In re Sabine: Rejection of Oil & Gas Agreements that Purport to Run with the Land | Practical Law

In re Sabine: Rejection of Oil & Gas Agreements that Purport to Run with the Land | Practical Law

The US Bankruptcy Court for the Southern District of New York held in a non-binding ruling that certain gas gathering contracts did not convey an interest in real property, and therefore could be rejected as executory contracts in a bankruptcy proceeding. While the rejection issue is considered a binding judgment, the underlying substantive issue of whether the agreements constituted real property interests and were therefore protected from rejection was beyond the authority of the court to determine in a summary proceeding.

In re Sabine: Rejection of Oil & Gas Agreements that Purport to Run with the Land

Practical Law Legal Update w-001-6360 (Approx. 6 pages)

In re Sabine: Rejection of Oil & Gas Agreements that Purport to Run with the Land

by Practical Law Bankruptcy & Restructuring and Practical Law Finance
Published on 24 Mar 2016 • USA (National/Federal)
The US Bankruptcy Court for the Southern District of New York held in a non-binding ruling that certain gas gathering contracts did not convey an interest in real property, and therefore could be rejected as executory contracts in a bankruptcy proceeding. While the rejection issue is considered a binding judgment, the underlying substantive issue of whether the agreements constituted real property interests and were therefore protected from rejection was beyond the authority of the court to determine in a summary proceeding.
On March 8, 2016, in In re Sabine Oil & Gas Corp., the US Bankruptcy Court for the Southern District of New York issued a non-binding ruling that certain oil and gas gathering contracts did not convey an interest in real property, and therefore could be rejected as executory contracts in a bankruptcy proceeding. The Court reserved judgment as to whether the claims resulting from the rejection of the contracts are general unsecured claims, since it did not have the authority to conclusively determine whether the agreements ran with the land ( (Bankr. S.D.N.Y. Mar. 8, 2016)).

Background

Sabine Oil & Gas Corp. (Debtor) was an independent energy company that engaged in the acquisition, production, exploration, and development of onshore oil and gas properties in the US. As part of a consolidation with Forest Oil Corporation, the Debtor became party to various production contracts with other parties, including:
  • With Nordheim (Nordheim Agreements), production and servicing agreements that included:
    • a gas gathering agreement, under which the Debtor agreed to dedicate to the performance of that agreement all of the gas produced by the debtor from a designated area for processing by Nordheim. Nordheim would then re-deliver treated gas back to the Debtor. As part of the agreement, Nordheim would construct, at its own expense, the treatment facilities needed to process the gas, and the Debtor would subsequently convey that parcel of land used for the facilities to Nordheim. The agreement contained language that specifically provided that the agreement itself was a "covenant running with the land" and enforceable against any successors or assigns; and
    • a condensate gathering agreement, which contained substantially the same terms, but addressed the treatment and construction of facilities to process liquid hydrocarbons instead of gas.
  • With HPIP Gonzales Holdings, LLC (HPIP, and the HPIP Agreements), agreements which included:
    • a production gathering, treating, and processing agreement, which obligated Sabine to "dedicate" to the "performance" of the agreement certain leases owned by Sabine and the oil, gas, and water produced from the wells located on the land subject to those leases. HPIP was required to construct, operate, and maintain the gathering facilities and provide other services; and
    • a water and acid gas handling agreement, which had substantially the same terms as the gathering agreement, but which governed the construction and operation of disposal facilities to process water and acid gas produced on the land.
On July 15, 2015, the Debtor filed its Chapter 11 petition, and continued its operations as a debtor-in-possession under sections 1107(a) and 1108 of the Bankruptcy Code. During the bankruptcy process, the Debtor filed a motion to:
  • Reject the Nordheim and HPIP Agreements as executory contracts under section 365(a) of the Bankruptcy Code, because delivery of the minimum amount of gas set out in the agreements would not be possible and payment of the contractual deficiency fees would unnecessarily drain the estate.
  • To treat any claim that stemmed from the rejection of the contracts as a general unsecured claim.
Generally, to contravene the business judgment of the Debtor in rejecting an executory contract, the court must find that the rejection occurred as the result of bad faith, whim, or caprice. However, in response to the motion, neither Nordheim nor HPIP offered evidence of bad faith, whim, or caprice, but instead:
  • Both argued that the transportation fees required to be paid for deficiencies in the amount of fuel provided were covenants that ran with the land, which could not be rejected.
  • HPIP argued that the Court should determine that the covenants run with the land, forming the basis of requiring the Debtor to assume the contract.
  • Nordheim argued that the Court did not have the power to determine contested factual issues regarding whether the covenants ran with the land on a motion to reject a contact under Second Circuit precedent.
  • Both argued that any damages stemming from rejection of the contracts should be treated as secured claims.

Outcome

The Court allowed the rejection of the contracts, but reserved judgment on the priority of the claims stemming from the rejection.

