Oil and Gas Industry Update: District Court Upholds Rejection of Sabine Gas Gathering Agreements

Oil and Gas Industry Update: District Court Upholds Rejection of Sabine Gas Gathering Agreements

In a highly anticipated decision—HPIP Gonzales Holdings, LLC v. Sabine Oil & Gas Corp. (In re Sabine Oil & Gas Corp.), 2017 BL 83510 (S.D.N.Y. Mar. 9, 2017)—Judge Jed S. Rakoff of the U.S. District Court for the Southern District of New York affirmed 2016 bankruptcy court rulings authorizing chapter 11 debtor Sabine Oil & Gas Corp. ("Sabine") to reject certain gas gathering and handling agreements. According to Judge Rakoff, the bankruptcy court did not err in finding that the agreements could be rejected under section 365 of the Bankruptcy Code because, under applicable nonbankruptcy law, the agreements contained neither real covenants which run with the land nor equitable servitudes.

Prior to filing for chapter 11 protection in the Southern District of New York in July 2015, Sabine entered into three gas gathering and handling agreements with Nordheim Eagle Ford Gathering, LLC ("Nordheim") and HPIP Gonzales Holdings, LLC ("HPIP"). All of the agreements were governed by Texas law.

In connection with its efforts to restructure in chapter 11, Sabine filed a motion to reject the gathering agreements. Sabine argued that it could not deliver the required minimum amounts of gas and condensate and that rejection would save it as much as $115 million. In addition, Sabine had the ability to deliver the gas through other avenues, an option that is not always available to producers. Nordheim opposed the motion to reject, arguing that rejection was not a proper exercise of Sabine's business judgment because the agreements included dedications that Nordheim alleged were covenants running with the land, which would continue to burden the debtor's interests following rejection.

Although HPIP did not oppose rejection, it too argued that the relevant hydrocarbon dedications were covenants running with the land which would survive rejection. Sabine countered that the purported dedications lacked the requisite intent and privity to establish covenants running with the land and were not consistent with real property conveyances under Texas law, since they lacked traditional real property terms and were instead more consistent with services agreements.

In In re Sabine Oil & Gas Corp., 547 B.R. 66 (Bankr. S.D.N.Y. 2016), bankruptcy judge Shelley C. Chapman held that Sabine's rejection of the midstream agreements was a proper exercise of Sabine's business judgment, but she determined that the questions of Texas real property law were not properly before the court because those issues could not be adjudicated in the context of a motion to reject an executory contract. In a nonbinding portion of her ruling, however, Judge Chapman noted that the agreements failed to meet Texas's five-part test for covenants running with the land, stating that "none of the covenants run with the land either as a real covenant or as an equitable servitude." In particular, she explained that the covenants merely identified the rights and obligations related to the services to be provided under the agreements and did not convey interests in the underlying real property.

Sabine later commenced adversary proceedings against Nordheim and HPIP seeking a declaratory judgment that the covenants included in the agreements did not run with the land.

In Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC (In re Sabine Oil & Gas Corp.), 550 B.R. 59 (Bankr. S.D.N.Y. 2016), Judge Chapman granted Sabine's motion for summary judgment in those adversary proceedings, ruling, for substantially the same reasons articulated in her earlier opinion, that the covenants in the rejected midstream gathering agreements "do not run with the land either as real covenants or as equitable servitudes."

She concluded, among other things, that in accordance with Texas law, the covenants in the agreements do not "touch and concern" Sabine's real property. "By the plain terms of the [agreements]," Judge Chapman wrote, "the mineral dedications concern only minerals extracted from the ground, which indisputably constitute personal property, not real property, under Texas law."

The judge also concluded that, even if "horizontal privity of estate" were a requirement under Texas law for a covenant to run with the land, such privity did not exist between Sabine and Nordheim or between Sabine and HPIP. She explained that horizontal privity is created by "the conveyance of an interest in property that itself is being burdened with the relevant covenant, not the conveyance of an interest in property that is distinct from (even if somewhat related to) the property burdened by the covenant."

Finally, Judge Chapman ruled that the covenants at issue did not limit the use of or burden Sabine's mineral estate such that they could run with the land as equitable servitudes, because the agreements with Nordheim and HPIP "are fundamentally service contracts relating to personal property of Sabine."

On May 17, 2016, Judge Chapman entered an order authorizing Sabine to enter into an alternative gas gathering agreement with DCP South Central Texas LLC. She later denied Nordheim's motion seeking a stay of that order pending appeal as well as permission to appeal her rulings directly to the U.S. Court of Appeals for the Second Circuit. Nordheim and HPIP appealed Judge Chapman's rulings authorizing rejection of the gas gathering agreements to the district court.

The district court affirmed those rulings on March 9, 2017. District judge Rakoff explained that, under Texas law, four conditions must be met for a covenant to run with the land: "it touches and concerns the land; relates to a thing in existence or specifically binds the parties and their assigns; is intended by the original parties to run with the land; and when the successor to the burden has notice." Focusing on the initial element, he further noted that, according to two tests applied in relevant case law, a covenant "touches and concerns" land if: (i) it lessens the promisor's legal relations or increases the promisee's legal relations with respect to the land; or (ii) it affects the nature, quality, or value of the subject of the covenant or affects the mode of enjoying it.

Judge Rakoff ruled that the gas gathering agreements satisfied neither test. He concluded that HPIP and Nordheim failed to show that the agreements "either increased their legal relations to the real property interests at issue or decreased Sabine's." Among other things, the judge rejected Nordheim's assertion that Sabine's "dedication" of the gas and condensate which was produced and saved in the Nordheim dedicated areas for gathering conveyed an interest in minerals in the ground, which under Texas law is a property interest. "[T]he nature of the interest that Nordheim received," he wrote, "is different from a royalty interest" because Nordheim did not receive the right to any share of the gas that came from the designated areas, but merely the right to process the gas and redeliver it to Sabine in exchange for a fee. Judge Rakoff also found that Sabine did not convey any real property interests to Nordheim or HPIP by dedicating leases to performance of the agreements.

Judge Rakoff concluded that the agreements did not decrease Sabine's legal relation to its real property interests. Sabine's obligation under the agreements, he wrote, "is simply to use Nordheim's and HPIP's respective gathering and processing services when it does not produce and deliver gas and condensate, and that restriction does not limit Sabine's enjoyment of the land itself."

Addressing the second test, Judge Rakoff concluded that the covenants in the agreements did not "affect[] the nature, quality or value of the thing demised, independently of collateral circumstances" or affect the mode of enjoying it. He found, among other things, that the agreements did not reduce Sabine's ability to make use of its real property interests. Given his finding that the covenants did not satisfy the "touch and concern" requirement, Judge Rakoff declined to address whether a real covenant under Texas law requires horizontal privity and, if so, whether such privity existed in the case before him.

Finally, Judge Rakoff ruled that the bankruptcy court did not err in concluding that the gas gathering agreements did not contain equitable servitudes as a matter of Texas law. He explained that the gas gathering agreements "do not limit Sabine's use of its property interests in the Dedicated Areas" and that the agreements themselves "do not render more valuable the land on which appellants have located their processing facilities."

Having concluded that the bankruptcy court did not err in ruling that the gathering agreements do not include covenants which run with the land, Judge Rakoff affirmed Judge Chapman's ruling authorizing Sabine to reject the agreements.

Nordheim and HPIP appealed Judge Rakoff's ruling to the U.S. Court of Appeals for the Second Circuit on April 11, 2017.

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