Rulings may impact pipeline contracts

TWO NEW YORK BANKRUPTCY COURT DECISIONS COULD JEOPARDIZE MIDSTREAM GATHERING CONTRACTS

RAYMOND M. PATELLA AND MICHAEL J. VISCOUNT, JR., FOX ROTHSCHILD LLP, ATLANTIC CITY, NJ

THE FIRST MAJOR TEST of whether bankruptcy may be used to end an unfavorable pipeline contract with companies in the midstream sector of the energy industry recently unfolded in the Bankruptcy Court of the Southern District of New York.

In a pair of rulings this year, the judge overseeing the bankruptcy of Sabine Oil & Gas Corp. held that midstream gathering contracts can be rejected in bankruptcy and that such contracts do not constitute "covenants running with the land."

For the energy sector, the rulings were a stunning development because midstream gathering contracts had generally been considered bankruptcy proof.

WHAT ARE COVENANTS RUNNING WITH THE LAND?

A covenant that runs with the land is considered "part of" or "belonging to" (or legally, "appurtenant to") the land. It inures to the benefit of, or must be fulfilled by, whatever party holds the land at the time fulfillment is due.

Under the law, a covenant running with the land is an enforceable real property interest. State laws vary and the specific requirements differ, but generally real covenants require:

• The covenant be in writing
• The contracting parties intend the burden and benefit to run with the land
• Some form of privity of estate
• The covenant "touch and concern" with the land
• Any subsequent purchaser to have notice of the covenant

For midstream gathering contracts in the oil and gas industry, the party that incurs the expense in building out the pipeline and other gathering materials to collect oil or gas products would consider the real property upon which that is built to be subject to a real covenant. That would mean that obligations under the gathering agreements cannot be readily shed in a future economic downturn because they are an interest in the real property itself.

If other judges follow the analysis and conclusions reached in the Sabine Oil case, the expectations of midstream service providers in the oil and gas extraction process might be turned on their heads.

FACTS OF THE SABINE OIL CASE

The debtor in Sabine Oil was an independent energy company engaged in the acquisition, production, exploration, and development of oil and natural gas properties in the United States. In its bankruptcy proceedings, Sabine Oil sought to reject gathering contracts it had with Nordheim Eagle Ford Gathering LLC and HPIP Gonzales Holdings LLC.

Section 365 of the Bankruptcy Code allows a debtor to assume or reject its executory contracts. As a practical matter, this means the debtor will live with favorable contracts and try to shed or breach unfavorable contracts. Both Nordheim and HPIP were midstream "gatherers"-companies that gather, treat, transport, and process mineral products produced from a well before the products enter the commercial market. Sabine Oil's agreements with both parties had multiple components, including transporting oil and gas produced at the debtor's wells by the pipeline companies to a designated area. The agreement with HPIP also included services related to the handling of water and gas produced by the debtor from the same land.

The gathering agreements generally provided that Nordheim and HPIP would construct, at their sole cost and expense, a gathering system of pipeline and treatment facilities to provide the agreed upon services. In exchange, Sabine agreed to deliver a certain minimum amount of product to the pipeline companies on an annual basis. If the minimums were not met, Sabine would be required to make a minimum deficiency payment.

The agreements also provided that Sabine's undertaking to deliver the products to the pipeline company was a covenant running with the land and leasehold interest identified in the agreement - the intent being that any successor as to the real estate interests and operations of Sabine would be bound by the terms of the gathering agreements. Upon filing for bankruptcy, Sabine sought to reject the agreements as being burdensome given the downturn in the oil and gas industry.

THE MARCH 8, 2016 DECISION

In a March 8, 2016 decision, the court noted that neither pipeline company truly challenged the debtor's business judgment as to whether the contracts were burdensome. It also noted there was no dispute that, from a business perspective, the pipeline contracts were no longer economically viable for Sabine. Neither pipeline company put forth any argument or evidence that Sabine's decision to reject the agreements were a product of bad faith, whim, or caprice. Instead, the pipeline companies focused their arguments on the assertion that Sabine's obligations under the agreements constituted covenants running with the land that would survive rejection of the contract in bankruptcy.

Ultimately, the court concluded that Sabine was permitted to reject the agreements with both pipeline companies. However, the judge also determined that it was premature to make a final decision about whether the contracts constituted covenants running with the land such that, even if rejected, the debtors would not be able to walk away from their obligations. Such a ruling, the court found, would require a separate action to be filed with the court (which was done shortly thereafter).

