On March 10, 2017, the U.S. District Court for the Southern District of New York issued a Memorandum Order, in which it affirmed a controversial bankruptcy court ruling. The district court agreed with the bankruptcy court that Sabine Oil & Gas Corp., an upstream oil and gas producer, could reject a number of its gathering contracts with midstream energy companies. The bankruptcy court ruling in early 2016 caused some surprise in the energy industry, because of the general belief that such midstream contracts contained covenants running with the land, which would have provided sufficient protections against the effects of rejection. The bankruptcy court concluded that the contracts did not contain valid covenants running with the land, and in its recent ruling, the district court agreed. As a result, midstream companies will continue to face unfavorable negotiating dynamics when facing distressed oil and gas producers.

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Sabine Oil & Gas Corporation (Sabine) filed a Chapter 11 bankruptcy petition in July 2015. As part of its restructuring effort, it filed a motion on September 30, 2015, asking for court approval to reject four of its contracts: (1) a gas gathering agreement with Nordheim Eagle Ford Gathering, LLC (Nordheim); (2) a condensate gathering agreement with Nordheim; (3) a gathering, treating and processing agreement with HPIP Gonzales Holding, LLC (HPIP); and (4) a water and acid gas holding agreement with HPIP.

Section 365(a) of the Bankruptcy Code generally allows a debtor in bankruptcy to reject unfavorable executory contracts. The Bankruptcy Code does not define an executory contract, but it is generally understood to mean an agreement that has some material amount of performance still owing on both sides. The standard for whether a bankruptcy court will approve the rejection of a contract is the generally lenient “business judgment rule,” meaning that the bankruptcy court looks only to whether the debtor is employing its business judgment in deciding to shed the contract. Any long-term contract in which the non-debtor provided its performance early in the contractual relationship is likely to be vulnerable to rejection.

A gathering agreement generally refers to a contract that provides for collecting gas or other commodities at the point of production, and for moving it through a low-pressure pipeline system to a junction with a pipeline’s primary transmission system. Gathering agreements and other midstream contracts have been increasingly prevalent in recent years, because the shale boom gave rise to production in new areas that lacked the infrastructure needed to get gas and other commodities to market. As an oversimplification, the gathering agreements represented a bargain in which midstream companies agreed to invest significant resources to build out infrastructure, in return for a long-term payout from the producers to compensate for the creation and use of the infrastructure. Two portions of the typical gathering agreement are especially relevant to the Sabine case: contractual provisions that dedicate acreage to the midstream company, in the form of covenants that purport to “run with the land,” and a commitment of a minimum volume of oil or gas to flow through the system, which requires the producer to pay a fixed fee to the midstream company if that volume is not met.

The Nordheim and HPIP agreements clearly met the definition of executory contracts. Because the midstream companies invested in the infrastructure upfront, the economic structure of the contracts were similar to those that typically get rejected in bankruptcy. Midstream companies viewed the acreage dedications as a protection against rejection, because of the idea that the dedications were conveyances of real property that would continue to exist regardless of the fate of the contracts.

In opposing the Sabine motion, Nordheim first argued that rejection of its agreements was improper, because there was no business reason to reject those contracts after the dedication provisions were separated out. In other words, it contended that the conveyances were the key terms of the contracts, and regardless of rejection, the real property interest conveyances would survive rejection. Sabine responded that it sought to reject the contracts because of the minimum volume commitments, which obligated Sabine to make significant deficiency payments each month.
Nordheim and HPIP also argued that Sabine could not reject the portion of the agreements that purported to dedicate gas and other commodities to the midstream companies, because those portions of the contracts were conveyances of real property. Sabine asserted that rejecting the four contracts could save as much as $115 million.

For example, the dedication language in the Nordheim gas gathering agreement was as follows:

So long as this Agreement is in effect, the Agreement shall (i) be a covenant running with the Interests now owned or hereafter acquired by [Sabine] and/or its Affiliates within the Dedicated Area and (ii) be binding on [Sabine] and enforceable by [Nordheim] and its successors and assigns against [Sabine], its Affiliates and their respective successors and assigns.

