Pain on the Way to the Pump: Rejection of Executory Contracts and the Midstream Sector: An analysis of Sabine Oil & Gas

by John Stoelker

In re Sabine Oil & Gas Corp., 2016 WL 890299, __ B.R. __ (Bankr. S.D.N.Y. Mar. 8, 2016)
By John Stoelker, Esq.

While the recent decline in oil prices has led to better value at the pump for consumers, it has also resulted in a wave of bankruptcy filings among U.S. oil and natural gas companies beginning in 2015. Until recently, it was unclear what impact, if any, this would have upon the “midstream sector” of the energy industry, including companies that transport and process the gas produced by these bankrupt entities. These midstream operators had been viewed as insulated from the effects of energy prices, particularly due to the nature of their contracts with energy companies. But in a recent decision, the Bankruptcy Court for the Southern District of New York dealt a major blow to the midstream industry by permitting the rejection of its contracts with energy producers.

Background

Sabine Oil & Gas LLC (“Old Sabine”) was formed in 2007 with a focus on shale oil and gas production. Forest Oil Corporation (“Forest”), formed in 1916, was known primarily for its invention of a technique known as “waterflooding,” which is designed to initiate the secondary recovery of oil from wells when pressure drops within the oil reservoir. In 2014, Old Sabine and Forest combined to form Sabine Oil & Gas Corporation (“Sabine”) and its various affiliated entities. As part of the combination, Sabine inherited certain contracts with Nordheim Eagle Ford Gathering, LLC (“Nordheim”) and HPIP Gonzales Holdings, LLC (“HPIP”).

Pursuant to its contracts with Nordheim (the “Nordheim Contracts”), Sabine was required to deliver to Nordheim all gas, liquid hydrocarbons and other liquids produced by Sabine from a designated area, which Nordheim would then gather, treat, dehydrate and return to Sabine. Nordheim also agreed to construct pipelines and treatment facilities in order to perform its contractual obligations. Under the Nordheim Contracts, which had ten-year terms beginning in 2014, Sabine was required to pay monthly gathering fees to Nordheim and to make deficiency payments to Nordheim if it did not deliver a certain minimum amount of its products on an annual basis. The Nordheim Contracts expressly provide that they constitute a “covenant running with the [land]” as to the designated area.

Sabine also had two contracts with HPIP (the “HPIP Contracts”), pursuant to which Sabine agreed to dedicate certain leases, as well as the oil, gas and water produced from the wells located on the leased premises, to its performance of the HPIP Contracts, such that it would deliver that oil, gas, and water to HPIP. In turn, HPIP agreed to construct gathering facilities and to perform certain services with respect to the products received from Sabine. HPIP was also required to construct disposal facilities and to perform certain disposal services for the water and acid gas produced by Sabine at the subject leases premises. As with the Nordheim Contracts, the HPIP Contracts provided that Sabine’s obligation to deliver products to HPIP was a covenant “running with the lands and leasehold interests.”

On July 15, 2015, Sabine and several of its affiliated entities (together, the “Debtors”) filed Chapter 11 bankruptcy petitions in the Bankruptcy Court for the Southern District of New York. On September 30, 2015, the Debtors filed a motion to reject the Nordheim Contracts and the HPIP Contracts (together, the “Contracts”) pursuant to section 365(a) of the Bankruptcy Code, which provides that a debtor in possession, “subject to the court’s approval, may assume or reject any executory contract…of the debtor.”

In support of the motion, the Debtors argued that the Contracts were “unnecessarily burdensome,” in that the Debtors no longer had the financial wherewithal to deliver the minimum quantities of gas and other products to Nordheim and HPIP required by the Contracts. This inability to satisfy the minimum delivery threshold would, in turn, result in the imposition of daunting deficiency fees under the Contracts. Therefore, according to the Debtors, it was in the best interests of their collective estates to shed themselves of the Contracts and enter into new contracts with other parties on more favorable terms.

Both Nordheim and HPIP filed objections to the motion, asserting that Sabine’s dedication of certain leases and products under the Contracts were covenants that run with the land. Therefore, such covenants should survive rejection of the Contracts under Texas property law. The two parties took slightly different positions with respect to rejection.

HPIP asserted that rejection of the HPIP Contracts in general was appropriate, but rejection of specific covenants that purportedly “run with the land” could not properly be rejected. Moreover, HPIP argued that the Bankruptcy Court could – and should – as part of its decision on the rejection motion, make a determination under Texas law as to whether the covenants in the Contracts do, in fact, survive rejection.

