rejection of executory contracts

Co-author Lydia Webb

Q: How many New York federal judges does it take to make a mess of Texas property law?

A: In In Re: Sabine Oil and Gas Corp., five. One to get it wrong, another to affirm the wrongness, and three more for reinforcement.

For the third time, a federal court in New York has allowed an E&P debtor to reject its gas gathering agreements because its midstream counter-parties could not establish that the agreements were covenants running with the land under Texas law. This time it was the Second Circuit, which upheld a district court ruling, which upheld a  bankruptcy court ruling.

E&P debtor Sabine sought to reject a series of above-market gas gathering agreements. The bankruptcy court allowed the debtor to do exactly that, over the objection of the midstream counter-party. The question on appeal: Under Texas law, are midstream agreements covenants running with the land (and thus, cannot be rejected in bankruptcy)?

This result could have wide-reaching negative effects on the oil and gas industry.  We won’t delve deep into the weeds of the legal analysis.  But we will raise a serious question about the process.

Horizontal privity?

The key question was whether Texas law requires a showing of horizontal privity as part of the covenant analysis.  The New York courts concluded that Texas requires horizontal privity, which was not satisfied under the present circumstances. This allowed Sabine to escape from its midstream agreements.

Horizontal privity requires that the parties make their covenant in connection with, and at the same time as, a conveyance of real property.  The Second Circuit acknowledged that the trend across the country is to do away with the horizontal privity requirement. However, the Court went on to rationalize that “[i]t would be improper for us to read a traditional requirement of real covenants out of Texas state law when there is no Texas law instructing courts to do so.”

The maddening reality

The test, according to the Texas Supreme Court, does not include horizontal privity as a requirement for a covenant to run with the land!

Rather than opining on the nuances of Texas property law, the Second Circuit could have (and should have) certified the question to the Texas Supreme Court so that the law could be uniformly applied by all federal courts in similar cases arising from contracts for the transportation or sale of Texas oil and gas production.  This option would have made the most sense and was proposed by several trade groups.

The Texas high court, the ultimate authority on Texas common law, should decide what it takes to constitute a covenant running with the land in this state – not a federal court sitting thousands of miles away and not at all versed in Texas property law. Leave it to the experts and let Texas tell the world how its laws should be interpreted and enforced.

Railroaded?

Noble Energy Inc. v. ConocoPhillips Company, a 6-to-3 Texas Supreme Court decision, is a reminder of two things:

  • How parties to a property transaction describe what’s being acquired and what’s being left behind can have grave consequences. The purchaser can acquire specific obligations associated with purchased assets, excluding all others not mentioned. Or, he can acquire all obligations, disclaiming none, including those not even mentioned and those he doesn’t even know about. Here, the difference cost Noble $63 million.
  •  When given a choice, the Texas Supreme Court is likely to resolve a dispute by relying on the words in a contract rather than notions of equity.

Continue Reading Texas Supreme Court Dabbles in Bankruptcy Law

gas processingWhat’s a sure way to destroy untold millions of dollars of energy infrastructure value built in reliance on the promise of reimbursement for huge capital investments necessary to move a producer’s product to market for the next 20 years or more?

Here’s another one: What’s a helpful way to effect the goal of bankruptcy reorganization, to give a bankrupt energy producer and its shareholders a fresh start by shedding burdensome contracts?

The answer to both questions: Allow a bankrupt energy producer to reject, as in walk away from with no remorse, gas gathering, processing and transportation agreements.

This is the hot issue

Can the E&P debtor reject, under Section 365 of the Bankruptcy Code, what is in today’s environment an above-market agreement?

The typical contract dedicates the producer’s oil and gas interests and associated acreage to its midstream counterparty.  These dedications assure that the producer and everyone who follows will be bound by the original bargain. Midstream companies invest billions of dollars to develop the infrastructure necessary to gather, process, and transport oil and gas for their E&P counterparty-producer.

A significant right of a debtor is to reject burdensome executory contracts. Upon rejection, the debtor no longer can be compelled to perform, leaving the counterparty with a breach of contract claim, which generally an unsecured claim worth very little. Bankruptcy courts apply a business judgment standard to the debtor’s decision, and generally do not consider the effect on the counterparty.

The legal question

From the midstream company‘s point of view: Dedications of producers’ underlying mineral interests are covenants running with the land that are real property interests and therefore, cannot be rejected in bankruptcy.

From the debtor’s point of view: The gathering and processing agreements are executory commercial services agreements and only affect personal property interests – oil and gas that has already been severed from the land.

How it will be resolved

Reconciling the issue requires examination of state law. At least in Texas, courts have not been asked to determine whether a producer’s dedication of reserves is a real property interest or a commercial agreement. Bankruptcy courts are left to speculate how a state court would rule on this issue.

What does it mean for the future?

The resolution could have a far-reaching effect on the structural and financial underpinnings of both midstream and E&P companies. If these agreements can be shed, the sanctity of thousands of bargained-for contracts is in jeopardy, investor confidence in midstream companies will be shaken, and the cost of capital and thus the price producers would have to pay for gathering and processing services, will increase.

On the other hand, saddling a bankrupt producer with an above-market contract would limit its ability to restructure.

Bragging on Gray Reed

In the Quicksilver bankruptcy, see the objection by Crestwood Midstream Partners to the debtor’s motion to reject a gathering, processing and transportation agreement. Kudos to Gray Reed lawyers Philip Jordan, Lydia Webb, Jonathan Hyman and James Ormiston.

Our musical interlude: A message from litigants to judges everywhere.