Bankruptcy Judge’s Decision in Sabine Oil & Gas Alters the Relationships and Value Allocations Between Oil Producers and Midstream Companies. The hottest area in restructuring in 2016 is oil and gas. In the first five months of 2016, dozens of companies have sought bankruptcy protection in the wake of the substantial decline in oil prices and balance sheets burdened with hundreds of millions, and even billions, in funded debt. The bankruptcy cases often are fights over allocation of valuation among first lien secured lenders, second lien secured lenders, and unsecured bondholders, with little involvement of (or value left over for) trade creditors and contract counterparties. Often the companies have substantial operations and property in Texas.

Now, a recent decision by the influential United States Bankruptcy Court for the Southern District of New York in In re Sabine Oil & Gas creates a strategic reason for struggling companies to file for bankruptcy and escape performance under burdensome contracts— the ability to reject gas-gathering agreements as executory contracts. While using bankruptcy to reject burdensome contracts and leases is as old as the Bankruptcy Code, the ability to reject gas-gathering agreements and override previously held expectations about real property interests granted by such contracts may give producers a leg up, and midstream companies new risks, in the efforts to restructure.

In Sabine, the debtor, Sabine Oil & Gas Corp., sought court approval allowing it to “reject” certain gas gathering and handling agreements that it had with two counterparties. Rejection under Bankruptcy Code section 365 permits a debtor to cease performing under an “executory contract” or lease, and leaves the counterparty with a pre-bankruptcy general unsecured claim for rejection damages. Sabine argued that these contracts were burdensome to maintain. For one contract, Sabine claimed it was no longer shipping enough fuel to meet its minimum commitments under the agreement and would have to pay the counterparty $35 million over the life of the contract to make up the difference. Sabine also asked the court to permit it to reject agreements with a second pipeline operator, arguing that it would save as much as $80 million and avoid sinking money into unprofitable wells the company would be required to drill under the agreement.

What made this dispute unique was that the agreements (governed by Texas law) were drafted to create a property right known a “real covenant” that “runs with the land,” which normally cannot be invalidated through the bankruptcy contract rejection process. In other words, rejection itself would not change the economic burdens the debtor faced because the counterparties’ rights under the contracts were real property interest that were not capable of being rejected.

On May 3, 2016, Bankruptcy Judge Shelley Chapman, who is overseeing the Sabine case, issued a decision permitting the debtor to reject gas-gathering and related agreements with two midstream companies. In doing so, Judge Chapman resolved two important issues involving Texas oil and gas law. First, Judge Chapman addressed whether the agreements provided for covenants running with the land. The court explained that “under Texas law, a covenant runs with the land 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 her initial ruling in March 2016 (which is attached to her published decision), Judge Chapman held that because minerals extracted from the ground cease to be real property under Texas law, the right to gather and process such extracted minerals was not a right that touched and concerned the land. In her final ruling, Judge Chapman held that because the agreements contained language indicating that fees for the gathering services were triggered by the receipt of gas at times other than the extraction of the gas from the ground, the subject of the agreements was minerals extracted from the ground rather than minerals in the ground. The Court concluded that the covenants did not “touch and concern” the land and thus did not create valid real covenants as required under Texas law.

The second issue the court addressed was whether Sabine was in “horizontal privity of estate” with each of the midstream companies involved. The concept of horizontal privity means that a real covenant is not valid unless it is created simultaneously with the conveyance of a recognized property right. Acknowledging that Texas law was unclear on the issue, Judge Chapman held that the parties were not in horizontal privity because there was no such conveyance.

This ruling applies only to agreements under Texas law, and it is certainly possible to limit the ruling to the specific language used in the agreements. Nonetheless, given the number of E&P companies in distress with operations in Texas, this ruling has sent shockwaves through the midstream industry—an industry already reeling by the repeated bankruptcy filings of E&P companies. Within days of the preliminary ruling, The Wall Street Journal reported: “[P]roducers are already asking for breaks on fees and volume commitments, and some experts said the ruling could set a new tone for those discussions. The closely watched case is likely to upend the once symbiotic relationship between companies that pump fuel and those that spent billions to lay thousands of miles of pipelines to move it.” One E&P company in bankruptcy, Magnum Hunter Resources, quickly commenced proceedings to reject a gas purchase agreement, and touted its ability to use rejection to renegotiate approximately a dozen midstream and downstream contracts.