Earlier this year, in In re Sabine Oil & Gas Corp., 547 B.R. 66 (S.D.N.Y. 2016), the bankruptcy court for the Southern District of New York permitted a debtor to reject gas gathering and related agreements under § 356(a) of the bankruptcy code. Sabine filed a voluntary petition for Chapter 11 relief in July 2015 and continued to operate as a debtor in possession. Sabine was a party to gas gathering agreements with Nordheim Eagle Ford Gathering, LLC and HPIP Gonzales Holdings, LLC, which were governed by Texas law.
Sabine sought to reject the gas gathering agreements with HPIP and Nordheim pursuant to § 365(a) of the bankruptcy code which allows a debtor in possession, “subject to the court’s approval, [to] assume or reject any executory contract or unexpired lease of the debtor.” Essentially, the debtor in possession may examine the executory contracts and unexpired leases to decide which would be advantageous to continue and which to reject. Generally, parties to gas gathering agreements draft them with the intent that the agreements be real covenants running with the land—an interest in real property; in fact, many agreements contain language stating that the agreement is a “covenant that runs with the land.” The gas gathering agreements at issue in Sabine included such language, but the court found the agreements did not run with the land either as a real covenant or as an equitable servitude. Thus, the agreements could be rejected as executory contracts or unexpired leases.
In approving Sabine’s rejection of the agreements, the bankruptcy court examined the agreements in light of Texas law regarding real covenants and equitable servitudes. The court held HPIP and Nordheim failed to establish the gas gathering agreements constituted either of these interests in real property. Instead, the court held the agreements were service contracts relating to personal property, which could be rejected under § 365(a).
The court found that the gas gathering agreements did not touch and concern the land, which is a requirement for covenants that run with the land. The covenants in the agreements did not touch and concern the land because the mineral dedications related only to minerals extracted from the ground, at which point the minerals were personal—not real—property pursuant to Texas law. Additionally, the court noted that Texas law might also require horizontal privity of estate for covenants to run with the land, which the agreements also lacked. Generally, horizontal privity of estate exists where there is a conveyance of a recognized interest in the property being burdened by the covenant. While the bankruptcy court found that horizontal privity did not exist because no property right was conveyed, the court specifically said the decision was made without concluding whether Texas law actually does require horizontal privity for a covenant to run with the land. Furthermore, the court held the agreements did not meet the standard for an equitable servitude, which must burden or limit the use of the estate. The agreements did not burden or limit the use of Sabine’s mineral estate, rather, they were fundamentally service contracts relating to Sabine’s personal property.
What to Keep In Mind Going Forward
This decision should make midstream service providers more careful when entering into gas gathering or related agreements. Midstream companies that generally finance construction of pipelines, treatment facilities and recoup the costs through gas gathering agreements may find that strategy to be much riskier if oil and gas producers can reject the agreements in bankruptcy (Nordheim, for example, built the gathering system used by Sabine at the cost of about $84 million). Significantly, whether a debtor can reject a gas gathering or similar agreement will be determined by the facts of each case, the agreement itself, and the applicable state property law. Depending on the applicable state law, it could be possible to negotiate the terms of the agreement in a manner that would make a court more likely to consider the agreement to run with the land and not fall under § 365(a).
If you have any questions regarding the results of this ruling, please contact Mark A. Craige or any member of our Bankruptcy & Creditor’s Rights Practice Group for assistance.