The US Bankruptcy Court for the Southern District of New York has issued a ruling in a chapter 11 case that could have a significant  impact on future restructurings in the oil and gas industry.

On March 8, 2016,  in the case of Sabine Oil and Gas Corp., Judge Shelley Chapman ruled that Sabine could reject certain pipeline and gas gathering agreements with two midstream gathering pipeline companies.

Typical of gas gathering agreements, the Sabine contracts at issue required that the gathering pipeline companies install gas and condensate gathering pipelines and related facilities to Sabine’s oil and gas fields in Texas, and Sabine was required to use the pipelines to deliver its extracted oil and gas.  Many have long believed these gathering agreements to include “covenants running with land” and could not be rejected by a bankrupt upstream counterparty.   

Section 365(a) of the Bankruptcy Code allows a bankrupt debtor, “subject to the court’s approval,” to “assume or reject any executory contract.”  Thus, a debtor can evaluate its executory contracts and seek to assume those that are most beneficial to its business and to reject those agreements that are burdensome.  The test for approval of assumption or rejection of an executory contract is whether the debtor’s decision to do so is a “reasonable exercise” of its “business judgment.”

Sabine argued that rejection of its gathering agreements with the gathering pipeline companies was a reasonable exercise of Sabine’s business judgment and in the best interests of its estate because the agreements required Sabine to deliver the minimum amounts of gas and condensate set forth in the agreements, which they could not do, or pay certain deficiency payments.  One of the gathering pipeline companies argued that Sabine could not reject the agreements as a valid exercise of business judgment.  Additionally, both of the gathering pipeline companies argued that whether such agreements could be rejected or not, the gathering agreements or certain terms therein were “covenants that run with the land” which survive rejection by a bankrupt debtor.  

The Bankruptcy Court held that Sabine may indeed reject the agreements for gas and condensate gathering services because the gathering pipeline companies presented no evidence challenging Sabine’s business judgment.  Even though the Bankruptcy Court held that, due to procedural issues, it could not issue a binding decision on the issue of Texas real property rights in the context of a motion to reject and needed to be the subject of an adversary proceeding, it did issue a non-binding analysis that the gathering agreements should not be considered “covenants running with land” under Texas law because they did not “touch and concern” Sabine’s interest in or use of the land; rather, the gathering agreements relate to services with respect to products being gathered from the ground.

In a similar bankruptcy case currently pending in Delaware, the debtor, Quicksilver Resources Inc., has sought to reject its midstream gathering agreements with Crestwood Midstream Partners.  The proposed rejection is an effort to make Quicksilver’s assets more valuable in connection with a proposed sale.  A prospective purchaser of Quicksilver’s assets made its offer contingent upon rejection of midstream gathering agreements similar to those at issue in the Sabine case. 

Key takeaways

The portion of the Bankruptcy Court’s decision in Sabine regarding the issue as to whether the gathering agreements include covenants that run with the land under Texas law is non-binding.  The resolution of the issue could vary, depending on which state law governs the relevant contract and related property rights, yet the Sabine ruling has the potential to influence future court decisions considering these issues. 

These days, many oil and gas exploration companies are experiencing solvency issues and facing potential bankruptcy. If similar rulings are reached in the Quicksilver case and similar cases, it would adversely impact midstream gathering pipeline companies that have or will contract with exploration companies that could be facing insolvency issues.  Specifically, the value of pipeline and gathering facilities construction would be jeopardized if the agreements governing their use were rejected by the upstream exploration companies in bankruptcy. 

Relatedly, this decision provides leverage to financially troubled upstream exploration companies as they attempt to renegotiate agreements with gathering pipeline companies, giving them the leverage of a bankruptcy threat if their demands are not met. 

At minimum, this decision (and the decision to come in the Quicksilver case) creates an uncertainty as to the treatment of similar agreements in future chapter 11 cases and very likely will be the subject of further litigation and decisions.