PetrochemicalThis is the first of several posts on gathering agreements in bankruptcy, covenants running with the land and rejection claims that arise when a debtor finds gathering agreements financially burdensome. As our readers know, we waited with much anticipation for the Sabine ruling and wait with equal anticipation for the ruling on similar issues in QuickSilver.  Being pragmatic business lawyers we decided to blog on what parties to gathering agreements should be doing now in light of the non-binding, advisory Sabine ruling.

In this blog we overview the Sabine ruling and the maneuvering that resulted in Sabine getting some, but not all, of all what it wanted—rejection of the contracts. Sabine did not get a determination that the rejection damages were general unsecured claims.  The Court’s bench order left the counterparties to the gathering agreements alive to play another day as the Court could not, under controlling precedent, rule on the priority of the rejection claims.

Setting the Stage

Sabine filed a rejection motion in its bankruptcy case seeking approval to reject certain prepetition (1) gas condensate gathering agreements with Nordheim Eagle Ford Gathering, LLC, and (2) production gathering and handling agreements with HPIP Gonzales Holdings, LLC. The Nordheim and HPIP agreements included “dedications” providing that Nordheim and HPIP had the exclusive right to, among other things, to gather product from Sabine’s oil and gas properties in specific areas in Texas.

Nordheim and HPIP each objected to the motion on the basis that the dedications gave rise to real property covenants that run with the land under Texas law. They asserted that while the agreements could be rejected, the covenants would continue to encumber the land, calling into question whether rejection made business sense.

Sabine’s reply argued that the Nordheim and HPIP agreements did not run with the land because there was no privity of estate between Sabine and either Nordheim or HPIP. Sabine asserted that to demonstrate privity of estate under Texas law, one party must convey an interest in property to which a covenant attaches.  Sabine argued that a valid conveyance requires both (1) clear language evidencing an actual grant of such interest, and (2) the intent of the grantor to convey an interest in property.  Sabine noted that the dedications in the Nordheim and HPIP agreements were not sufficient to grant interests in real property because they did not include the words “grant,” “sale,” or “assignment” of any interest in real property.  With the granting language missing, Sabine concluded that the gathering agreements did not run with the land.

The Hearing

At the hearing on the rejection motion, the Court stated it was “inclin[ed] toward a ruling that [the dedications are] not covenants running with the land,” noting:  (1) the dedication language in the agreements was “not a conveyance”; (2) in Energytec[1], the fee under the relevant agreements burdened the land because if not paid, it would have resulted in a loss of ownership and use of the pipeline through foreclosure, which was not applicable here; and (3) the Nordheim and HPIP agreements relate to “oil, gas, and water produced by Sabine. Those are . . . personal property items . . . not real property.”  February 2, 2016 Hearing Transcript at 126:23-25 and 127:1-10 (emphasis added).

The Sabine Bench Decision – No Surprises

Simply stated, the Court permitted the debtors to reject their gathering agreements, at least the parts of the agreements that are executory contracts and can be rejected under the Bankruptcy Code. Judge Chapman relied on well-established bankruptcy law and the bankruptcy courts’ traditional deference to debtors in finding that the gathering agreements could be rejected as a valid exercise of Sabine’s business judgment because the debtors’ ability to perform was no longer financially viable.

Hence, Sabine got its rejection, but a significant amount of uncertainty remains regarding rejection damages. While Sabine wanted the Court to find that the rejection damages were general unsecured claims, one of the counterparties objected asserting the Second Circuit Orion decision[2] prevented the Court from deciding priority because of the contested factual issue regarding whether the gathering agreements “run with the land,” and therefore, cannot be rejected.

Frustrated by the need for a second hearing on the priority of the rejection damage claims, the Court issued a non-binding ruling initially finding, after a careful analysis of Texas law, that the gathering agreements did not run with the land. The Court emphasized during the reading of the ruling that it was not likely to revisit the issue. The Court encouraged the parties to return to the negotiating table and find a “commercial resolution.”  Because the Court’s analysis of “covenants running with the land” is extensive and well worth reviewing we will cover it in detail in an upcoming blog.

What is the state of play in Sabine?

The contracts have been rejected, at least the parts of the contracts that can be rejected.  To the extent that the Court changes its nonbinding ruling, there remains a remote possibility that some portion of the gathering agreements could be found to run with the land making the scope and impact of the rejection less than clear.  Further, if a negotiated settlement on the issue is reached by the parties, this decision is rendered moot, other than to be used as a stick by E&P companies in future negotiations related to gathering agreement restructurings.

Nevertheless, covenants running with the land under governing state law, in this case Texas, still cannot be rejected.  In this case the Court found in a non-binding ruling that none of the gathering agreements before the Court run with the land or are equitable servitudes.