THE MAY 3, 2016 DECISION

Shortly after the March decision, Sabine filed the requisite action to bring the "covenant running with the land" issue properly before the court. After briefing, the court held that, under Texas law, the contracts at issue do not run with the land either as real covenants or equitable servitudes.

The court reasoned that, under Texas law, a covenant runs with the land when (1) it touches and concerns the land; (2) it relates to a thing in existence or specifically binds the parties and their assigns; (3) it is intended by the original parties to run with the land; and (4) the successor to the burden has notice.

Three covenants by Sabine Oil were at issue -a dedication to HPIP of certain oil, gas and water products and certain leases to the performance of the HPIP Agreements; a dedication to Nordheim of certain gas and condensate products to the performance of the Nordheim Agreement; and a covenant to pay Nordheim a gathering fee.

The court held that the characterization under Texas law of a conveyance of oil and gas "produced and saved" as a royalty interest does not lead to the conclusion that the burdening of oil and gas "produced and saved" also burdens oil and gas still in the ground. The judge reasoned that there was no allegation Sabine Oil owed to either party a royalty payment or any other obligation deemed a real property interest under Texas law and that Texas law does not hold that all rights and obligations relating to minerals yet to be produced necessarily create rights and obligations relating to real property.

Instead, the judge reasoned, the mineral dedications concerned only minerals extracted from the ground, which, under Texas law, constitute personal property, not real property. The court further reasoned that the contracts did not support an interpretation of those agreements as relating to minerals in the ground but rather included provisions to the contrary, including that the non-debtor midstream gatherers would connect their gathering systems at certain receipt points and not directly to Sabine's wells.

The judge also reasoned that, assuming horizontal privity of the estate was required to be proven under Texas law, neither non-debtor party had demonstrated that horizontal privity of the estate existed between the original covenanting parties with respect to the covenants at issue. The court found that those parties had the burden to prove the existence of a conveyance of an interest in property that itself is being burdened with the relevant covenant and not the conveyance of an interest in property that is distinct from, even if somewhat related to, the property burdened by the covenant.

As a result, the judge concluded that neither non-debtor party had a right directly related to a real property interest. Rather, Sabine was responsible for connecting its wells to the receipt points at which Nordheim and HPIP would connect their gathering system. Under this framework, the court found, neither non-debtor parties' structures in fact connected to Sabine's wells themselves and neither had a right to connect its pipelines to the debtor's wells.

In sum, the court held that the covenants at issue did not limit the use of or burden Sabine Oil's minerals estate and were fundamentally service contracts related to its personal property.

WHAT THE SABINE OIL DECISIONS MEAN

The Sabine Oil decisions may have several distinct consequences for the industry. First, the rulings may encourage other exploration and production companies to file bankruptcy if they are faced with onerous gathering and other pipeline contracts. Alternatively, the ruling may provide E&P companies with a powerful new tool to negotiate with pipeline companies for more favorable terms.

On the other hand, even if the court's analysis of Texas law is correct, it may not hold in other states as the judge's analysis was explicitly limited to Texas law. E&P companies operating in different states should closely examine the law in each state to determine whether they would be able to gain additional leverage in a bankruptcy case.

This also means that companies in this space need to carefully review their contracts to determine if they come with rejection risks in a bankruptcy. If they do, that may provide an ideal opportunity for renegotiation.

Perhaps most importantly, these rulings could provide a roadmap for midstream gatherers to modify or redraft their contracts. The judge repeatedly focused on the parties' contracts, specifying that the gathering point for collecting the minerals was "above ground," after the product was removed from the ground which, under Texas law, made the product "personal property" and not "real property" which could be burdened with a covenant or equitable servitude.

The outcome of the case could have been different if the language of the non-debtor parties' contracts differed. For example, if the facts provided that the pipeline in fact gathered the oil or gas directly at the well head such that the product being gathered was still "real property," that fact may have swayed the court.

Alternatively, the language of the contracts could have been revised to require Sabine Oil to provide all of its product produced at the wellhead such that, under state law, the interest would clearly be classified as one in real property.

But, even if the non-debtor contract counter-parties could prove an interest in real property, the next logical step for the E&P debtor would be to try to "sell" the debtor's property "free and clear" of that interest (with any lien or interest to attach to the proceeds of sale) under Section 363(f) of the Bankruptcy Code, which permits the debtor to sell property to a third-party buyer "free and clear" of certain interests.

While the issues do not appear to have arisen to date, existing law in bankruptcy cases provides a roadmap to make such an assertion. The analysis is premature in oil and gas production cases, but nonetheless something to be considered when and if midstream gathers are able to find creative strategies to overcome the prospect for rejection of gathering agreements.

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