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June 07, 2016 Articles

New York Bankruptcy Judge Sends Shudders Through Midstream Market

Sabine Oil and Gas Corp. wins bankruptcy court approval to enter into a new facilities agreement after the court allowed it to reject existing facilities agreements.

By Stephen A. Roberts – June 7, 2016

Midstream companies would be well advised to explore restructuring and redrafting their contracts with exploration and production companies. In March 2016, New York bankruptcy judge Shelley Chapman sent shudders through the midstream energy market when she ruled that Sabine Oil and Gas Corp. could reject, or breach, its gas-gathering contracts with Nordheim Eagle Ford Gathering, LLC, and then later ruled, contrary to the prevailing wisdom in the industry, that the debtor could avoid the dedications of the hydrocarbons in the contracts because they were not covenants running with the land. In re Sabine Oil & Gas Corp., No. 15-11835 (SCC) (Bankr. S.D.N.Y. Mar. 8, 2016). Observers predicted her rulings would shift the leverage to distressed energy and production companies saddled with unfavorable gas gathering contracts. It did not take long to prove observers right. On May 19, 2016, Judge Chapman allowed Sabine to enter into a new facilities agreement with DCP South Central Texas LLC, bypassing Nordheim’s gathering system.

Bankruptcy law generally allows debtors to reject, or breach, certain burdensome contracts, but not contracts that contain covenants “running with the land”; that is, contracts relating to real property that are binding not only on the parties but also on anyone who acquires an interest in the property. Gas gathering contracts are commonly drafted with covenants the parties agree are covenants running with the land and so have been widely believed to be enforceable in bankruptcy.

Judge Chapman has changed all that.

On May 3, 2016, Judge Chapman ruled that the dedication of hydrocarbons from specified mineral leases to midstream pipeline companies in gas gathering contracts are not covenants running with the land under Texas law, despite the parties’ agreement that they are. Previously on March 8, 2016, Judge Chapman had ruled that the debtor Sabine Oil and Gas Corp. could reject, or breach, its gas gathering contracts with Nordheim Eagle Ford Gathering, LLC, because they were burdensome. Together, these decisions released Sabine from the contracts, leaving Nordheim with a substantial unsecured claim for breach of contract. Nordheim is appealing.

It did not take long for the consequences of these decisions to materialize. Sabine immediately reached a more favorable agreement with DCP South Central Texas, LLC, which the bankruptcy court approved on May 19. Sabine had been transporting its gas through Nordheim’s gathering system to DCP’s existing pipeline system. Under the new agreement, Sabine is constructing a new gathering system, bypassing Nordheim’s, and connecting directly to DCP’s pipeline. According to Sabine, the new arrangement will save Sabine over $200,000 per month.

What makes this case particularly significant is that the contracts at issue are similar to those used throughout the industry and, until now, were widely believed to be enforceable in bankruptcy. Midstream companies collectively invest billions of dollars annually developing the infrastructure necessary to gather, process, and transport oil and gas. In exchange, they receive a promise of payment, if and when oil and gas is produced, and dedications of the hydrocarbons produced from the underlying oil and gas mineral interests and associated acreage. The contracts characterize these dedications as covenants running with the land so that the contracts are intended to bind not only the parties to the contracts but also anyone who acquires the mineral rights in the dedicated acreage, and they are recorded in the real property records to give the public notice. This arrangement is designed to protect the midstream company’s substantial capital investment by preserving the bargain even if their counterparty files bankruptcy.

The Bankruptcy Code permits a debtor to “reject,” or breach, an “executory” contract that is burdensome to the estate, with court approval. There is no definition of an executory contract in the code, but case law generally defines an executory contract as one in which both parties have an ongoing obligation to perform after the date of the bankruptcy filing. However, the case law excludes covenants that run with the land from the definition of executory contracts.

On March 8, 2016, Judge Chapman granted Sabine’s motion to reject its gas gathering and treatment agreements with Nordheim, ruling that the debtor had met its burden to prove that the contracts were burdensome and that it was in the best interest of the estate to reject them. A rejection is deemed to be a breach of contract by the debtor immediately before the filing and so gives rise to a claim for damages in the bankruptcy case.

Nordheim argued that, even though Sabine had rejected the contract, Sabine was still bound by the covenants dedicating the mineral leases and extracted hydrocarbons to the contract. Sabine filed an adversary proceeding, or lawsuit, seeking a declaratory judgment that it was not bound by the covenants because they were not covenants running with the land. Judge Chapman granted Sabine’s motion for summary judgment, ruling that the covenants were not truly covenants running with the land, even though the parties agreed they were, because they did not reserve an interest in real property; rather, they dedicated the severed hydrocarbons, which are not real property interests. So Sabine was no longer bound by the covenants once it rejected the contract.

This cleared the way for Sabine to enter into the facilities agreement with DCP at a substantial savings to the company.

Judge Chapman’s opinion is not binding on any other courts, and scholars can argue whether she is right. Her thoughtful and thorough opinion has a significant and immediate impact, however, because it introduces considerable uncertainty when there had been none and gives exploration and development companies in Chapter 11 more leverage to renegotiate unfavorable contracts with midstream companies. And, while the opinion is based on Texas law, it has wider application because it is based on ancient and arcane common-law principles shared by other states.

Moreover, the uncertainty can be expected to last for some time. When Judge Chapman issued her earlier ruling in March, the same issues of Texas law were pending in at least two other Chapter 11 cases pending in the Bankruptcy Court in Delaware: In re Quicksilver Resources, Inc., and In re Magnum Resources, Inc. Since then, however, both cases were settled without any decision by those courts, leaving Judge Chapman’s opinion as the single judicial opinion on the subject. For now.

Keywords: energy litigation, bankruptcy, covenant running with the land, gas gathering contract

Stephen A. Roberts is a partner at Strasburger & Price, LLP, in Austin, Texas.

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