Executive Summary New York bankruptcy judge allows Sabine Oil & Gas to reject gathering agreements over the objections of midstream companies, finding that the covenants do not run with the land.

On March 8, 2016, the United States Bankruptcy Court for the Southern District of New York issued a bench ruling in the Sabine Oil & Gas Corporation bankruptcy (Case No. 15-11835) with wide-ranging implications for midstream and exploration & production companies. On September 30, 2015, Sabine, an oil exploration & production company, filed a motion to reject midstream agreements with two parties: gas and condensate gathering agreements with Nordheim Eagle Ford Gathering LLC, and a production, gathering, treating and processing agreement with HPIP Gonzales Holdings LLC.

The court agreed with Sabine, finding that Sabine’s rejection of the midstream agreements were in the best interests of Sabine’s bankruptcy estate. The court overruled objections by Nordheim and HPIP that the covenants in the midstream agreements were not subject to termination because they ran with the land. The court found, among other things, that the midstream agreements did not touch and concern Sabine’s real property, and only burdened Sabine’s personal property interests in already-extracted products. The court acknowledged as a procedural matter under bankruptcy law that its ruling was binding on the issue of rejecting the midstream agreements, but was not binding on the parties on the substantive issue of whether the covenants ran with the land, which would be finally adjudicated in another proceeding, such as a claim objection.

Similar issues regarding the rights of midstream companies in bankruptcy are also now front and center in the Quicksilver Resources Inc. case pending in the Bankruptcy Court for District of Delaware, where the court is expected to rule by the end of this month.

The ruling in Sabine (although technically non-binding), and the expected ruling in Quicksilver may drastically impact both exploration & production companies and midstream companies. On one hand, exploration and production companies often file bankruptcy to reorganize, and the ability of debtors to reject burdensome executory contracts and to otherwise remove encumbrances from a debtor’s property are critical tools to accomplish this maneuver. Likewise, a debtor’s secured lenders wish for the debtor to maximize its value by minimizing or eliminating burdensome agreements.

On the other hand, rejection of such agreements raises serious risks for midstream companies, which may result in extreme financial loss both because midstream companies may lose the benefits of their bargained-for rights under their agreements, and because rejection may allow debtors in the distressed oil and gas industry to drive down prices and shop for “better deals” in a buyers’ market. Additionally, these agreements often require midstream companies to incur substantial costs building infrastructure in anticipation of recouping the costs over the life of the agreement. Rejection may result in a midstream company party to an existing agreement losing any hope of recovering its costs of investment.

Turning to the specific issues of Sabine, the Nordheim agreements contained a take-or-pay clause that obligated Sabine to deliver minimum amounts of gas and condensate to Nordheim, or to pay annual deficiency payments if the minimums were not met. Sabine determined that rejecting the Nordheim agreements would save it $35 million over the life of the agreements. Nordheim, on the other hand, argued that it spent tens, if not hundreds of millions of dollars in the short term to construct gathering systems in anticipation of long-term gains over the life of the contract and in reliance on Nordheim’s covenants running with the land.

The HPIP agreements required HPIP to construct and operate gathering and disposal facilities, which HPIP had ceased construction on, and required Sabine to drill at least one well per year through 2017, or, upon failing to drill, to purchase HPIP’s gathering facilities. Sabine determined that rejecting the HPIP agreements would save it between $2.5 million and $80 million over the life of the agreements. HPIP argued that, although it had not completed construction, it spent at least $80 million under the contract in anticipation of long-term gains over the life of the agreement.

Sabine argued that the agreements were merely executory service agreements and were subject to rejection like any other executory agreement. Nordheim and HPIP each objected, arguing that the terms of the gathering agreements were covenants running with the land or equitable servitudes under Texas state law, and were therefore not subject to termination or avoidance. Notably, both Nordheim and HPIP’s agreements expressly provide that the contractual obligations run with the land, and both Nordheim and HPIP recorded memorandums of agreement in the real property records in the counties where Sabine’s mineral interests are located, which they argued clearly evidenced the parties’ mutual intent that the agreements run with the land.

The Bankruptcy Court found that the language in the midstream agreements expressly stating that the covenants ran with the land was not dispositive because the covenants did not touch and concern Sabine’s real property interests.1Among other things, the court found that the right to transport or gather produced gas is clearly not one of the five traditional “sticks” of real property interest provided for under Texas law. However, the Bankruptcy Court also noted the opinion of many that labeled the “law of covenants as an ‘unspeakable quagmire.’”

A similar dispute has arisen in the Quicksilver bankruptcy case, where Quicksilver and a midstream company are litigating whether a midstream agreement may be rejected in bankruptcy. The matter is complicated in Quicksilver, however, by the fact that Quicksilver previously obtained an order permitting it to sell its assets free and clear of liens and encumbrances without any objection to such a sale being filed by the midstream company. Highlighting the importance of these issues to the midstream industry is the fact that the Gas Processors Association and Texas Pipeline Association have each filed amicus briefs in the Quicksilver case, which is an extremely rare occurrence in bankruptcy court.

Given the steep declines in the oil and gas industry and numerous pending and imminent bankruptcies of oil and gas producers, the Sabine decision (although technically not binding) and the upcoming decision in Quicksilver may have a broad impact on the oil and gas industry for both upstream oil and gas producers and midstream gathering and transportation companies. It would not be difficult to envision that even the increased risk associated with the rejection of such agreements (and the attendant risk to their investment) may increase the price midstream companies will seek from producers, dramatically increase the amount of collateral required by the transporter, and influence parties relying on revenue streams under gathering and transportation agreements to determine a midstream company’s credit worthiness. Participants in the industry would be advised to monitor developments in this area as the results continue to unfold.