Earlier this year, we covered Judge Shelley Chapman’s ruling in the Sabine bankruptcy, permitting the Debtors to reject a handful of gathering and other midstream agreements. Previously, Judge Chapman permitted rejection on the grounds that the Debtors exercised their reasonable business judgement in doing so.  At that time, the Court issued a “non-binding” ruling on whether the agreements were (or contained) “covenants running with the land” that would have rendered rejection impossible or useless.

On May 3, 2016, approximately six weeks later, Judge Chapman reached a final “binding” ruling on this open issue – holding that the contracts do not constitute (or include) covenants running with the land, and can be rejected in full. The Court largely reiterated its prior analysis – and even attached the prior opinion to the new opinion.  The Court also noted for the first time that, if the contracts had contained covenants affecting the value and use of the real property, they likely would have defaulted the Debtors’ credit facility.  Mem. Decision on Motions of Nordheim Eagle Ford Gathering, LLC et al. at 11, In re Sabine Oil & Gas Corp., No. 15-11835 (Bankr. S.D.N.Y., May 3, 2016).

Background.

As detailed in our prior article, the Debtors entered into contracts with Nordheim Eagle Ford Gathering, LLC and HPIP Gonzales Holdings, LLC for gathering and other midstream services. The Court permitted rejection in an order dated March 8, but required the Debtors to initiate adversary proceedings seeking declaratory judgment that the contracts could be rejected.  The parties filed a series of pleadings and appeared to agree that the matter could be heard by the Court on a summary judgment basis as no critical facts were disputed.

Analysis.

The Court cited to its analysis in the prior opinion by reviewing the standard for whether a covenant “runs with the land” under Texas law. Again the Court focused on whether the covenants “touch and concern” the Debtors’ real property.  And again, the Court held “the mineral dedications concern only minerals extracted from the ground, which indisputably constitute personal property, not real property, under Texas law.”

Additionally, the Court considered a new argument from Nordheim and HPIP – that the Debtors could have granted Nordheim and HPIP interests in real property without consent of the Debtors’ lienholders. The Court held that if the covenants “satisfy the ‘touch and concern’ requirement  . . . then the real property interests allegedly conveyed through those covenants cannot qualify as ‘Excepted Liens’ under the Credit Agreement.”  The Court therefore held that the provisions could not have been covenants that touched and concerned the land without the conveyance violating the terms of the credit agreement.

The Court also found, again, that, to the extent horizontal privity is required under Texas law for a covenant to run with the land, it is absent here. The model for horizontal privity is a conveyance of property subject to the relevant covenant.  Here, the Court again found such a direct relation lacking, viewing each agreement as “the conveyance of an interest in property that is distinct from (even if somewhat related to) the property burdened by the covenant.”

The counter-parties also made an argument that the inclusion of a pipeline easement over the leases constituted an interest in real property, thereby satisfying horizontal privity. Judge Chapman rejected this argument.  Under the terms of the agreements, the pipeline easements only extended to specified receipt points that did not connect to Sabine’s wells, neither Nordheim’s nor HPIP’s structures connected to Sabine’s wells directly and neither Nordheim nor HPIP had the right to connect its pipelines to Sabine’s wells.  Therefore, the counterparties could not demonstrate a real property interest extending to Sabine’s mineral estate.

Judge Chapman likewise rejected HPIP’s argument that any “dedication” of property is by definition a conveyance of real property, pointing out that “under Texas law, a conveyance of real property requires a grant of an interest in such real property, which requires certain operative language, including an identification of a grantee.” Not only did the HPIP agreement lack this requisite language, but it actually contained language expressly disclaiming any such conveyance, stating that Sabine did not “sell, transfer or assign” to HPIP any interest in Sabine’s real property.

For these reasons the Court granted the Debtors’ summary judgment motions and found that the relevant agreements are not covenants running with the land – and thus can be rejected.

Impact.

Observers fully expected this result, unlike the initial motion to reject. This ruling – in and of itself – should have little market impact.  However, the impact of the initial motion to reject remains significant.  Midstream parties have been reviewing closely their counterparty risk – both with respect to the parties themselves and the terms of their midstream service agreements.  While Judge Chapman’s ruling pertains only to one debtor, it has had a ripple effect, causing upstream parties to reconsider their leverage with midstream parties.  We expect other upstream parties to rely on these rulings to seek renegotiation of midstream contracts in or out of bankruptcy.

This ruling is instructive for midstream parties seeking to avoid similar disputes in the future. Judge Chapman’s skepticism that the pipeline easement that did not reach the wellhead constituted an interest in the mineral estate highlights the importance of identifying the mineral estate and the wells themselves as part of the real property interest being conveyed as part of the dedication.

Judge Chapman’s emphasis on using the correct operative language for conveyance of a real property interest should encourage parties to pay close attention to drafting of these terms and clearly identify what real property interest is being conveyed. Finally, to the extent that the parties to these agreements intend to convey a real property interest and satisfy the requirements for covenants running with the land, but their agreements include standard disclaimer language limiting the real property interest conveyed, they should make a point to include a carve out to the disclaimer – explicitly stating that the disclaimer does not apply to the intended conveyance.