Summary

On March 10, 2017, the United States District Court for the Southern District of New York entered an order affirming a bankruptcy court ruling that permitted the debtors to reject certain gas gathering agreements, finding that such agreements did not run with the land under Texas law. The case of In Sabine Oil & Gas Corp., et al. is significant because it upheld the Bankruptcy Court’s ruling providing a mechanism by which companies similar to Sabine may rid themselves of gas gathering agreements by filing for bankruptcy — even where such agreements expressly contemplate covenants running with the land.  

Although under section 365(a) of the Bankruptcy Code, a debtor is generally permitted to assume or reject an executory contract if it determines that such assumption or rejection is in its best interests, a debtor may not reject a covenant that runs with the land since it is a property interest that is not extinguished through bankruptcy.

Sabine decision is significant because it provides a mechanism by which companies similar to Sabine may rid themselves of gas gathering agreements by filing for bankruptcy — even where such agreements expressly contemplate covenants running with the land. In light of the Sabine decision, scrutiny over gas gathering agreements (or other similar agreements) is advisable in order to determine whether, under applicable state law, such agreements establish an interest in land sufficient to constitute an enforceable covenant running with the land, which will in turn protect against rejection.

Further background regarding the court’s ruling is set forth below, and a copy of the Court’s Memorandum Opinion can be found here.

Background: The Gathering Agreements

Prior to its bankruptcy filing, Sabine Oil & Gas Corp. (“Sabine”), an energy company that explores and develops onshore oil and natural gas properties, was party to certain gathering agreements with the Appellants, “midstream gatherers” in the business of gathering, transporting and processing oil and gas extracted from land.

In particular, Sabine and appellant Nordheim Eagle Ford Gathering, LLC (“Nordheim”) were parties to two gathering agreements (the “Nordheim Agreements”) under which Sabine agreed to gather and deliver to Nordheim all gas and condensate produced and saved from wells in certain specified areas of land. Nordheim agreed to receive, treat, dehydrate and re-deliver the gas and condensate to Sabine in exchange for certain fees. The Nordheim Agreements expressly provided that title to the gas and condensate remained with Sabine, that the agreements were covenants running with Sabine’s interest in the dedicated area of land, and that such agreements were binding upon Sabine’s successors and assigns.

Sabine was also party to two gathering agreements with HPIP Gonzales Holdings, LLC (“HPIP”), under which HPIP agreed to perform gathering services with respect to all oil, gas and water produced from a “dedicated area” (the “HPIP Dedicated Area”) and to construct facilities required for those services. Sabine held certain leases over the HPIP Dedicated Area.

In exchange for HPIP’s services, Sabine agreed to pay to HPIP certain fees and “dedicated[d] and commit[ted] to the performance of [the] Agreement the Lease and all of [Sabine]’s owned or controlled Production produced and saved” from the wells located on the leased property. Furthermore, similar to the Nordheim Agreement, the HPIP Agreements expressly stated that Sabine retained title to the leases in question, that the agreements constituted a covenant running with the land, and that such agreements were binding upon the parties’ successors.

The Bankruptcy Filing

On July 15, 2015, Sabine and its affiliates (the “Debtors”) filed for bankruptcy under chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”). Shortly thereafter, the Debtors moved to reject the HPIP Agreements and the Nordheim Agreements pursuant to section 365(a) of the Bankruptcy Code. The Appellants objected to the motion, arguing that the Agreements could not be rejected because they contained covenants running with the land. The Debtors then instituted an adversary proceeding for a declaratory judgment confirming whether the covenants contained in the Agreements ran with the land.

The Bankruptcy Court ultimately ruled in favor of the Debtors, permitting the Debtors’ rejection of the Agreements and finding that none of the Agreements contained covenants running with the land, either as real covenants or equitable servitudes. The Appellants challenged this order on appeal, raising the issue of whether the Bankruptcy Court erred in deciding that the Agreements did not contain real covenants or equitable servitudes and allowing the Debtors to reject the Agreements.

The District Court Ruling

As noted above, although under section 365(a) of the Bankruptcy Code, a debtor is generally permitted to assume or reject an executory contract if it determines that such assumption or rejection is in its best interests, a debtor may not reject a covenant that runs with the land. This is because a covenant that runs with the land creates a property interest that is not extinguished through bankruptcy.

Despite provisions in the Nordheim and HPIP Agreements (together, the “Agreements”) stating that the Agreements run with the land, the Court determined that such Agreements did not contain covenants running with the land (and could therefore be rejected).

Specifically, the Court concluded that the Agreements did not “touch and concern the land” as required under Texas law, because (i) it was not shown that the Agreements either increased the Appellants’ “legal relations to the real property interests at issue or decreased Sabine’s;” and (ii) the Agreements did not “affect the nature, quality or value of the things demised,” as required under Texas law, because the Agreements did not reduce Sabine’s ability to make use of or alienate its property interests.

In so concluding, the Court rejected Nordheim’s contention that it had a “royalty interest” in the gas and condensate produced from the land so as to hold a property interest that touched and concerned the land. The Court reasoned that even though Sabine had dedicated to Nordheim gas and condensate that was “produced and saved” in the dedicated area, such dedication was not a royalty interest because Nordheim received no right to any share of the gas and condensate coming from the dedicated areas, and was only entitled to process those materials for a fee. The Court explained that in the present case, “the appellants have not purchased the minerals underlying the Dedicated Areas but, again, have merely agreed to provide services to the minerals’ owner,” which was insufficient to establish a real property interest.

The Court also rejected HPIP’s contention that “by dedicat[ing] ‘the Leases’ to the performance of the HPIP Agreements, Sabine implicated some interest in those leases.” Indeed, because HPIP could not precisely identify what kind of property interest it might have obtained from the leases, the Court declined to hold that HPIP’s interest in the leases increased so as to “touch and concern” the land under Texas law.

The Court also concluded that the Agreements did not decrease Sabine’s legal relation to its real property interest in the Dedicated Areas, finding that the fact that Sabine was obligated to deliver the gas and condensate it produced to the Appellants was insufficient. The Court explained: “Sabine’s obligation under the agreements is simply to use Nordheim’s and HPIP’s respective gathering and processing services when it does produce and deliver gas and condensate, and that restriction does not limit Sabine’s enjoyment of the land itself.”

Lastly, the Court distinguished the instant facts from the Fifth Circuit’s decision in In re Energytec, Inc. – a case in which the Fifth Circuit determined that an agreement contained covenants that touched and concerned the land – and concluded, for reasons similar to those described above, that the Agreements did not constitute equitable servitudes. 

Having determined that the Agreements did not contain covenants running with the land, the Court held that the Bankruptcy Court properly authorized the rejection of the Agreements under section 365(a) of the Bankruptcy Code.