Addressing a pivotal issue of state law not yet decided by the Texas Supreme Court, a bankruptcy judge in New York handed a significant although preliminary victory to oil and gas producers in chapter 11, at the expense of pipelines that thought their contracts were inviolable.
Burdened by unprofitable contracts with pipeline companies, Sabine Oil & Gas Corp. initiated a reorganization in July. The agreements obligated the pipeline companies to build pipelines to transport and treat Sabine’s products. The exclusive agreements obligated Sabine to pay monthly gathering fees. If Sabine did not deliver minimum amounts to the pipelines, it was required to make deficiency payments to the pipeline operators.
With the plunge in the prices of oil and gas, it was no longer profitable for Sabine to make minimum deliveries. Sabine therefore promptly filed motions to reject the agreements as executory contracts under Section 365(a).
The pipeline companies responded by pointing to provisions in the agreements characterizing them as “covenants running with the land” that Sabine could not escape, even if the court authorized rejecting the agreements as executory contracts.
Bankruptcy Judge Shelley C. Chapman of Manhattan issued a 19-page opinion on March 8 in which she granted the debtor’s motion to reject the agreements as executory contracts. She did not definitively decide, however, whether the agreements are covenants running with the land. She did give her preliminary, non-final opinion that the agreements are not enforceable as covenants running with the land under Texas law.
Judge Chapman concluded that the “business judgment” standard for rejection of executory contracts was easily met. Indeed, one of the two pipeline companies in the litigation conceded that Sabine was entitled to reject the agreements, leaving aside whether rejection would do any good if they were covenants running with the land.
Allowing rejection fell short of ending the controversy in view of the Second Circuit’s 1993 decision in Orion Pictures. Judge Chapman read that case to mean that the bankruptcy court cannot decide a “substantive legal issue” like covenants with the land as part of a “summary proceeding” dealing with rejection. Judge Chapman said that a motion to reject “is not the time or place for prolonged discovery or a lengthy trial with disputed issues” surrounding covenants running with the land.
She nonetheless went ahead and wrote 10 pages with her non-binding analysis of what she called the “unspeakable quagmire” surrounding the enforceability of agreements that claim to be covenants running with the land. She preliminarily concluded that the covenants at issue were unenforceable because they were neither “real covenant[s]” nor “equitable servitude[s].”
If the covenants eventually are found unenforceable, Judge Chapman said that Sabine can negotiate new gathering agreements with “any party,” saving millions of dollars a year in operating costs. If they do run with the land and remain binding, she said Sabine “will likely need to pursue alternative arrangements” with the gathering companies.
Judge Chapman’s opinion does not say whether she has the ability to issue a final order on the covenants under Orion Pictures and Stern v. Marshall. If the dispute eventually reaches the Second Circuit, the appeals court might certify the state law question to the Texas Supreme Court, because the outcome could profoundly affect oil and gas interests in that state and perhaps elsewhere.