The U.S. District Court for the Southern District of New York, in the case of HPIP Gonzalez Holding, LLC v. Sabine Oil & Gas Corp. (In re Sabine Oil & Gas Corp.), recently affirmed three decisions of the U.S. Bankruptcy Court for the Southern District of New York, finding that certain mineral gathering agreements could be rejected as executory contracts pursuant to 11 U.S.C. § 365(a).

Facts Sabine Oil & Gas Corp. was a counterparty to three agreements (HPIP agreement and Nordheim agreements, and, collectively, the agreements) individually entered into with HPIP Gonzalez Holdings, LLC (HPIP) and Nordheim Eagle Ford Gathering, LLC (Nordheim, and, collectively with HPIP, the appellants, which are “midstream gatherers” that gather, transport and process oil and gas after extracted from the land).

Appellants agreed to gather and process certain minerals extracted from designated parcels of Sabine’s real property (collectively, the dedicated areas). Under the Nordheim agreements, Sabine retained title to the minerals and agreed to compensate Nordheim should certain production benchmarks not be met. Under the HPIP agreement, Sabine dedicated certain leases on the dedicated areas (leases) to performance of the HPIP agreement but retained title thereto. Both agreements stated that they were covenants that ran with the dedicated areas.

Sabine and certain affiliates (collectively, the debtors) filed chapter 11 in July 2015, and subsequently moved to reject the agreements pursuant to 11 U.S.C. § 365(a) (rejection motion). The appellants argued that the agreements could not be rejected, as they were covenants that ran with the dedicated areas. The bankruptcy court granted the rejection motion but held that it could not decide the issue of whether the agreements were covenants that ran with the land, except in the context of an adversary proceeding. The debtors initiated adversary proceedings seeking declaratory judgments that the agreements did not run with the land. The appellants each asserted counterclaims seeking declaratory judgments to the opposite effect. The bankruptcy court found in the debtors’ favor and the instant appeal followed.

Decision Bankruptcy code section 365(a) allows a debtor to reject certain executory contracts unless the contract is, or contains, a covenant that runs with the land. Under Texas law, a covenant runs with the land if:

  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.

The court limited its opinion to the first factor, finding that, under Texas law, a covenant touches and concerns the land if:

  1. It affects the nature, quality, or value of the thing demised, independently of collateral circumstances, or it affects the mode of enjoying it (first test); or
  2. The promisor’s legal relations in respect to the land in question are lessened, or the promisee’s legal relations in respect to the land are increased (second test).

Nordheim argued that the first test was satisfied because Sabine’s interests in the dedicated areas were negatively affected due to fluctuating hydrocarbon and gathering market rates. However, the court found such circumstances to be collateral to the agreements in that they would affect the value of any oil-producing land and not just the dedicated areas. As such, Sabine’s interests in the dedicated areas were not reduced and the first test was unsatisfied.

As to the second test, Nordheim argued that it acquired an interest in the minerals in the ground, which, under Texas law, is a real property interest. However, the court found that Nordheim was simply contractually obligated to process and then return the minerals. As such, Nordheim’s legal relations with respect to the dedicated areas were not increased.

Similarly, HPIP argued that it acquired an interest in the leases dedicated to the performance of the HPIP gathering agreement. The court held that Sabine explicitly retained title to the leases, and it was unclear what property interest HPIP was claiming. HPIP, like Nordheim, was merely contractually entitled to be the exclusive provider of certain services for Sabine.

Additionally, Sabine’s legal relations to its property interests in the dedicated areas were not decreased. Sabine (a) did not convey an interest in real property, (b) was free to produce any amount of minerals it chose, and (c) was not obligated under the agreements until the minerals were extracted. Rather, Sabine was contractually obligated to use the appellants’ services, which was not sufficient to restrict Sabine’s enjoyment of its land.

Finally, the court found that the agreements were not equitable servitudes, as alternatively argued by the appellants. An equitable servitude restricts the use of the subject land. As was noted during the court’s analysis above, Sabine’s property interests in the dedicated areas were unaffected by the agreements.