Gathering Agreements Are Executory Contracts That May be Rejected in Bankruptcy

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Gabrielle Glemann, Stoel Rives[/caption] On May 25, the Second Circuit upheld the New York district court’s decision concluding that certain midstream gathering agreements were executory contracts, subject to rejection in a bankruptcy proceeding. Oil and gas exploration and production companies negotiate complex gathering agreements with midstream providers governing the processing and transportation of oil and natural gas. In order to provide these services, the midstream providers invest significant capital to construct and maintain the required infrastructure of pipelines and treatment facilities. In consideration for this investment and to provide both parties with assurance of performance throughout the life of the contract, the gathering agreements contain dedication clauses, which may grant committed access to acreage and typically include a commitment to deliver a minimum volume of oil or gas for transportation or processing through the provider’s facilities, with a guaranteed fixed fee payment if that volume is not met. The contracts also usually state that the parties intend the agreement to be a “covenant running with the land,” meaning it will automatically extend to any party claiming an interest in the land after the covenant was created, including successors in interest, grantees, assignees and heirs. Whether an agreement creates a covenant running with the land is of particular significance in the bankruptcy context. Section 365(a) of the Bankruptcy Code generally allows a debtor in bankruptcy to reject executory contracts, relieving the debtor of its obligations under those agreements and converting the other party’s interest to a prepetition claim for damages, which will be adjudicated and satisfied exclusively through the debtor’s claims administration process in its bankruptcy proceeding. The Bankruptcy Code does not define executory contract, but it is generally understood to mean an agreement where each side continues to owe some material amount of performance. In contrast, an agreement that creates a covenant that “runs with the land” is characterized as a property interest, and not an executory contract. As a result, such agreements are not subject to rejection under the Bankruptcy Code. Whether an agreement creates a covenant that runs with the land is governed by state law and varies from state to state. In a recent decision issued on May 25, the Second Circuit affirmed decisions by the courts below that the gathering agreements in that case were executory contracts subject to rejection under the Bankruptcy Code. Sabine Oil & Gas Corp. (Sabine), an energy company engaged in production, exploration and development of onshore oil and natural gas properties in the United States, filed a bankruptcy petition in the U.S. Bankruptcy Court for the Southern District of New York on July 15, 2015. On Sept. 30, 2015, Sabine filed a motion in the bankruptcy proceeding asking the court to approve the rejection of two agreements with Nordheim Eagle Ford Gathering, (Nordheim) related to the gathering of gas and condensate, and two agreements with HPIP Gonzales Holding (HPIP) related to gathering, handling and disposal of oil, gas and water. All of the agreements were governed by Texas law. Each of Nordheim and HPIP objected to the motion, arguing that the agreements Sabine sought to reject contained covenants that run with the land and, as a result, were not subject to rejection. On March 8, 2016, Bankruptcy Judge Shelly C. Chapman issued a decision approving the motion to reject as a proper exercise of Sabine’s business judgment. Judge Chapman determined that the procedural posture did not afford the bankruptcy court jurisdiction to decide the issue of whether the dedication provisions of the agreements granted “property interests” under Texas law in the context of a motion to reject an executory contract. However, in a non-binding part of her ruling, Judge Chapman nonetheless concluded that the covenants in the agreement did not run with the land or convey interests in the underlying real property under Texas law. To correct the procedural posture and obtain a binding judgment, Sabine then commenced adversary proceedings against Nordheim and HPIP seeking a declaratory judgment that the covenants contained in the agreements did not run with the land. On May 3, 2016, Judge Chapman granted Sabine’s motion for summary judgment in those adversary proceedings on substantially the same grounds articulated in the nonbinding portion of her earlier opinion. In her interpretation and application of Texas law, Judge Chapman was guided by the U.S. Court of Appeals for the Fifth Circuit decision In re Energytec, 739 F.3d 215 (5th Cir. 2013), which states that under Texas law, a covenant runs with the land if: it touches and concerns the land, it relates to a thing in existence or specifically binds the parties and their assigns, it is intended by the parties to run with the land, the successor to the burden has notice that the land is so burdened, and it satisfies the requirement of privity of estate (so-called horizontal privity) between the parties creating the covenant. Recent cases from Texas have called into question whether