rejection of midstream 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?

Empty tomb with three crosses on a hill side.

Co-author Lydia Webb

One of the hottest issues from 2016 was whether an E&P debtor can reject, under section 365 of the Bankruptcy Code, an above-market midstream contract. Given the potential for a “no-win” situation, in all but one case where the issue arose E&P debtors and midstream companies were able to settle, often by entering into new midstream contracts upon mutually agreeable terms that take into account the changed market conditions since the downturn in commodity prices.

However, the bankruptcy judge in Sabine Oil and Gas Corp. held that an E&P debtor could reject its gas gathering agreements because its midstream counter-parties could not establish that their agreements were covenants running with the land under Texas law. The midstream companies appealed to the U. S. District Court for the Southern District of New York, hoping for a better answer. They did not get their wish.

Many were surprised by the opinions, given the billions of dollars invested in necessary midstream infrastructure that was built under the assumption that gathering, processing and transportation agreements would bind the producer’s successors. The Sabine court was unsympathetic, and last month affirmed the bankruptcy court’s rejection orders. The midstream companies’ primary argument was that the dedication language in the agreements were analogous to the conveyance of a royalty interest in minerals “produced and saved”.  Thus, Sabine’s dedication must have conveyed a real property interest. The district court was not impressed, and held that the gathering agreements were mere service contracts, and Texas law did not support a finding that they constituted a conveyance of mineral rights or otherwise burdened the underlying leases.

The debate will continue. Sabine is not the end of the argument that interests created by midstream oil and gas agreements are covenants running with the land that can survive a producer’s bankruptcy. Why?

  • A Texas court has not yet ruled on the issue, although at least one Houston bankruptcy judge has commented that he would love the opportunity to set the record straight for his New York colleagues. Given the complex issues of state law involved in the interpretation of these agreements, there is reason to believe that a Texas judge experienced in Texas property law would rule differently.
  • Energy companies continue to construct creative arguments that these agreements create real property interests that cannot be shed in bankruptcy. Most recently, in the Vanguard Natural Resources Corp. bankruptcy it has been argued that the right to drill and develop acreage assigned under a farmout agreement creates a covenant running with the land that burdens the entirety of the lessee/farmor’s undeveloped acreage (Caveat: This is not a midstream situation).

Stay tuned. Whether these arguments hold water, and in which contexts, is yet to be seen. What is clear is that midstream companies will continue to innovate in their effort to protect agreements in which they have invested millions of dollars, and the producers will respond.

It’s Holy Week, a time for musical interludes, one Jesusy but not churchy, one churchy. See you there.