The Southern District of New York upheld a very closely watched decision of recent years affecting bankruptcies in the oil and gas industry.

On March 10, 2017, Judge Jed S. Rakoff of the Southern District of New York affirmed Bankruptcy Judge Shelley Chapman’s determination that the natural gas gathering agreements at issue in the Sabine bankruptcy could be treated as executory contracts, rather than as contracts involving real property interests, and rejected by the debtor. In a case of first impression, Bankruptcy Judge Chapman had determined that the acreage dedications in Sabine Oil & Gas Corporation’s (“Sabine”) gathering agreements did not constitute real covenants or equitable servitudes that run with the land under Texas law and, consequently, the gathering agreements could be rejected under 11 U.S.C. § 365. Bankruptcy Judge Chapman’s decision and District Judge Rakoff’s affirmance may affect the midstream and exploration and production industry’s analysis with respect to restructuring and the potential benefits of seeking to reject gathering agreements and the economic terms when entering such deals.

Background

On July 15, 2015, Sabine and certain subsidiaries filed voluntary petitions for relief under chapter 11 of title 11 of the United States Code, 11 U.S.C. §101 et seq. (the “Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”). As part of its ongoing restructuring efforts, Sabine engaged in a review of its executory contracts, including its gathering agreements. A gathering agreement generally refers to a contract that provides for collecting gas or other commodities at the point of production, and for moving it through a low-pressure pipeline system to a junction with a pipeline’s primary transmission system.

Prior to filing for bankruptcy, Sabine entered into agreements with Nordheim Eagle Ford Gathering LLC (“Nordheim”) and HPIP Gonzales Holdings, LLC (“HPIP” and, together with Nordheim, the “Gathering Parties”). The agreements between Sabine and Nordheim (the “Nordheim Agreements”) provided, among other things, that: (i) Nordheim will gather, treat and deliver all of the gas and condensate produced by Sabine in a certain area; and (ii) Sabine will exclusively dedicate to Nordheim’s gas gathering system Sabine’s entire supply of natural gas attributable to interests in a specific area. The agreements between Sabine and HPIP (the “HPIP Agreements” and, together with the Nordheim Agreements, the “Agreements”) provided, among other things, that: (i) HPIP will construct, operate, and maintain disposal facilities for gathering and disposal facilities regarding all of the oil, gas, and water and acid gas produced by Sabine in a certain area; and (ii) Sabine will grant HPIP the exclusive right to perform gathering services on any hydrocarbons produced from Sabine’s wells.

On September 30, 2015, upon completing the review of its executory contracts, Sabine filed a motion in the Bankruptcy Court seeking entry of an order authorizing rejection of the Agreements. Under the Bankruptcy Code, a debtor may assume its beneficial executory contracts and reject those that are burdensome to the estate. See 11 U.S.C. § 365. In its motion to reject the Agreements, Sabine argued that the Agreements are executory contracts that can be accepted or rejected. Further, according to Sabine, rejection of the Agreements would save it a considerable amount of money. Thus, Sabine concluded that it was well within its business judgment to reject the Agreements because the Agreements were unduly burdensome and such rejection would benefit the estate. The Gathering Parties objected to Sabine’s motion to reject the Agreements, arguing that the covenants in the Agreements run with the land under the applicable Texas law and should therefore not be rejected in bankruptcy because any agreement that conveys a real property interest is not subject to rejection.

The Bankruptcy Court’s Decision

On March 8, 2016, the Bankruptcy Court entered a non-binding decision granting Sabine’s motion for rejection of the Agreements because, according to the Bankruptcy Court, the Agreements did not create real covenants that run with the land under Texas law and rejection of the Agreements was, therefore, permissible. The Bankruptcy Court’s decision was non-binding because it could not make a final determination as to whether the covenants at issue were covenants running with the land in the procedural context of a motion to reject an executory contract. With respect to the issue of whether the Agreements run with the land, the Bankruptcy Court explained that under Texas law, a covenant runs with the land when it: (i) touches and concerns the land; (ii) relates to a thing in existence or specifically binds the parties and their assigns; (iii) is intended by the original parties to run with the land; and (iv) the successor to the burden has notice. The Bankruptcy Court determined that the covenants did not run with the land because they did not “touch and concern” the land and merely affected the value of the land itself. Additionally, the Agreements did not affect the owner’s interest in or use of the property because the minerals, once extracted from the ground, ceased to be real property and became personal property.

Following the Bankruptcy Court’s non-binding decision, Sabine commenced an adversary proceeding seeking a declaratory judgment that the covenants contained in the Agreements do not run with the land. On May 3, 2016, relying on its previous decision, the Bankruptcy Court entered a final ruling determining that the Agreements did not create real covenants or equitable servitudes that run with the land and, therefore, authorized Sabine to reject the Agreements.

On Appeal

On appeal, the Gathering Parties argued that the Bankruptcy Court erred in holding that the Agreements do not contain real covenants that run with the land under Texas law. In an opinion authored by Judge Jed Rakoff, the District Court disagreed and upheld the Bankruptcy Court’s decision. In reaching its decision, the District Court set forth the conditions that must be satisfied for a covenant to run with the land and noted that the preliminary issue under Texas law is whether the covenant touches and concerns the land. The District Court held that the Agreements did not touch and concern the land because the Agreements did not increase Nordheim’s or HPIP’s relationship to the real property, or decrease Sabine’s. First, the court held that Sabine did not convey real property interests, essentially disagreeing with Nordheim that in the Nordheim Agreements it had received an interest akin to a royalty interest. Next, the court held that Sabine’s “dedication” of various oil and gas leases to the HPIP Agreements was clearly stated not to be a conveyance of title to the leases, and no other conveyance was made to HPIP. The court also held that Sabine’s relationship to the real property was not decreased by its obligation to deliver gas to the Gathering Parties because Sabine was free to produce as much or as little gas and condensate as it chose, and Sabine’s obligations under the Agreements were only triggered once the gas and condensate were produced. The District Court next held that the Agreements did not touch and concern the land because they did not affect “the nature, quality or value of the thing demised …” Specifically, the court found the Agreements did not reduce Sabine’s ability to use the real property. Because the District Court determined that the Agreements did not touch and concern the land, it did not need to reach the remaining issues with respect to the test for whether a covenant runs with the land. The District Court also found that the Gathering Agreements were not equitable servitudes. Accordingly, the District Court ruled that the Bankruptcy Court did not err in holding that the Agreements did not create real covenants that run with the land. The Bankruptcy Court’s order was affirmed.

The District Court opinion is one that will significantly impact the upstream oil and gas industry because it introduces greater uncertainty as to whether midstream gathering contracts that often require significant upfront capital investment can be easily rejected. Such uncertainty may create significant volatility and increase credit risk protections at the front-end of such contracts.