Bankruptcy Judge Shelley Chapman held that Sabine Oil & Gas Corp. has satisfied the standards for rejection of several gathering and handling agreements between Sabine and its midstream counter-parties, Nordheim Eagle Ford Gathering, LLC and HPIP Gonzales Holdings, LLC. The ruling has limits.  The matter ultimately turns on whether certain covenants “run with the land” under Texas law.  While the Court held that Sabine exercised reasonable business judgment in rejecting the agreements, the Court declined to decide “in a binding way the underlying legal dispute with respect to whether the covenants at issue run with the land,” and instead offered a “non-binding” analysis to determine the reasonableness of Sabine’s rejection.  Thus, if the counter-parties can demonstrate that the covenants do run with the land in an adversary proceeding, Sabine may not be able to terminate those covenants. In re Sabine Oil & Gas Corp., No. 15011835 (SCC) (Bankr. S.D.N.Y. Mar. 8, 2016).

How did Judge Chapman come to this ruling and how will it affect agreements between upstream and midstream providers? See below for background on this case, the two main arguments and an analysis of potential implications this case may have, particularly on midstream counter-parties who may have thought they were protected from upstream credit risk.

Background.

Sabine, an oil and gas exploration and production company, filed a motion to reject several gathering and handling agreements with midstream companies Nordheim and HPIP in September of 2015. Each of the relevant agreements stated expressly that it included a covenant running with the land. The covenants included Sabine’s dedication to Nordheim and HPIP of certain products and agreements, and a covenant to pay Nordheim a gathering fee.

In a February 2016 hearing Judge Chapman considered whether Sabine had exercised reasonable business judgment in rejecting the agreements and whether the covenants in fact ran with the land. She indicated at the hearing that she believed the agreements could be rejected, but took the matter under advisement before issuing an oral and written ruling on March 8, 2016.

The Debtors Exercised Business Judgment in Rejecting the Agreements.

Section 365(a) of the Bankruptcy Code permits a debtor to reject executory contracts upon approval of the court. Bankruptcy courts permit a debtor to reject executory contracts provided that the rejection constitutes an exercise of sound business judgment.  Unless the debtor acted with “bad faith, whim or caprice,” a court typically offers a debtor wide latitude in determining whether to reject a contract.

Here, Sabine argued that rejection of the agreements constituted a sound exercise of business judgment because it was not “financially viable for them to deliver” on the requirements of the agreements. Nordheim objected to the motion, arguing that rejection was not a sound exercise of business judgment.  At the hearing, Nordheim made an additional argument that, even if the Court could authorize rejection, “it cannot in doing so make a determination as to the legal status under Texas property law of those covenants  . . . that Nordheim argues ‘run with the land.’”  HPIP did not object to rejection but argued that Sabine could not reject the covenants themselves because they run with the land.

Judge Chapman concluded that while she could rule on rejection, she could not “decide substantive legal issues, including whether the covenants at issue run with the land, in the context of a motion to reject, unless such motion is scheduled simultaneously with an adversary proceeding . . . to determine the merits of the substantive legal disputes . . . .”

In light of these facts, “there is no dispute with respect to the reasonableness of the Debtors’ decision to reject the HPIP Agreements.” Moreover, Nordheim put forward no evidence that the rejection failed to satisfy the business judgment standard.  Accordingly, the Court determined that Sabine exercised business judgment in rejecting the agreements.

The court held: “If it is ultimately determined that the covenants at issue in the Agreements do not run with the land, as the Debtors argue and the Court believes to be the case, the Debtors will be free to negotiate new gas gathering agreements with any party . . . .  If, however, the covenants are ultimately determined to run with the land, the Debtors will likely need to pursue alternative arrangements with Nordheim and HPIP consistent with the covenants by which the Debtors would remain bound.”

The Covenants Do Not “Run With the Land.”

Judge Chapman then provided a “non-binding” analysis of whether the covenants run with the land and thus the decision to reject was reasonable. The Court looked at the history of real property covenants dating back to English law.  While initially limited, over time the use of covenants has become common – “Yet, many characterize the law of covenants as an ‘unspeakable quagmire.’”

The Court noted that the parties agree that the question of whether the covenants run with the land is a question of Texas state law. Under Texas law, a covenant runs with 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.”  Other courts have required “horizontal privity of the estate,” which generally means “‘simultaneous existing interests or mutual privity’” between the original parties as landlord/tenant or grantor/grantee.  Traditionally this involves “a property owner reserving by covenant, either for itself or another beneficiary, a certain interest out of the conveyance of the property burdened by the covenant.”

Here, the Court held that the facts do not fit this traditional model. Sabine did not “reserve any interest for Nordheim or HPIP; rather they simply engaged Nordheim and HPIP to perform certain services related to the hydrocarbon products produced by Sabine from its property.”  Moreover, the Court held that the agreements did not grant Nordehim or HPIP any property rights in Sabine’s mineral estates.  A right to transport or gather gas is not a fundamental property right under applicable Texas law (such as the right to develop, lease, or receive royalties).

The Court also held that the covenants do not appear to “touch and concern” the land. To satisfy this test, it is not enough for the covenant to affect the value of the land; “‘it must still affect the owner’s interest in the property or its use.’”  Here, the covenants fail the test because once minerals are extracted from the ground, they cease to be real property and become personal property.  For these reasons, the Court held (in “non-binding” fashion) that the covenant does not run with the land – and thus Sabine could reject the agreements.

Analysis.

While Judge Chapman’s decision leaves room for her or another judge to prevent the termination of these agreements, she lays the foundation for upstream debtors to reject contracts with midstream counter-parties – even if the contracts include supposed protections in the form of covenants running with the land. Midstream parties cannot rely on these provisions for blanket protection and instead must analyze each agreement on a case-by-case and state-by-state law basis to determine if rejection could occur in a bankruptcy.  This will require detailed legal analyses by midstream parties (and their investors) to assess their potential risk of rejection.

For additional coverage on bankruptcy issues in the oil & gas industry, check out our five-part video series.