On June 27, 2018, the Second Circuit denied Nordheim Eagle Ford Gathering, LLC’s petition for a panel rehearing and request that the court certify issues of Texas property law to the Texas Supreme Court. The denial leaves in place the Second Circuit’s May Summary Order affirming the widely publicized decisions of the bankruptcy and district courts below which concluded that the midstream contracts could be rejected because they did not create covenants running with the land under Texas law.

Summary of Key Takeaways

  • The Second Circuit declined to revisit its conclusion that a debtor may reject midstream contracts that were argued to contain covenants running with the land.
  • The creation of covenants running with the land in midstream contracts requires careful drafting and transactional structure to meet the requirements set forth in Sabine.
  • While the Second Circuit’s Summary Order does not have precedential effect, it will likely be used as persuasive authority by parties seeking to reject midstream contracts.

Background

On May 25, 2018, the Second Circuit issued a Summary Order1 affirming the bankruptcy and district courts, holding that Sabine, the debtor, had the right to reject certain midstream gathering agreements despite a clause in the agreements dedicating produced gas to Nordheim, a midstream processor, and purporting to protect the dedication via a covenant running with the land. The court concluded that Texas law requires horizontal privity between the parties to create a covenant running with the land, and that no such horizontal privity existed2. The court explained that to create horizontal privity, “there must have been some common interest in the land other than the purported covenant itself at the time [the midstream contract] was executed.”3 Had a covenant running with the land been established (i.e., an interest in real property), as opposed to mere contractual rights, it could have survived rejection of the midstream contract in bankruptcy.4

Nordheim sought a panel rehearing, specifically requesting the court certify two questions to the Texas Supreme Court. First, it sought to clarify with Texas’s highest court whether horizontal privity is necessary to establish a real covenant running with the land as the Second Circuit concluded. Second, it sought certification on whether midstream gathering agreements sufficiently “touch and concern” the land to support a real covenant under Texas law, a question the bankruptcy court in Sabine answered in the negative, and a question the Second Circuit determined it did not need to answer given its ruling that no horizontal privity existed.

On June 27, 2018, the Second Circuit denied Nordheim’s request, leaving in place its May Summary Order affirming the rejection of Sabine’s midstream agreements.

Overview of Horizontal and Vertical Privity

Generally, horizontal privity concerns the nature of the transaction creating the purported real covenant in the first instance between or among the original transacting parties, while vertical privity concerns the privity between the original parties and/or successors and assignees of the original parties seeking to enforce the real covenant.

Typically, horizontal privity requires that there be some additional transactional element involving real property to support the creation of a real covenant. For example, where real property is granted and the covenant relates to such property, horizontal privity is usually established.

The requirement of horizontal privity as an element to establish a real covenant has its roots in English common law, but is falling out of favor and is required by a minority of modern courts.5

Vertical privity concerns the extent to which successor parties are bound to the original covenant. Vertical privity was not an issue in dispute in Sabine.

Nordheim’s Arguments Regarding Construction of Texas Property Law and the Importance of Certification to the Texas Supreme Court

Nordheim argued in its petition for panel rehearing that the court misinterpreted Texas law and relied on nonbinding and misguided opinions of Texas intermediate appellate courts to conclude that horizontal privity is required to establish a real covenant under Texas law. Specifically, Nordheim argued that the Texas cases upon which the Second Circuit relied focused on vertical privity rather than horizontal privity, but referred to the element generally as privity of estate, obscuring the required element and demanding analysis of the facts to determine the type of privity that existed.

Coupled with the lack of binding authority on the matter, Nordheim cited amicus briefs filed by midstream industry associations to demonstrate the impact of the court’s decision on hundreds of multi-million-dollar gathering arrangements in Texas. Nordheim argued that a decision with such serious consequences for the entire midstream industry “deserve[s] a definitive holding from the Texas Supreme Court.”6

To obtain full resolution of the issues on appeal, Nordheim recommended the court also certify to the Texas Supreme Court the question of “whether the covenants at issue dedicating all of Sabine’s production to Nordheim’s gathering facilities, and requiring Sabine to pay related gathering fees, ‘touch and concern’ the land.”7 Nordheim noted that, like horizontal privity, no binding authority in Texas exists as to whether this type of midstream dedication covenant touches and concerns the land.

The Second Circuit’s Ruling

In a one sentence order, the Second Circuit denied rehearing, and with it, Nordheim’s request for certification.8 Importantly, the Second Circuit’s Summary Order affirming the bankruptcy and district courts and concluding that horizontal privity is required is non-precedential and therefore does not represent binding law in the Second Circuit. Nevertheless, it will likely serve as persuasive authority for lower courts in the circuit. Likewise, the arguments formulated in Nordheim’s petition for rehearing regarding horizontal privity will likely be reasserted before other tribunals called on to decide the issue.

For now, the rulings in Sabine appear to be the guidance on covenants running with the land in the energy space. It remains to be seen whether and how the Texas Supreme Court, the ultimate authority on Texas law, resolves these complex and important issues.

This update presents a high-level summary of several key takeaways from the Second Circuit Court of Appeal’s Summary Order in In re Sabine Oil & Gas Corp. (Sabine Oil & Gas Corp. v. Nordheim Eagle Ford Gathering, LLC), -- Fed. Appx. --, 2018 WL 2386902 (2d Cir. May 25, 2018) and subsequent order denying panel rehearing.