U.S. Bankruptcy Judge Shelley Chapman ruled last week in the chapter 11 case of Sabine Oil & Gas that Sabine could utilize the U.S. Bankruptcy Code to “reject” certain agreements with pipeline operators.  This decision will permit Sabine to walk away from its obligations under the agreements and leave the pipeline operators with nothing but a claim in the bankruptcy case for breach of contract damages (a claim that is likely to be virtually worthless).  It upends the generally held view regarding the nature of these types of agreements, which is that they create cognizable real property interests under applicable state law.  Such real property interests have far stronger protections in bankruptcy cases than contractual rights.

Sabine, an exploration and production (E&P) company, filed for bankruptcy under chapter 11 of the Bankruptcy Code back in July 2015 in the Southern District of New York. Similar to most E&P companies, it had arrangements with two midstream gathering and processing (G&P) companies that gathered, treated, transported and processed Sabine’s oil and gas productions.  As is typical with these arrangements (the “midstream agreements”), Sabine agreed to dedicate certain oil and gas production to the G&P companies, and they, in turn, committed at their own expense to construct, operate and maintain for Sabine a system of pipelines and facilities.  Sabine committed under the midstream agreements to deliver certain minimum amounts of oil and gas on an annual basis, or else to make deficiency payments and other fees over a term of ten years.  The midstream agreements specifically provided that they are covenants intended to “run with the land.”

After filing for bankruptcy, Sabine sought to reject the midstream agreements. Section 365 of the Bankruptcy Code permits debtors to walk away from unexpired contracts and leases if they can demonstrate that such agreements are burdensome to their bankruptcy estates and that doing so would be in the best interests of the debtor and all of its creditors.  This is a crucial power under the Bankruptcy Code for troubled companies that are seeking to reorganize.

The G&P companies objected, and asserted strongly that the rejection of the midstream agreements would be of little avail to Sabine, because Sabine had conveyed real property interests to the G&P. They contended that even if Sabine terminated its ongoing contractual obligations under the midstream agreements, the covenants that run with the land could not be affected.

Property rights in bankruptcy are determined by applicable non-bankruptcy (in this case Texas) law. Notwithstanding that the covenants in the midstream agreements purported to run with the land, Judge Chapman, lamenting the “arcane and anachronistic rules” governing real property covenants, observed that the parties’ intentions were not necessarily dispositive, and that a number of conditions were required to be met in order to establish the existence of real property rights in Texas.  Since there were no decisions on point by the Texas Supreme Court that controlled all aspects of the questions at issue, she undertook her own analysis of whether the covenants between Sabine and the G&P companies did in fact “run with the land.”  She concluded that no such real property rights were created under Texas law.  (For technical reasons under the Federal Rules of Bankruptcy Procedure, she did not make a “final” ruling, but instead provided a “non-binding analysis” that can be readily applied when the procedural deficiencies are remedied).

Under Judge Chapman’s reading of Texas law, for a covenant to run with the land and thereby create a real property interest, among other things it must “touch and concern” the land (i.e., affect the fee owner’s ownership rights in some way), and also result from a “horizontal privity” between the parties (i.e., result from some transactional relationship between the parties, such as the reservation of certain rights upon a conveyance of a tract of land). In Judge Chapman’s view, the midstream agreements did not satisfy either of those requirements.  Instead, she found that

[Sabine] simply engaged [the G&P companies] to perform certain services related to the hydrocarbon products produced by Sabine from its property. The covenants at issue are properly viewed as identifying and delineating the contractual rights and obligations with respect to the services to be provided, and not as reserving an interest in the subject real property.

The decision in Sabine clearly has significant potential ramifications for G&P companies which have made substantial investments in facilities and infrastructure for distressed E&P companies. If Judge Chapman’s analysis is followed by other courts, E&P companies in chapter 11 would have the ability effectively to wipe out those investments by rejecting the midstream agreements under Section 365 of the Bankruptcy Code.  Other aspects of the Bankruptcy Code are implicated as well.  For example, a debtor in bankruptcy may sell its assets under Section 363 of the Bankruptcy Code “free and clear” of most contractual rights.  It is far more difficult to strip away real property interests such as covenants that run with the land.  This precise issue has arisen in the chapter 11 proceedings of Quicksilver Resources, which is pending in the District of Delaware, and a decision in that case from U.S. Bankruptcy Judge Laurie Silverstein is expected very shortly.

A number of factors make clear, however, that Judge Chapman’s decision will not, in and of itself, lead to a cascade of E&P companies seeking to reject midstream agreements with G&P companies. First and foremost, as the opinion itself demonstrates, the resolution of these questions is highly dependent on the facts of each individual case.  For example, Judge Chapman noted that Sabine only granted rights to the G&P companies in hydrocarbons after they were extracted from the ground and were thus personal property under Texas law.  Had the G&P companies in Sabine been granted rights to minerals in the ground, they would have constituted an interest in real property, and the outcome could very well have been different under Judge Chapman’s analysis.

Next, while Judge Chapman’s opinion will undoubtedly be persuasive, it will not be binding on any other court, even in the Southern District of New York. Judge Silverstein will shortly be rendering her decision in Quicksilver, and bankruptcy courts in Texas will almost certainly soon be weighing in on this topic.  Some of these decisions are certain to be appealed, setting up a process that will take two or three years, at a minimum, to play out in full.  Ultimately, it is not unreasonable to expect that a federal court of appeals will certify this question to the Texas Supreme Court for resolution.  The laws of different states are certain to be implicated in other cases as well.

Many industry observers are justifiably concerned over the prospects of G&P companies in the wake of the severe economic distress facing E&P companies, and whether other troubled E&P enterprises will similarly seek to jettison pipeline arrangements and other types of midstream agreements in bankruptcy.  However, Judge Chapman’s opinion will not in and of itself be a game-changer regarding the rights of G&P companies.  It is, rather, the first salvo in what could be a protracted battle among E&P companies and G&P transporters, and ultimately probably downstream refiners as well (and their accompanying lenders, creditors and investors) regarding the allocation of the ongoing economic pain stemming from historically low prices for oil and gas.  Many similar encounters lie ahead.