In re Sabine: District Court Affirms Rejection of Oil & Gas Gathering Agreements as Executory Contracts

Practical Law Legal Update w-007-0301 (Approx. 7 pages)

In re Sabine: District Court Affirms Rejection of Oil & Gas Gathering Agreements as Executory Contracts

by Practical Law Bankruptcy & Restructuring

Background

Sabine Oil & Gas Corp. (Sabine) was an independent energy company that engaged in the acquisition, production, exploration, and development of onshore oil and natural gas properties in the US. Sabine entered midstream oil and gas agreements with Nordheim Eagle Ford Gathering, LLC (Nordheim) and HPIP Gonzales Holdings, LLC (HPIP), each midstream gatherers that gather, transport, and process oil and gas after they have been extracted from the land.

The agreements at issue included:

Production and servicing agreements with Nordheim that included a gas gathering agreement and a condensate gathering agreement under which Sabine agreed to dedicate all of the gas produced by them from a designated area for processing by Nordheim (Nordheim Agreements).
Production gathering, treating, and processing agreements with HPIP for oil and gas produced from certain wells located on land subject to leases owned by Sabine. HPIP and Sabine also had similar agreements pertaining to water and acid gas produced on the land (HPIP Agreements).

On July 15, 2015, Sabine and various affiliates (Debtors) filed voluntary Chapter 11 petitions in the SDNY Bankruptcy Court. Subsequently, the Debtors filed a motion to reject the Nordheim Agreements and HPIP Agreements (collectively, Agreements) as executory contracts under section 365(a) of the Bankruptcy Code. Nordheim and HPIP objected, arguing the Agreements contained covenants running with the land.

On March 8, 2016, the SDNY Bankruptcy Court held that the Debtors could reject the Agreements because they did not contain real covenants that run with the land under Texas law. However, its ruling was non-binding because under In re Orion Pictures Corp., the SDNY Bankruptcy Court lacked the authority to decide the substantive legal issues, including whether the covenants ran with the land, in the procedural context of a motion to reject (4 F.3d 1095, 1098 (2d Cir. 1993) (see In re Sabine Oil & Gas Corp., 547 B.R. 66 (Bankr. S.D.N.Y.2016) and Legal Update, In re Sabine: Rejection of Oil & Gas Agreements that Purport to Run with the Land)).

The Debtors commenced adversary proceedings in the SDNY Bankruptcy Court and sought declaratory judgments that the covenants in the Agreements did not run with the land. Nordheim and HPIP sought declaratory judgments affirming the opposite. Nordheim and HPIP moved for judgment on the Debtors' claims and their own counterclaims while the Debtors moved for summary judgment on their claims and Nordheim and HPIP's counterclaims.

On May 3, 2016, the SDNY Bankruptcy Court granted summary judgment for the Debtors and held, in a binding ruling, that the Agreements did not contain covenants that run with the land, either as real covenants or as equitable servitudes (see 550 B.R. 59 (Bankr. S.D.N.Y. 2016); Legal Update, In re Sabine: Binding Ruling Authorizing Rejection of Midstream Oil & Gas Agreements). The SDNY Bankruptcy Court entered final orders authorizing rejection of the Agreements, as well as final orders in the adversary proceedings.

Nordheim and HPIP filed appeals in the SDNY District Court, which were subsequently consolidated. The issues raised were whether the SDNY Bankruptcy Court erred in:

Deciding that the Agreements did not contain real covenants.
Deciding that the Agreements did not contain equitable servitudes.
Allowing the Debtors to reject the Agreements.

Outcome

The SDNY District Court held that:

The Agreements neither contained real covenants nor equitable servitudes.
The SDNY Bankruptcy Court did not err in allowing the Debtors to reject the Agreements.

The Agreements Do Not Run with the Land as Real Covenants

The SDNY District Court determined that, in order to find that an agreement runs with the land as a real covenant under Texas law, the agreements must "touch and concern the land" (see Inwood N. Homeowners' Ass'n v. Harris, 736 S.W.2d 632, 635 (Tex. 1987)). To determine if an agreement touches and concerns the land under Texas law, the Court applied two tests, which were whether:

The "promisor's legal relations in respect to the land in question are lessened" or "if the promisee's legal relations in respect to that land are increased."
The covenant "affect[s] the nature, quality or value of the thing demised, independently of collateral circumstances, or if it affect[s] the mode of enjoying it."

(Westland Oil Dev. Corp. v. Gulf Oil Corp., 637 S.W.2d 903, 911 (Tex. 1982).)

The First Touch and Concern Test

Under the first test, the SDNY District Court held that Nordheim and HPIP did not show that the Agreements either increased their legal relations to the real property interests at issue or decreased Sabine's.

The Court determined that, from the Agreements, the legal relations of Nordheim and HPIP were not increased by gaining interests in the minerals extracted from the land, which under Texas law could have afforded them real property interests (see American Refining Co. v. Tidal W. Oil Corp., 264 S.W. 335, 338 (Tex. Civ. App. 1924)). Instead, Nordheim's and HPIP's interests were in the services they agreed to provide to the minerals' owner, Sabine.

