New York authorized Chapter 11 debtor Sabine Oil & Gas Corp. to reject gas and condensate gathering and treatment contracts, governed by Texas law and purporting to run with the land, with two midstream pipeline companies, Nordheim Eagle Ford Gathering LLC and HPIP Gonzales Holdings LLC—although the Court did not issue a definitive ruling that the covenants at issue do not run with the land ... yet.1

Background

In December 2014, as a result of Sabine’s merger with Forest Oil Corp., Sabine became party to contracts with, separately, Nordheim and HPIP (the Counterparties). Under the contracts, Sabine agreed to “dedicate” to the Counterparties (as applicable) all of the natural gas and condensates produced by Sabine from certain designated areas. Sabine also agreed to deliver certain minimum volumes, make deficiency payments if the minimums were not met, and pay certain monthly fees.

The contracts expressly provided that Sabine’s undertakings were covenants that run with Sabine’s real property interests, and were binding on Sabine’s successors and assigns. The Counterparties recorded a memorandum of each contract in the applicable local real property recording offices. And, in reliance on Sabine’s covenants, the Counterparties agreed to construct, at their own expense, the necessary pipeline systems and facilities for gathering and treating the gas and condensates.

In July 2015, Sabine commenced its Chapter 11 bankruptcy case, and two months later sought Court approval to reject the Nordheim and HPIP contracts under section 365(a) of the Bankruptcy Code.

Contract Rejection in Bankruptcy

Section 365(a) of the Bankruptcy Code permits debtors to evaluate their executory contracts and, with Court approval, reject those that are burdensome or assume those that are beneficial. As long as it is not the product of “bad faith, whim or caprice” and reflects the sound judgment of a reasonable business person under similar circumstances, bankruptcy courts usually will not second guess a debtor’s decision to reject or assume a contract.

In this case, Sabine explained that rejecting the Nordheim and HPIP contracts was a reasonable business decision because delivering the required minimum volumes of gas and condensates on the existing terms was not economic in the current market, and making the resulting deficiency payments would be an unnecessary burden on the bankruptcy estate that could be avoided by rejection. Sabine also argued that rejection would free the company to enter into new contracts on better terms.

HPIP did not object to the rejection of its contracts, arguing only that the rejection could not eliminate the covenants at issue because they expressly run with the land. Nordheim, however, in addition to making this argument, objected to the rejection of its contracts on the grounds that rejection was not a reasonable exercise of business judgment by Sabine because any replacement contract with a new counterparty would be uneconomic in light of Sabine’s surviving covenants to deliver gas and condensates (or make deficiency payments) to Nordheim, which could not be rejected.

Judge Chapman reluctantly observed that Second Circuit precedent precluded her from deciding, in the “summary proceeding” context of a motion to reject, substantive legal issues such as whether the covenants in question truly run with the land under applicable Texas law.2 She laid out the alternate paths ahead: “If it is ultimately determined that the covenants at issue…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…. 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.”

Even with this contingency, however, Judge Chapman concluded that she could rule on rejection as a matter of Sabine’s reasonable business judgment. On that basis, she held that Sabine could reject all of the contracts in question. Judge Chapman found that “there is no dispute with respect to the reasonableness of the Debtors’ decision to reject the HPIP Agreements,” and that despite Nordheim’s arguments, it had not presented evidence that the proposed rejection failed the requisite business judgment test.