Updates

Yesterday, a bankruptcy court in New York approved the rejection of several midstream contracts secured by dedications of production, provisionally ruling that, under Texas law, such dedications are neither covenants running with the land nor equitable servitudes. Many midstream companies (some of which are organized as MLPs) rely on dedications of production as a form of credit support from producers to assure the future cash flows necessary to recover the significant capital expenditures incurred by such companies to construct and maintain the gathering, transportation and processing assets built for such producers. Many of our clients, including upstream producers, midstream companies and their respective lenders, are anxious to understand what this decision means for them.

1. Background: Dedications as Covenants Running with the Land

For several decades, midstream companies have relied on upstream producers to help finance the construction and expansion of oil and gas gathering, processing and transportation systems through contracts with producers that granted the midstream companies the exclusive right to gather, process or transport all hydrocarbons produced by such producers from leases and wells located within an agreed geographic area. These contracts included provisions known as “dedications” because they dedicate all hydrocarbon production from identified upstream assets (namely, leases and wells) to a particular midstream asset.

It is commonplace in modern midstream contracts for the parties to treat such dedications as covenants running with the land (rather than merely personal covenants) and to file evidence of their dedications in the county property records to put third parties on notice of the dedications (such that if a producer were to sell its producing assets, then the purchaser of such assets would be subject to the same contractual obligations as the seller). For many years, county clerks have accepted memoranda of dedication agreements and filed them in the property records. No Texas state court has ever expressly ruled, however, on whether a “dedication” is a “covenant running with the land”.

Practically speaking, the primary differences between dedications as a personal covenant and as a covenant running with the land are (1) whether successors are bound and (2) survivability during bankruptcy. A burdensome unperformed contract, including a personal covenant, may be rejected in bankruptcy and replaced with a general unsecured claim for damages. Because unsecured claims share pro rata with other unsecured claims after all secured lender claims are satisfied, where the cash flows of upstream companies have dropped due to low commodity prices, such unsecured claims may receive substantially less than the face value of their claims in bankruptcy. In contrast, many courts have ruled that covenants running with the land cannot be rejected in bankruptcy because they constitute interests in real property rather than future performance obligations.

2. Yesterday’s Decision: In re: Sabine Oil & Gas Corporation

The bankruptcy court’s decision, announced yesterday in In re: Sabine Oil & Gas Corporation, et al., Case No. 15-11835, in the United States Bankruptcy Court for the Southern District of New York, brings into question whether under Texas law, a “dedication” is a covenant running with the land and whether gathering agreements secured with a dedication are simply executory contracts that may be rejected by the bankrupt producer.

At issue in the case was the bankrupt producer’s argument that it should be able to reject a gas gathering agreement secured by a dedication as an executory contract under Section 365 of the U.S. Bankruptcy Code. By rejecting the contract, the debtor would be free to attempt to arrange alternative gathering services or sell its producing assets without the gathering obligations (e.g. fixed fees, minimum volume commitments, etc.), thereby increasing the value of its assets and conserving cash. At the very least, rejection would give the debtor (or a purchaser of the debtor’s assets) leverage in a renegotiation of fees and costs for go-forward gathering and transportation services. Cheniere Energy’s Nordheim Eagle Ford Gathering, with whom the debtor entered into the gathering agreement, responded that the gathering agreement’s dedication was a covenant running with the land and, therefore, could not be rejected in bankruptcy. The gathering company argued that if the gathering agreement were rejected, then it would be left in the same position as a landlord without a tenant and its rental property would be an $84 million pipeline to nowhere.

The Court concluded that the debtor’s rejection is a “reasonable exercise of their business judgment” and allowed the gathering agreements in question to be rejected. The Court did not decide the issue of whether the dedications were “covenants running with the land” because of certain procedural concerns, but it did issue “non-binding analysis” reaching the “preliminary” conclusion that the dedications were not covenants running with the land under Texas law.

The Court found that under Texas law, a covenant runs with the land if all of the following are true:

  • the covenant touches and concerns the land;
  • the covenant relates to a thing in existence or specifically binds the parties and their assigns;
  • the covenant is intended by the original parties to run with the land;
  • the successor to the burden has notice; and
  • there is horizontal privity of the estate.1

During the hearings, the last element above was the major point of contention. The Court, citing In re: EnergyTec, Inc.2, held that horizontal privity was a required element to create a covenant running with the land. Horizontal privity requires a relationship between the original parties to a covenant at the time the covenant was made (e.g., a grant of a legally recognized interest in real property). Stated differently, under the Court’s interpretation ofEnergyTec, in order for a dedication to be a covenant running with the land, there must be (as part of the creation of the dedication) either a conveyance or reservation of a real property interest.