Similar provisions were contained in each of the relevant contracts. Sabine, however, contended that those provisions did not meet the criteria under Texas law (which governed each of the relevant contracts) for a covenant running with the land. Under the Energytec decision from the Texas Court of Appeals, a contract must satisfy five requirements in order to constitute a covenant running with the land:

• There must be privity of the estate;
• The covenant must touch and concern the land;
• The covenant must relate to a thing in existence or specifically bind the parties and their assigns;
• The parties must intend the covenant to run with the land; and
• The successor to the burden must have notice.

Sabine contended that Nordheim and HPIP could not establish privity of estate, that the covenant “touches and concerns” the relevant land, or that the parties intended the covenant to run with the land.

In a March 8, 2016, ruling from the bench and a subsequent written opinion, the U.S. Bankruptcy Court for the Southern District of New York agreed with Sabine. The bankruptcy court’s decision had immediate effects on the energy industry, as several other bankrupt oil & gas producers sought to reject midstream contracts. Each of those later cases settled, reportedly on terms favorable to the producers and unfavorable to the midstream companies.

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In his March 10 Order, Judge Jed Rakoff of the district court followed a similar analysis to that of the bankruptcy court. He acknowledged that “it is not possible for a debtor to reject a covenant that runs with the land, since such a covenant creates a property interest that is not extinguished through bankruptcy.” Nevertheless, he ultimately determined that the Nordheim and HPIP contracts did not contain valid covenants running with the land, and therefore that they could be rejected in their entirety.

Judge Rakoff distinguished the Energytec opinion, but employed a similar analysis with regard to the requirements for a covenant running with the land. He focused primarily on two questions: (1) whether the relevant contracts either increased the midstream companies’ legal relations to the real property interests at stake or decreased Sabine’s relations to those interests; and (2) whether the covenant touched or concerned the land.

On the first issue, he determined that the midstream companies had not demonstrated that their contracts increased their relationship to the real property interests, or decreased that of Sabine. In reaching that conclusion, Judge Rakoff rejected the idea that the nature of the interest conveyed in the contracts was a royalty interest. He emphasized that they “have not purchased the minerals underlying the Dedicated Areas but ... have merely agreed to provide services to the minerals’ owner.” He further determined that no other interests recognized under Texas law—such as the right to develop, the right to lease, or the right to receive royalty payments—were conveyed in the contracts either.

Likewise, the court concluded that nothing in the contracts decreased Sabine’s relationship with the property interests. It emphasized that Sabine’s obligation was solely to use the midstream companies’ gathering and processing services when it produces gas and condensate. That obligation, it concluded, was not enough to limit Sabine’s use or enjoyment of the land.

The court’s analysis of whether the covenant touched and concerned the land was similar. Under Texas Supreme Court precedent, the standard for that issue is “whether the covenant affects the nature, quality or value of the thing demised ... or if it affects the mode of enjoying it.” As with the first issue, the court determined that the contracts do not restrict Sabine’s “ability to make use of or alienate its real property interests.”

As a result, the district court held that the bankruptcy court had properly authorized the rejection of the midstream contracts.

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Over the past year, the overall effect of the Sabine ruling has been somewhat more muted than was originally feared. In large part, that lesser impact is the result of stabilizing commodity prices, which seems to have reduced the number of producer bankruptcies. Nonetheless, among those producers that have filed bankruptcy, the rejection of midstream contracts continues to be a prominent issue. The issue has regularly settled when it has arisen after Sabine, but the decision represents an effective lever for troubled producers.

The district court’s affirmation will only solidify the leverage for the producers. For the midstream industry, there are limited possible avenues for relief. HPIP and Nordheim could successfully pursue their appeal to the next level, the Second Circuit Court of Appeals. If that does not happen, then midstream companies may need to consider an industry-wide effort, either to create a form contract backed by legal opinions, or to initiate a strenuous lobbying effort to make statutory changes.