horizontal privity is still a required element under Texas law, but in the absence of any clear authority on point, Judge Chapman ruled there was no horizontal privity, which typically requires some contemporaneous conveyance of an interest in property that is itself being burdened with the relevant covenant. Even were horizontal privity not required, Judge Chapman also concluded that the covenants did not “touch and concern the land” because the dedications in the midstream agreements at issue concerned only minerals once extracted and did not burden oil and gas still in the ground. Nordheim and HPIP initially sought to directly appeal the bankruptcy decision to the Second Circuit, where the property law issues governed by Texas law could be certified to the Supreme Court of Texas. The bankruptcy court denied this request, forcing the defendants to pursue their appeal first in the U.S. District Court for the Southern District of New York, which affirmed the bankruptcy court’s decision. On March 10, 2017, Judge Jed S. Rakoff issued his decision, in which he agreed with the bankruptcy court’s conclusion that Nordheim’s and HPIP’s gathering agreements did not convey a property interest in any real property, because they did not grant any right to share in the gas or condensate itself, but only a contractual right to be the exclusive providers of certain services in connection with these products for a fee. In the subsequent appeal to the Second Circuit, Nordheim renewed its attempt to have the issues of Texas law certified to the Texas Supreme Court, this time supported by amicus curiae briefs filed by organizations representing the midstream industry. Despite these efforts, the Second Circuit declined to certify the Texas property law issues for presentment to the Supreme Court of Texas. Instead, it issued a summary order affirming the district court decision based on its view that horizontal privity remained a requirement under Texas law. The Circuit Court acknowledged a growing trend toward abolition of this requirement but determined that it could not eliminate the requirement in the absence of Texas authority instructing it to do so. In contrast to the lower courts, which focused their analysis on the touch and concern requirement, the Second Circuit based its opinion solely on the lack of horizontal privity and noted that, based on this result, it did not need to reach the issue of whether the touch and concern requirement had been met. As a result, parties hoping for further clarity on this issue from the Second Circuit may be disappointed by the decision. As an initial matter, the Second Circuit’s decision was rendered by summary order, which does not have precedential effect. Secondly, a decision from the Supreme Court of Texas eliminating the requirement of horizontal privity could render the Second Circuit’s decision moot. At present, however, no such case is pending before the Supreme Court of Texas, and notwithstanding the lack of precedential effect, producers seeking to reject gathering arrangements governed by Texas law may gravitate toward courts in the Second Circuit, which likely will give deference to the Second Circuit’s decision. Some commentators following the procedural development of the case suggested that the bankruptcy court’s initial advisory opinion and reluctance to certify a direct appeal were meant to encourage the parties in Sabine to reach a settlement. If that is the case, while the efforts were not successful in that proceeding, they may have influenced the parties in other large bankruptcy cases where similar requests to reject gathering agreements were pending while the Sabine litigation proceeded. For instance, in In re Quicksilver Resources, No. 15-10585 (Bankr. D. Del.), a buyer that conditioned its acquisition of the debtor’s assets on the rejection of certain midstream gathering agreements ended up entering a new contract with the midstream operator, eliminating the need for the bankruptcy court to rule on the motion to reject. In In re Magnum Hunter, No. 15-12533 (Bankr. D. Del.), the debtor negotiated agreements with two of its midstream providers that facilitated the termination of those agreements, in one case resulting in a significant allowed claim to the midstream gathering company and in the other case on undisclosed terms. The extent of the impact of the Sabine decision on the midstream industry is still unknown, and the applicability of the decisions may be limited where non-Texas state law governs. What is clear is that parties are carefully considering the impact of their choice-of-law provisions and the underlying state law on granting property interests and are considering alternative forms and structures to provide some security for their investment, such as upfront commitment fees or security interests. In the interim, distressed exploration and production companies will have a more credible threat of rejection in bankruptcy as negotiating leverage vis-à-vis their producers. Gabrielle Glemannis of counsel in Stoel Rives’ corporate group. Gabrielle advises corporations across a number of industries regarding a broad array of commercial and regulatory matters, including financing transactions, asset sales and acquisitions, risk assessment and mitigation, corporate governance and regulatory compliance.