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In re Sabine: Binding Ruling Authorizing Rejection of Midstream Oil & Gas Agreements
Practical Law Legal Update w-002-2648 (Approx. 5 pages)
In re Sabine: Binding Ruling Authorizing Rejection of Midstream Oil & Gas Agreements
by Practical Law Bankruptcy & Restructuring
| Published on 17 May 2016 • USA (National/Federal) |
The US Bankruptcy Court for the Southern District of New York held in a binding ruling that certain midstream gas gathering contracts did not convey an interest in real property under Texas law, and therefore could be rejected as executory contracts in a bankruptcy proceeding. This decision is consistent with a summary proceeding of a non-binding ruling of the same dispute.
On May 3, 2016, in In re Sabine Oil & Gas Corp., the US Bankruptcy Court for the Southern District of New York (SDNY) held in a 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 ( (Bankr. S.D.N.Y. May 3, 2016)). The Court held that the agreements between the parties did not touch and concern real property and, therefore, did not run with the land under Texas law.
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 Nordheim Eagle Ford Gathering, LLC (Nordheim) and HPIP Gonzales Holdings, LLC (HPIP).
The agreements at issue included:
- Production and servicing agreements with Nordheim (Nordheim Agreements) that included a gas gathering agreement and a condensate gathering agreement under which the Debtor agreed to dedicate all of the gas produced by the debtor from a designated area for processing by Nordheim.
- Production gathering, treating, and processing agreements with HPIP (HPIP Agreements) for oil and gas produced from certain wells located on land subject to leases owned by the Debtor. HPIP and the Debtor also had similar agreements pertaining to water and acid gas produced on the land.
On July 15, 2015, the Debtor filed a voluntary Chapter 11 petition. During the bankruptcy process the Debtor filed a motion to reject the Nordheim Agreements and the HPIP Agreements as executory contracts under section 365(a) of the Bankruptcy Code and treat any claim that stemmed from the rejection of the contracts as a general unsecured claim.
On March 8, 2016, the Bankruptcy Court issued a non-binding ruling (Rejection Decision) ( (Bankr. S.D.N.Y. Mar. 8, 2016)) that the Nordheim Agreements and HPIP Agreements did not convey an interest in real property under Texas law, and therefore could be rejected as executory contracts in a bankruptcy proceeding under section 365(a) of the Bankruptcy Code (see Legal Update, In re Sabine: Rejection of Oil & Gas Agreements that Purport to Run with the Land).
In its Rejection Decision, the Court noted that its determination was non-binding and that further proceedings would be necessary to enable the Court to render a binding ruling on the substantive issue of whether the covenants ran with the land. 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)).
Because the Court did not make a binding determination, the Debtor filed an adversary proceeding seeking a declaratory judgment that the covenants contained in the agreements did not run with the land. The parties then filed a series of pleadings and appeared to agree that the matter could be resolved on the pleadings because no material facts were in dispute.
Outcome
SDNY Bankruptcy Court Judge Shelly C. Chapman reached a final binding ruling that the Nordheim Agreements and HPIP Agreements did not run with the land as real covenants or equitable servitudes under Texas law, and granted the Debtor's motion for summary judgment.
The Court incorporated by reference its analysis in the Rejection Decision and addressed the additional arguments and authorities raised by Nordheim and HPIP.
Covenants Do Not Touch and Concern the Debtor's Real Property
The Court began by referencing its analysis in the Rejection Decision concerning the standard for whether a covenant runs with the land under Texas law. The Court then focused on whether the covenants under the Nordheim and HPIP Agreements touch and concern the land, an element required under Texas law, and held that the Debtor's agreements with Nordheim and HPIP only concerned minerals extracted from the ground which constitute personal property, not real property. The Court determined these agreements concerned personal property based on:
- The Debtor's reservation of its rights to operate its oil and gas properties independent of and without interference from its gatherers.
- Nordheim and HPIP's obligations to connect their gathering systems to receipt points and not directly to the Debtor's wells.
- The gathering fee having been triggered by the receipt of the product, not the extraction of the product from the ground.
The Court also addressed a new argument from Nordheim and HPIP; that the Debtor could have granted Nordheim and HPIP interests in real property without the consent of the Debtor's lienholders. However, the Court rejected this argument and held that the Debtor's credit agreement required lienholder consent for the Debtor to grant Nordheim and HPIP interests in the Debtor's real property. Therefore, the provisions in the Nordheim and HPIP Agreements could not have been covenants that touched and concerned the land because they would have violated the credit agreement and constituted a default by the Debtor.
Horizontal Privity Does Not Exist
The Court acknowledged that there is some ambiguity under Texas law whether horizontal privity of estate is required for a covenant to run with the land. Nordheim and HPIP cited to a selection of Texas cases that they argued did not expressly address horizontal privity and found that the covenants at issue ran with the land. The Court, however, concluded that because Texas courts have not definitively rejected horizontal privity of estate as a requirement, it would address it and include it in its analysis of the agreements.
As in the Rejection Decision, the Court held horizontal privity of estate did not exist between the original covenanting parties. Horizontal privity of estate is created in the conveyance of an interest in property that itself is burdened with the relevant covenant. The Court found this direct relation lacking, viewing each agreement as a conveyance of an interest in property that is distinct from the property burdened by the covenant.
Practical Implications
The impact of this Sabine decision further demonstrates the importance of using the correct operative language for 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. Practitioners are encouraged to pay close attention when drafting these terms and clearly identify what real property interest is being conveyed. 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.
Oil and gas producers and midstream gatherers will pay close attention to these opinions, as legal conflicts within the US oil and gas industry continue. On the debtor side, the decision 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. This ruling will also cause midstream parties to adjust their expectations, monitor their risk, and evaluate the terms of their midstream service agreements. Counterparties to midstream agreements, like upstream parties, will also likely reconsider their leverage with midstream parties and possibly renegotiate midstream contracts in or out of 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.