The SDNY District Court rejected:

Nordheim's argument that Sabine's dedication of the gas and condensate that was produced and saved in an area set aside for Nordheim for its gathering services conveyed an interest in the minerals in the ground. The Court rejected this because Nordheim did not receive a right to any share of the gas and condensate from those areas but instead received an entitlement to provide services to Sabine in exchange for a fee.
HPIP's argument that by dedicating certain leases to Sabine's performance of the HPIP Agreements, Sabine had conveyed an interest in the leases. The Court disagreed because HPIP did not identify what kind of property interest it might have obtained in the leases and Sabine clearly disclaimed any intention to convey title to the leases. The Agreements merely granted HPIP the contractual right to be the exclusive provider of certain services for gas and condensate produced in a certain area.

Also, the SDNY District Court concluded that the Agreements did not decrease Sabine's legal relation to its real property interests. The Court rejected Nordheim's and HPIP's arguments that Sabine's interests were burdened by its obligation to deliver all of the gas and condensate it produced to Nordheim and HPIP because:

As noted above, Sabine did not convey real property interests to Nordheim and HPIP.
Sabine was free to produce as much gas and condensate as it chose. If Sabine failed to meet the minimum volumes set out in the Agreements, it would have to make a deficiency payment. However, the Court determined that this was merely a contractual obligation and did not decrease Sabine's legal relation to its real property interests.
Relying on Colorado Interstate Gas Co. v. Hunt Energy Corp., the Court determined that Sabine's obligations were only triggered after the gas and condensate had been produced, at which point they are personal property, not real property (see 47 S.W.3d 1, 10 (Tex. Ct. App. 2000)).

Nordheim and HPIP relied on In re Energytec, Inc., in which an agreement to pay a transportation fee based on the amount of gas flowing through a pipeline was ruled to touch and concern the land because the prior owner had reserved to its subsidiary an interest that pertained to the use of real property, that is, the travelling of natural gas through the pipeline beginning to end, and that restriction affected the owner's interests in the pipeline (see 739 F.3d 215 (5th Cir. 2013)). The SDNY District Court rejected and distinguished Energytec, Inc. because Sabine's obligation to pay a gathering fee was only incurred on delivery of produced gas and condensate to Nordheim and HPIP.

The Second Touch and Concern Test

Under the second test, the SDNY District Court held that the Agreements did not affect the nature, quality, or value of the thing demised, because they did not reduce Sabine's ability to make use of or alienate its real property interests.

The Court rejected Nordheim's argument that the Nordheim Agreements make Sabine's interest more or less valuable depending on the price of hydrocarbons and the market rates for gathering because, in the Court's opinion, those factors are clearly collateral to the terms of the Agreements and would affect the value of any oil-producing land.

The Agreements Do Not Run with the Land as Equitable Servitudes

The SDNY District Court held that the Agreements did not constitute equitable servitudes. Relying on Reagan National Advertising of Austin, Inc. v. Capital Outdoors, Inc., the Court determined that, in order to find that the Agreements constituted equitable servitudes, the relevant factors include whether:

The covenants limit the use of the burdened land.
The covenants benefit the land of the party seeking to enforce it.

(see 96 S.W.3d 490, 495 (Tex. Ct. App. 2002).)

The SDNY District Court rejected Nordheim's and HPIP's arguments that the Agreements constituted equitable servitudes because:

The Agreements did not limit Sabine's use of its property interests in the real property dedicated to Nordheim and HPIP for their processing facilities.
The Agreements benefited only Nordheim and HPIP, not the land on which they have their processing facilities, as they received fees for the processing of gas and condensate regardless of where the processing took place.

The SDNY Bankruptcy Court Did Not Err in Allowing Rejection of the Agreements

The SDNY District Court held that because it did not find that the Agreements run with the land as real covenants or equitable servitudes, the SDNY Bankruptcy Court did not err in allowing the Debtors to reject the Agreements as executory contracts under section 365(a) of the Bankruptcy Code.

Practical Implications

The impact of this decision further demonstrates the importance of using the correct operative language for conveyance of a real property interest. Because 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.

The SDNY District Court decision creates more uncertainty for midstream gatherers, as their contracts with oil and gas producers who have filed for bankruptcy are more likely to be rejected. For oil and gas producers, this decision may provide an incentive to file for bankruptcy and it supports a position to renegotiate terms to eliminate burdensome obligations under their agreements with midstream gatherers. Since Sabine, the issue has been regularly settled, as the decision provides powerful negotiating leverage for bankrupt oil and gas producers.

For more information on this case, see Legal Updates, In re Sabine: Binding Ruling Authorizing Rejection of Midstream Oil & Gas Agreements and In re Sabine: Rejection of Oil & Gas Agreements that Purport to Run with the Land.

For more information on the treatment of executory contracts in bankruptcy, see Practice Notes, Executory Contracts and Leases: Overview and Executory Contracts and Leases: Strategies for Non-Debtors.

In re Sabine: District Court Affirms Rejection of Oil & Gas Gathering Agreements as Executory Contracts | Practical Law