Midstream Companies face increased risk with financially distressed E&P companies
In a decision entered yesterday afternoon, Judge Shelley Chapman of the U.S. Bankruptcy Court for the Southern District of New York authorized Sabine Oil & Gas Corporation to reject certain midstream contracts under Section 365(a) of the Bankruptcy Code and, critically, made a non-binding holding that Sabine's obligations under these contracts were not "covenants running with the land" under Texas law. While this part of the court's decision is not binding and is based on the specific language on the agreements at issue in the case, it represents an increased risk to midstream companies who are dealing with financially distressed E&P companies.
Sabine had contracts with several midstream companies, including Nordheim Eagle Ford Gathering, LLC (Nordheim) and HPIP Gonzales Holdings, LLC (HPIP), to gather and process natural gas produced by Sabine. Pursuant to those contracts, the midstream companies would gather, transport and process gas produced by Sabine and deliver it to a downstream purchaser. Those agreements were governed by Texas law.
In both the Nordheim and the HPIP agreements, the parties agreed that the obligations of Sabine to dedicate the gas produced from its owned or leased real property, the minimum delivery requirements, and payment of the deficiency were all covenants that ran with the land and were binding on and enforceable against Sabine's successors and assigns.
Rejection of Executory Contracts
On July 15, 2015, Sabine commenced a chapter 11 bankruptcy case in the U.S. Bankruptcy Court for the Southern District of New York. As part of its reorganization efforts, Sabine filed a motion to reject executory contracts under Section 365 of the Bankruptcy Code. The motion sought to reject the Nordheim and HPIP agreements as burdensome to the estate. Sabine argued that the contracts were burdensome because it was unable to meet minimum gas delivery requirements in the contracts and, absent rejection, Sabine would be required to make substantial deficiency payments to Nordheim and HPIP. Sabine acknowledged that upon rejection it would seek to enter into new contracts with other midstream companies on more favorable terms.
Nordheim and HPIP both objected to the motion. Nordheim argued that Sabine failed to show how rejection of the contracts would benefit the estate because Sabine's requirements are covenants running with the land. As a consequence, Nordheim argued, Sabine's minimum delivery obligations would survive any rejection of the contracts. Nordheim further argued that even if the court authorized rejection of the agreements, the court could not make a determination as to whether Sabine's obligations were covenants running with the land under Texas law.
HPIP did not object to the rejection of the agreements, but did object to any attempt to reject Sabine's obligations under those agreements that constituted covenants running with the land. HPIP argued that the court should determine as a matter of Texas law that the covenants in the agreements are covenants running with the land that survive rejection.
The court reviewed the Second Circuit's decision in Orion Pictures Corp. v. Showtime Networks, 4 F.3d 1095, 1098 (2d Cir. 1993) and determined that the court could not decide substantive legal issues in the context of a motion to reject unless the motion was scheduled simultaneously with an adversary proceeding brought against the counterparties to the agreement. Even though rejection of an executory contract is a contested matter under Fed. R. Bankr. P. 6006 and 9014, the court held that a rejection hearing "should be considered a summary proceeding, intended to efficiently review the trustee's or debtor's decision to adhere to or reject a particular contract in the course of the swift administration of the bankruptcy estate. It is not the time or place for prolonged discovery or a lengthy trial with disputed issues." Id. at 1098-99.
The court authorized Sabine to reject the Nordheim and HPIP agreements, finding that Sabine had satisfied the requirement that it show rejection of the agreements would be in Sabine's sound business judgment. While the court delayed until a later proceeding any binding ruling on the effect of such rejection, the court went on to analyze the midstream agreements under Texas law, finding that Sabine's contractual obligations were not covenants running with the land.
"Covenants Running With the Land"
Under Texas law, a covenant runs with the land when (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. See Inwood North Homeowners’ Ass’n, Inc. v. Harris, 736 S.W.2d 632, 635 (Tex. 1987). In addition, some courts in Texas have required that the parties have horizontal privity of estate. See, e.g., Westland Oil Dev. Corp. v. Gulf Oil Corp., 637 S.W.2d 903, 910-11 (Tex. 1982).
The court found that there was no horizontal privity of estate in this case where Sabine did not reserve any interest for Nordheim or HPIP in the context of any real property conveyance; rather, Sabine simply engaged Nordheim and HPIP to perform a service related to the products located on Sabine's property. The court further held that the agreements did not transfer any interest in real property because the right to gather or process products is not an interest in minerals under Texas law. Having found that the covenants did not involve parties that horizontal privity of estate, the court then concluded that the covenants did not "touch and concern" Sabine's land. In so holding, the court seemed to focus on the following facts: (1) that the agreements involved products removed from the land, which had become personal property once extracted; and (2) the gathering fees were not secured and remained subject to pre-existing liens held by Sabine's lenders.
The upshot of the court's holding is that, if it is ultimately determined that under Texas law these agreements are not covenants that run with the land, then Sabine is free to solicit and enter into new midstream contracts with new processors, likely on more favorable terms. If the agreements are determined to be covenants that run with the land, then Sabine would remain bound under the agreements notwithstanding the rejection. It will be interesting to see whether this issue is ultimately brought before the bankruptcy court in the context of an adversary proceeding (or claim objection) and whether the court's non-binding holding changes based on any additional facts presented by the parties.
In light of this ruling, both E&P and midstream companies should review their existing midstream agreements and the governing state law to assess whether they are susceptible to being rejected in a bankruptcy case. In the current environment of low oil and natural gas prices, E&P companies may rely on that risk for leverage to obtain concessions from midstream companies and midstream companies can assess the risks associated with a bankruptcy filing.