The Court’s non-binding ruling that the gathering agreements do not run with the land is intended as a guide to the parties as they move on through the bankruptcy process, and the decision clearly benefits Sabine in these negotiations.  If a business agreement is not reached, the next step will be a contested hearing on the priority of the rejection claims.  The counterparties are alleging theories that their rejection damages are more than general unsecured claims and are attempting to convince the Court that the non-binding ruling should be reconsidered and even though the contracts have been rejected, the asserted covenants running with the land remain in place.

What does Sabine mean for parties to gathering agreements?

First and foremost, the determination of whether a gathering agreement runs with the land is a factual inquiry that is specific to each agreement.  This inquiry involves applying applicable state law to determine whether the gathering agreement meets the test for a covenant running with the land.  This means there is no general rule coming out of Sabine or any other case for that matter.  Contrary to a lot of commentary, this case does not stand for the general proposition that gathering agreements do not run with the land.  If the Court’s non-binding ruling becomes final and binding, it will apply only to the specific gathering agreements at issue in Sabine.

Second, Sabine provides parties to gathering agreements with the analytical tools to assess their gathering agreements and consider whether their agreements could be rejected in bankruptcy.  The actual contract language is determinative.

In the February 2, 2016 hearing on Sabine’s rejection motion, the Court asked Sabine whether it had other gathering agreements that were not being rejected. In response, Sabine told the Court that

“. . . we have at least two other agreements, which do have what we could call stronger language in them, speaking to things like grant and convey versus, you know, what we have here which is language that’s much more consistent with the services agreement, language that says dedicate, commit, dedicate for purposes of this agreement, dedicate for purposes of performance under this agreement.”  Transcript at 56:21-25.

Sabine’s view of the world of gathering agreements demonstrates that there are gathering agreements that run with the land which are not subject to rejection because they are property interests and not executory contracts and there are gathering agreements like those under consideration in this instance that are executory contracts.

Third, Sabine establishes the importance of considering rejection damages and the need for an adversary proceeding to obtain a binding order on contested factual matters. The legal maneuvering in Sabine left the counterparties alive to negotiate and litigate another day.  It denied Sabine a clean rejection of the gathering agreements with a determination that the rejection damages were general unsecured claims.  The bottom line, as noted by the Court is that this issue is still open and the parties should return to the negotiating table.  Without a negotiated settlement, the counterparties should be prepared to litigate the priority and scope of their rejection claims.

Applying Sabine- The Take-Aways

Existing gathering agreements should be reviewed to determine whether the:

  • Necessary “granting language” is present and clearly evidences an intent to “run with the land” that impacts the value of the burdened real property
  • Dedicated acreage creates a covenant running with the land with a view to a direct relationship to real property, not an indirect relationship through a lease
  • Successors and assigns are bound by the agreement
  • “Grant or conveyance” has horizontal privity or it is not required (Horizontal privity is intended to capture a mutual relationship between the original covenanting parties and the land (as opposed to the “successive” relationship represented by vertical privity.)
  • Grant conveys any portion of the working mineral interest (the burdened estate) or only provides access to the surface estate
  • Owner of the burdened property is a party to the agreement
  • Agreement conveys recognized real property interests (under the law of the state in which the property is located) and has been properly recorded
  • Agreement provides for specific performance (monetary damages are inadequate)

While reviewing the gathering agreements, the parties should also review their business relationship with their counterparties to determine:

  • Risk of restructuring, insolvency or bankruptcy
  • Whether viable alternatives exist to bring product to market
  • Alternative uses for pipeline systems
  • Benefit of opening communications early, gathering information necessary to negotiate alternative terms to address and manage financial risk

There is a very common saying that parties to a contract can often reach a resolution that is more beneficial than a court order. There is also a saying that desperate times demand desperate measures.  Whether gathering agreements can be rejected seems to call for negotiation instead of judicial resolution in the first instance.

The obvious challenge for parties to gathering agreements is to determine whether there is a business solution that works for everyone or an alternative source or business use for the pipeline. Absent a business solution that works, understanding and evaluating the strengths and weaknesses of your gathering agreements and your counterparties is essential to understanding what a bankruptcy court may do with the agreement if the debtor seeks to reject.  Lenders (or investors) may also want to review midstream borrower gathering agreement contracts and risk profiles with a view to these issues as a part of their annual borrower review or any loan agreement amendment process.

In our next blog on gathering agreements we will review the Court’s application of Texas law to the Sabine gathering agreements with an eye to expanding on our list of what you need to know in reviewing your own agreements.

[1] In re Energytec, Inc., 739 F.3d 215 (5th Cir. 2013).

[2] Orion Pictures Corp. v. Showtime Networks (In re Orion Pictures Corp.) 4 F.3d 1095 (2nd Cir. 1993).