After considering the parties’ arguments, the Court did not interpret the agreements under review as having conveyed or reserved to the gathering company any portion of the debtor’s real property mineral interests. Thus, the Court’s conclusion that the dedications were not covenants running with the land turned heavily on its reliance on EnergyTec in holding that there must be horizontal privity of the estate as part of the creation of the dedication.The decision, even as a preliminary ruling, causes producers, midstream companies and their respective lenders to reevaluate their existing arrangements and determine whether there are steps to be taken to address this non-binding ruling.

3. Similar Pending Bankruptcy Cases

Several other bankruptcy courts are currently considering whether similar dedications in other midstream agreements are covenants running with the land. If the courts hearing these other proceedings are inclined to issue a decision informed by the Court’s decision inSabine, a string of instructive case law precedents could find their way into state court opinions, recharacterizing many existing dedications as personal covenants and limiting their ability to survive bankruptcy as well as to be filed in county property records where they can provide notice to third parties.

One such case is In re: Quicksilver Resources Inc., Case No. 15-10585, in the United States Bankruptcy Court for the District of Delaware. In that case, a bankrupt producer with dedication clauses in its gathering contracts is arguing for a resolution similar to that achieved by Sabine. The producer has asked the judge overseeing its case to reject a dedication with the operator who took over the producer’s affiliated gathering system before the producer filed for bankruptcy in March 2015. Although the bankruptcy court approved the $235 million sale of the producer’s upstream producing assets in January 2016, the prospective purchaser indicated that it will terminate its purchase contract unless the dedications set forth in the gathering agreements are rejected.

In another case, In re: Energy & Exploration Partners, Inc., Case No. 15-44931, in the United States Bankruptcy Court for the Northern District of Texas (Fort Worth Division), the bankrupt producer has argued, preemptively, for the court to decide that a dedication in a gathering agreement is not a covenant running with the land – relying on the same arguments raised in Sabine – in order to limit a creditor’s ability to use the gathering agreement as leverage to setoff amounts owed to it. Although the debtor in this case appears to want to maintain the gathering agreement, its arguments before the bankruptcy court would eliminate any bankruptcy protections from the contract’s dedication provisions in much the same way as under Sabine.

4. What do These Cases Mean For Our Clients?

This is not the end of dedications-as-credit-support for midstream contracts, but it is undoubtedly the beginning of a period of greater focus on whether and how dedications can achieve their intended result. We expect, and are already starting to see, increased interest from our midstream clients regarding potential ways to address the diminished value of credit support provided by producers under midstream contracts. In addition, our producer clients are interested in what types of additional credit support may be requested by gathering companies with whom they do business. Furthermore, the fate of the gathering contracts in Sabine and Quicksilver may provide leverage for producers seeking to discard or re-negotiate long-term gathering contracts. All of these issues are likely to be magnified if commercial lenders seek additional credit support from their midstream borrowers to protect against the risk that existing contracts may be rejected in bankruptcy. This is especially acute given the current low commodity price environment and the competing liens of the producers’ existing lenders.

Many existing gathering contracts contain “further assurances” provisions relating to the granting of dedications and the filing of information to help perfect and solidify such dedications, as well as “adequate assurances” provisions relating to the times at which, and the types of, additional credit support that a midstream company may request from producers. Under such agreements, producers may be requested to provide adequate assurances of performance that substitute for the diminished value of their dedications as well as undertake other actions to help existing dedications survive future court scrutiny. By making requests of producers under both provisions simultaneously, midstream companies may be able to couple the grant of the dedication with a grant of interests in the mineral estate, thereby securing additional credit support as well as potentially strengthening their existing dedications as covenants running with the land. Other requests may simply seek to require producers to obtain increased lines of credit or new parent guaranties. The ability of midstream companies to obtain this additional credit support from producers will depend on the existing language in the applicable contracts, the overall negotiating strength of the parties and the current liens for borrowed money that exist on the producers’ assets, among other things.

Under new midstream contracts, we are seeing midstream companies request from producers enhanced credit requirements that expand beyond the confines of historical midstream contracts. Such new credit requirements may include liens, mortgages or other interests in real property that can support stand-alone dedication provisions to ensure the commercial arrangement is binding on successor owners of the dedicated properties and will not be rejected in bankruptcy. In addition, midstream companies are likely to focus heavily on the structure and wording of the dedications in midstream agreements to address the risks raised by the Sabine court and increase the likelihood that such dedications will be treated by future courts as covenants running with the land. To address these issues going forward, each of the interested parties will need to be creative in developing arrangements that are acceptable to producers, midstream companies and their respective lenders.