On May 3, 2016, Judge Shelley Chapman issued a final ruling in the Sabine Oil and Gas bankruptcy proceedings permitting the debtor to reject gas-gathering and related agreements with two midstream companies.
These proceedings, which are pending in the Bankruptcy Court for the Southern District of New York, have been closely watched by energy professionals and midstream industry participants ever since the debtor first requested authority to reject the contracts in September 2015. The reason for the attention is that such agreements are drafted with the intention of creating a property right known a “real covenant” that “runs with the land” and cannot be invalidated through the bankruptcy contract rejection process.
In a preliminary ruling issued on March 8, 2016, Judge Chapman held that the Texas property law requirements for creating real covenants were not satisfied by the agreements at issue and that the debtor could effectively terminate the arrangements. As noted by the authors in a recent article in Forbes Energy Source, this ruling alarmed many in the midstream industry and potentially introduced a risk to their business model that was not previously appreciated. Others noted that the March 8 decision was preliminary and thus had little precedential value. In fact, the parties were urged by the judge to reach a settlement rather than take the procedural steps needed for a binding decision. The judge also warned the midstream companies that she was unlikely to change her mind if the issue came before her again. Nevertheless, a settlement was not achieved and the parties pressed forward with litigation regarding whether the Texas property law requirements for creating a real covenant were satisfied.
The first such requirement was the “touch and concern requirement,” which provides that a valid real covenant should affect the nature, quality or value of the property or property interests at issue. In her initial ruling, 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 the latest round of litigation, the midstream companies cited for the first time various cases that seemed to counter Judge Chapman’s conclusion. These cases suggested that in determining whether a covenant involving a mineral touches and concerns the land, one should look to where the mineral is located at the time of contracting. If, for example, the contract involves yet-to-be-produced gas, such underground gas is a form of real property at that moment and any covenant regarding such mineral should be a real covenant that runs with the land.
In her final ruling, Judge Chapman noted that these cases did not apply to the agreements at issue because the agreements contained language stating that the receipt points for the relevant gathering systems were not at the debtor’s wells and that the fee for the gathering services was triggered by the receipt of gas at those points, rather than the extraction of the gas from the ground. Accordingly, in Judge Chapman’s view, the subject of the agreements was minerals extracted from the ground rather than minerals in the ground, meaning that they did not touch and concern the land and thus did not create valid real covenants.
The other property concept that Judge Chapman’s initial ruling examined was whether Sabine was in “horizontal privity of estate” with each of the midstream companies involved. Under this concept, a real covenant is not valid unless it is created simultaneously with the conveyance of a recognized property right. Because there was no such conveyance in Sabine, in Judge Chapman’s view, the parties were not in horizontal privity. Thus, the contracts did not create real covenants that run with the land.
In their latest motions, the midstream companies noted that “Texas courts [have] consistently analyze[d] whether covenants run with the land without considering horizontal privity,” implying that horizontal privity is no longer a requirement under Texas law.
In her final ruling, Judge Chapman acknowledged “that there is some ambiguity under Texas law as to whether horizontal privity of estate remains a requirement for a covenant to run with the land.” Nevertheless, because she was not presented with any governing authority in Texas that had affirmatively rejected the requirement, she proceeded with an examination of whether the horizontal privity requirement was satisfied and again found that it was not. Interestingly, she qualified this determination by noting that it was made “without concluding whether or not horizontal privity of estate is indeed a requirement under Texas law.”
As to where the parties go from here, the likely next steps are appeals to higher federal courts in New York. No matter what any federal judge decides, it is important to remember that the legal issues at the crux of the dispute are governed by Texas state law and the ultimate arbiter on the proper interpretation of Texas law is the Supreme Court of Texas. If a federal appellate court hearing an appeal of the Sabine ruling certifies the state law issues for consideration by the Supreme Court of Texas, or if the issues arise in another similar case before the Supreme Court of Texas, any such decision by the Supreme Court of Texas will be the final say on the matter. Further, in other cases, Texas law may not apply at all and another state’s jurisprudence may govern such issues.
This all demonstrates that the dispute in Sabine is merely the opening salvo in a legal conflict between producers and midstream companies that will play out in bankruptcy courts, federal appellate courts, state courts and possibly legislatures across the country over the coming months and years. Each dispute will be different and each outcome will be highly dependent on the specific terms of the contracts and governing law at issue.