Nordheim took a harder stance on rejection. While agreeing with HPIP’s position that certain covenants “run with the land” and are not subject to rejection, Nordheim made the broader argument that if the Debtors remained bound by such covenants, rejection of the remainder of the Contracts “would provide little or no benefit to the Debtors’ estates.” Therefore, rejection of the Contracts should be denied entirely. As for the Bankruptcy Court’s ability to make an immediate ruling on the application of Texas law to the covenants, however, Nordheim cited to the Second Circuit’s opinion in Orion Pictures Corp. v. Showtime Networks (In re Orion Pictures Corp.), 4 F.3d 1095 (2d Cir. 1993), which held that a disputed factual issue must not be decided in the context of a rejection motion. The Orion Court reasoned that “[a]t heart, a motion to assume should be considered a summary proceeding, intended to efficiently review the trustee’s or debtor’s decision to adhere to or reject a particular contract in the course of the swift administration of the bankruptcy estate. It is not the time or place for prolonged discovery or a lengthy trial with disputed issues.” Id. at 1098-99.

Analysis

Applying the standard for rejection of executory contracts under section 365 of the Code, which essentially requires a bankruptcy court to step into the shoes of the debtor and determine whether rejection would be a good business decision, the Court held that the Debtor’s proposed rejection of the Contracts was proper. In fact, the Court noted that neither Nordheim nor HPIP presented any legitimate challenge to the Debtors’ business decision. Accordingly, the rejection motion was granted.

However, the Bankruptcy Court grudgingly agreed with Nordheim’s analysis of the Orion decision and determined it could not make a substantive legal determination of whether certain covenants in the Contracts do, in fact, run with the land under Texas law and thus survive rejection under section 365 of the Bankruptcy Code. While noting that bifurcation of the rejection motion and the underlying legal issue as to the nature of the covenants would be procedurally inefficient, the Court determined that the bifurcation was required by Orion.

Although limited in its ability to render any immediate decision on the underlying legal issue, the Court was not inclined to direct the parties to blindly move forward with their dispute. Instead, the majority of the Court’s opinion was devoted to a “non-binding analysis” of whether the covenants at issue “run with the land” under Texas property law, either as real covenants or equitable servitudes.

Under Texas law, a contractual 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 of its existence. Moreover, most Texas courts have required “horizontal privity of estate,” which is typically created where a property owner conveys its property while reserving an interest in the property by way of covenant.

First, the Court determined that horizontal privity was lacking, as the Contracts were essentially service contracts whereby Nordheim and HPIP were engaged to gather, treat, dehydrate and return the products produced by Sabine on certain tracts of land. The covenants did not grant or reserve a real property interest in favor of Nordheim or HPIP.

Second, the Court concluded that the covenants did not “touch and concern” the land, as they only concerned Sabine’s interests in the products produced from the land – gas, liquid hydrocarbons and other liquids. Because Texas law provides that minerals, once extracted from the ground, become personal property rather than real property, the covenants at issue only affected Sabine’s personal property rights.

Having concluded that the first of four requirements of a real covenant was not satisfied by the covenants at issue, and that horizontal privity was lacking, the Bankruptcy Court opined that the covenants do not run with the land, and that they may be rejected under section 365. Without making a final determination due to the Orion precedent, the Court offered a preview of what its eventual determination would look like. In order for the Court to render a decision on this issue, the parties would need to bring the issue back before the Bankruptcy Court in the context of an adversary or other contested proceeding.

Key Takeaways

It should be noted that the importance of the Sabine decision is muted since it is not a final determination, and the parties have been invited to put the issue back before the Court for such a determination. However, the writing is on the wall and the Court has previewed its likely conclusion that the covenants at issue do not run with the land.

A question left unanswered as a result of the bifurcation of the proceeding is how the parties should conduct themselves pending a determination of the anticipated adversary proceeding. Presumably, until the Bankruptcy Court ultimately decides (rather than suggests, as it has done in Sabine) whether the covenants at issue survive rejection, the Debtors will simply treat the Contracts as rejected and of no force or effect. The counterparties to the Contracts will likely seek, as part of their adversary proceeding, or through the proof of claim process, damages associated with the Debtors’ failure to perform after the rejection motion was granted.

Moreover, as opinions from the Bankruptcy Court for the Southern District of New York tend to influence other venues, the Sabine decision is likely to carry a great deal of weight around the country. Midstream operators should be aware that other bankrupt energy companies may follow suit by rejecting their executory contracts and seeking more favorable ones.