Authority to Determine Substantive Issues

The Court began by examining its authority to determine the substantive issue of whether the covenant ran with the land on a motion to reject a contract. Under Second Circuit precedent, unless there is a concurrent adversary proceeding or contested matter to determine the merits of the substantive legal dispute related to the motion to reject, the court does not have the power to determine underlying substantive issues (see In re Orion Pictures Corp., 4 F.3d 1095 (2d Cir. 1993)). Here, while the rejection of the contract was a contested matter, a motion to reject a contract is still considered a summary proceeding. Therefore, the Court did not have the power to determine the contested substantive issue of whether the agreements were covenants that ran with the land.

Rejection of the Contracts

The Court went on to examine whether the contract could, nevertheless, be rejected by the Debtor. Section 365(a) of the Bankruptcy Code allows a debtor to reject or assume an executory contract, subject to notice, a hearing, and the bankruptcy court's approval. A bankruptcy court's role in the analysis is to place itself in the shoes of the debtor and determine whether assuming or rejecting the contract would be a good business decision, emphasizing the value to the estate of rejection. The bankruptcy court generally defers to the judgment of the debtor when making this determination, unless the decision was the result of bad faith, whim, or caprice.
In the absence of any allegation or evidence challenging the Debtor's decision-making process or of bad faith, whim, or caprice, the Court held that the Debtor had properly considered the business and legal risks associated with rejection of the contract and allowed rejection of the contracts.

Covenants Running with the Land

Whether a covenant runs with the land is significant because under the Bankruptcy Code and related case law, a covenant running with the land is a real property interest and cannot be rejected. The Court made a non-binding determination that the covenants did not run with the land, either as real covenants or as equitable servitudes. The Court examined the covenants relating to:
  • The Debtor's dedication to HPIP of the HPIP Products and certain leases to the performance of the HPIP Agreements.
  • The Debtor's dedication to Nordheim of the Nordheim Products to the performance of the Nordheim Agreements.
  • The Debtors' covenant to pay Nordheim a gathering fee.

Real Covenants

Examining real covenants, the Court noted that historically, real covenants running with the land arise when a grantor deeds property to another party, while intending to reserve some property right for itself. Under Texas law, to determine the parties' intent, a court must examined if the covenant:
  • Touches and concerns the land.
  • Relates to a thing in existence or specifically binds the parties and their assigns.
  • Is intended by the original parties to run with the land.
  • Provides notice to any successor.
  • Horizontal privity of estate exists.
Here, the court held that horizontal privity did not exist between the parties and that the covenants did not touch or concern the land. First, since there was no conveyance of a real property interest, but rather a simple contract for the provision of services relating to personal property (the hydrocarbons harvested from the land), no horizontal privity existed. Moreover, the agreements did not grant a real property interest because, under Texas law, a mineral becomes personal property once removed from the ground, and therefore the contracts regarding hydrocarbons that had already been removed from the ground did not concern real property.
Second, the Court held that the covenants did not touch and concern the land under either of two tests utilized in Texas law, since those tests both require that an agreement "affect the owner's interest in the property or its use in order to be a real covenant," which did not occur here. The Court went on to buttress its conclusions by further distinguishing the current facts from Fifth Circuit precedent in Newco Energy v. Energytec, Inc., 739 F.3d 215 (5th Cir. 2013).

Equitable Servitudes

The Court easily dismissed the argument in favor of finding that an equitable servitude existed. An equitable servitude exists when the parties are in privity of estate at the time of the conveyance and a subsequent party purchases the land with notice of a restriction that concerns the land or its use or enjoyment. Since, as discussed above, the agreements did not concern the land or its use or enjoyment, no equitable servitude existed.

Practical Implications

Under the guidance of Sabine, it is clear that in bankruptcy, the language of the contract, as interpreted under applicable state law, determines whether an agreement may be rejected as an executory contract or whether it must be honored as the conveyance of a real property interest. Since real property law is state-specific, and covenant and equitable servitude law is widely regarded as one of the more archaic and complex areas, practitioners that wish to protect gathering rights contracts from rejection must take care to inform themselves and should consider enlisting the help of experts in applicable state law. Even agreements that seem to implicate a real property interest may be interpreted to convey only personal property interests, and may therefore be subject to rejection in bankruptcy.
The ruling may prompt more oil and gas production companies to file for bankruptcy considering persistent low oil prices. The ability to reject long term gathering contracts in bankruptcy could be a strategic approach to eliminating burdensome obligations under those agreements. Parties to these agreements must adjust their expectations to consider the risk that covenants expected to run with the land may be subject to rejection and damages potentially treated as unsecured rejection damage claims in bankruptcy.
For more information on the treatment of contracts in bankruptcy, see Practice Notes, Executory Contracts and Leases: Overview and Executory Contracts and Leases in Bankruptcy: Strategies for Non-Debtors.