District Court Upholds Controversial Bankruptcy Decision in Sabine

by Eversheds Sutherland (US) LLP
Contact

Eversheds Sutherland (US) LLP

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.

* * * *

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.

* * * *

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.

* * * *

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.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Eversheds Sutherland (US) LLP | Attorney Advertising

Written by:

Eversheds Sutherland (US) LLP
Contact
more
less

Eversheds Sutherland (US) LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.
Feedback? Tell us what you think of the new jdsupra.com!