On March 8, 2016, U.S. Bankruptcy Court Judge Shelley C. Chapman permitted Sabine Oil & Gas (“Sabine”) to reject its gathering agreements with two pipeline operators as “executory contracts.” Although the Court’s decision is non-binding as to the underlying issue of the whether the contracts created a property interest in the underlying mineral estate, the ruling could nevertheless create a chilling effect on industry-typical practices regarding such agreements. Prior to this decision, pipeline operators (and the banks providing them financing for building the gathering and processing facilities) have believed that a well-drafted gathering and processing contract for certain minimum delivery obligations would survive a driller’s bankruptcy.
Before filing for bankruptcy, Sabine had entered into gathering contracts with pipeline operators where Sabine agreed to dedicate all oil and gas from certain designated areas, subject to specified minimum volume or payment requirements, to the pipeline operators. The agreements, governed by Texas law, specifically provide that the agreements themselves create a “covenant running with the land.” After filing for Chapter 11 protection in the Southern District of New York, Sabine filed a motion to reject the gathering agreements under the Bankruptcy Code as unduly burdensome “executory contracts.” The pipeline operators objected, arguing that the gathering agreements are covenants that run with the land and, therefore, cannot be rejected in bankruptcy. If the agreements are, in fact, covenants that run with the land, they would not be subject to rejection in bankruptcy.
The legal issue before the Court, then, was whether the gathering agreements are executory contracts subject to rejection in bankruptcy (thus creating a breach of contract and putting the pipeline operators in the category of general unsecured creditors), or if the agreements create a property interest that attaches to the mineral estate and continues with the land, unaffected by the bankruptcy.
The Court did not resolve the property interest issue in its ruling. Rather, the Court decided that Sabine satisfied the “reasonable business judgment” standard that is applied in determining whether executory contracts have been properly accepted or rejected by the debtor. For procedural reasons (the issue was before the Court on a Motion to Reject rather than an adversarial proceeding or contested matter, and the Court found that a substantive legal ruling must occur in the context of one of the latter), the Court explained that it’s decision was non-binding. However, it left no doubt as to what the final, binding determination would be if properly brought before the Court:
If it is ultimately determined that the covenants at issue in the Agreements do not run with the land, as the Debtors and the Court believes to be the case, the Debtors will be free to negotiate new gas gathering agreements with any party, likely obtaining better terms than the existing agreements provide. If, however, the covenants are ultimately determined to run with the land, the Debtors will likely need to pursue alternative arrangements with [the pipeline operators] consistent with the covenants by which the Debtors would be bound. In either scenario, the Debtors’ conclusion that they are better off rejecting the [gathering] Agreements is a reasonable exercise of their business judgment. Therefore, even though, as explained below, the Court’s conclusion that the covenants at issue do not run with the land is non-binding, the Court finds that the Debtors’ decision to reject each of the [gathering] Agreements to be a reasonable exercise of business judgment.
Applying Texas law, the Court noted that “language in a contract containing a covenant is the primary evidence of the parties’ intent, but terminology is not dispositive.” Instead, applying admittedly archaic property law principles, the Court determined that a covenant runs with the land when, among other elements, and it “touches and concerns the land.” The Court also considered whether there was “horizontal privity of estate,” which traditionally involves a property owner reserving, by covenant, an interest in the property for a third party.
Under the Court’s analysis, the primary terms of the gathering agreements relate to the rights and obligations regarding the oil and gas rather than to the land or leasehold interests from which they came. Further, the right to transport and transform the oil and gas products is not one of the property rights of a mineral estate under Texas law. The Court went on to find that to “touch and concern the land,” a covenant must affect the owner’s interest or its use of the land, and the gathering fee covenant had no direct impact on the land or on Sabine’s property rights.
While this ruling may fuel a driller’s desire to re-negotiate more favorable terms with pipeline operators, the impact of the non-binding ruling is still limited to the specific terms of those gathering agreements and the state law governing those agreements.
There are plenty of contract drafting questions to consider in light of the ruling. The Court distinguished certain cases where covenants were found to grant property interests, and arguably drafters could work to more closely mirror those covenants and the underlying provisions to create a genuine property interest.
Another option may be to consider an entirely different drafting approach, such as structuring the gathering agreements as forward contracts and/or swaps, especially in light of the CFTC’s recent willingness to include transportation and tolling agreements in the definition of a swap. Such a designation could potentially bring these contracts under the safe harbor provisions of the Bankruptcy Code, and the parties’ initial intent to have a gathering agreement survive a driller’s bankruptcy could be preserved.