Ignoring the Labels: Oil and Gas Gathering Agreements as Executory Contracts

Although 11 U.S.C. § 365(a) allows for rejection of executory contracts, determining whether a contract is, in fact, executory can be challenging. As illustrated by a recent Second Circuit case, whether an oil and gas gathering agreement can be fully rejected as an executory contract depends on the state law governing the dispute and the relationship of the covenants to real property.

In an unpublished decision issued in May 2018, the Second Circuit Court of Appeals affirmed a bankruptcy court decision finding that certain oil and gas gathering agreements were not covenants that “run with the land” and therefore could be rejected as executory contracts.[1] While the Second Circuit’s decision was premised on a finding of a lack of horizontal privity, that finding is of limited value given that the requirement is being abolished in a growing number of jurisdictions.[2] The analysis afforded by the bankruptcy court and district court, however, suggest that elimination of the horizontal privity requirement would not necessarily change the result unless the covenants can be shown to have a beneficial impact on the land itself, not merely on the product derived from the land.

Background

On July 15, 2015, Sabine Oil & Gas Corp., along with certain affiliated entities, filed petitions for chapter 11 relief in the Southern District of New York. The cases were administratively and procedurally consolidated. The debtors, along with additional nondebtor entities, were principally located in Texas and were engaged in the acquisition, production, exploration and development of onshore oil and natural gas properties.

Approximately seven months prior to the bankruptcy filing, Sabine had combined with another entity, Forest Oil Corp. As a result of this combination, Sabine had assumed Forest Oil Corp.’s contracts and debt obligations. Notably, the contracts included agreements with Nordheim Eagle Ford Gathering, LLC and HPIP Gonzalez Holdings, LLC.

The Rejection Motion

Following the commencement of their bankruptcy cases, on Sept. 30, 2015, the debtors filed a motion seeking to reject two contracts with Nordheim and two contracts with HPIP.

The Nordheim contracts consisted of a gas-gathering agreement and a condensate agreement. The gas-gathering agreement required Sabine to deliver gas harvested from a certain geographic area to Nordheim, which would then be processed and then retransferred back to Sabine. In separate agreements, Sabine would convey easements to Nordheim to build a system of pipelines and treatment facilities. The condensate agreement had substantially the same terms but applied to liquid hydrocarbons and other liquid products.

The HPIP agreements were comprised of a gathering agreement and a handling agreement. The gathering agreement required Sabine to deliver oil, gas and water from land subject to certain leases owned by Sabine. Like the arrangement with Nordheim, the agreement included an obligation for HPIP to construct, operate and maintain gathering facilities and provide services related to the oil, gas and water delivered by Sabine. The handling agreement required HPIP to handle the disposal of water and acid gas produced from the leased land and required HPIP to build, operate and maintain facilities for use in connection with the same.

Nordheim and HPIP objected to the motion. In their objections, they highlighted express language in each of the four agreements indicating that Sabine’s obligations were covenants that ran with the land. They reasoned that even if the debtors rejected the other parts of the agreements, Sabine would remain bound to the covenants. Therefore, rejection would not be beneficial to the debtors’ estates. At oral argument, citing to In re Orion Pictures Corp.,[3] Nordheim further argued that the bankruptcy court could not, in the context of a motion, determine whether Sabine’s obligations were covenants that ran with the land.

On March 8, 2016, the bankruptcy court granted the debtors’ motion to reject the Nordheim and HPIP contracts. In rendering its decision, the court agreed with Nordheim’s contention that it could not, as part of the rejection motion, adjudicate the nature of Sabine’s obligations and whether they ran with the land.[4] Instead, the court found that the rejection of the contracts was a reasonable exercise of the debtors’ business judgment because the worst-case scenario for Sabine would be a return to roughly the status quo. If the covenants did not run with the land, Sabine would be free to enter into more favorable contracts. However, if Nordheim and HPIP were correct, then Sabine would have to seek new arrangements consistent with the covenants to which it would remain bound.

Presumably making Nordheim regret its procedural argument, the bankruptcy court did not stop at simply finding that rejection was appropriate. The court also provided a “non-binding analysis” finding that the covenants did not run with the land as either real covenants or equitable servitudes. Each of the contracts had a choice-of-law provision requiring the contracts to be construed using Texas state law. In so doing, the bankruptcy court observed:

Under Texas law, language in a contract containing a covenant is the primary evidence of the parties' intent, but terminology is not dispositive. Rather, a covenant runs with the land when (1) it touches and concerns the land; (2) it relates to a thing in existence or specifically binds the parties and their assigns; (3) it is intended by the original parties to run with the land; and (4) the successor to the burden has notice. Many courts have also required that the parties have horizontal privity of estate.[5]

The court concluded that, notwithstanding their express language, the agreements at issue failed to meet the substantive requirements of horizontal privity and that the covenants “touch and concern” the land.

Horizontal privity did not exist because the agreements themselves did not, in the context of conveyance of an interest of real property, reserve an interest for Nordheim or HPIP. The bankruptcy court explained that “[t]he 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 bankruptcy court determined that the “touch and concern” requirement was not met because the covenants did not affect the land or its value. The court further noted that Texas law treated minerals extracted from the ground as personal property, not real property. The court therefore reasoned that the services to be rendered by Nordheim and HPIP as to Sabine’s already-extracted hydrocarbons would only affect personal property rights and not any real property.

The Adversary Proceedings

Following the decision on their rejection motion, the debtors commenced adversary proceedings seeking declaratory judgments that the covenants do not run with the land. Nordheim and HPIP filed motions for judgment on the pleadings, and the debtors filed motions for summary judgment. On May 3, 2016, the bankruptcy court issued an opinion that largely adopted its prior opinion and granted summary judgment in favor of the debtors. The bankruptcy court also addressed new arguments concerning whether horizontal privity would continue to be required. While the court acknowledged the possibility that Texas courts would decline to require horizontal privity in the future, the bankruptcy court did find that, given the absence of any Texas statute or case law expressly overturning prior precedent, horizontal privity was still a requirement and that none of the contracts satisfied the requirement. Nordheim and HPIP appealed.

The District Court’s Analysis

On appeal, Nordheim and HPIP argued that the bankruptcy court had erred by finding that the agreements did not contain real covenants or equitable servitudes and by allowing the debtors to reject the agreements. In affirming the bankruptcy court, the district court found that the agreements did not run with the land as real covenants or equitable servitudes because the agreements did not touch and concern the land. The district court did not consider whether horizontal privity was required or existed.

The district court emphasized that a covenant “touches and concerns” the land if it satisfies one of two tests:

First, a covenant touches and concerns the land “if it affect[s] the nature, quality or value of the thing demised, independently of collateral circumstances, or if it affect[s] the mode of enjoying it.” Second, a covenant touches and concerns the land either “[i]f the promisor's legal relations in respect to the land in question are lessened” or “if the promisee's legal relations in respect to that land are increased.”[6]

Beginning with the second test, the district court found that the covenants by Sabine to deliver hydrocarbon products already removed from the land did not affect the land. The district court further noted that neither Nordheim nor HPIP received an ownership interest in the hydrocarbon products at any time. Rather, they merely had a right to possession while they processed the products. The district court therefore found that none of the covenants affected Sabine’s enjoyment of the land.

With respect to the first test, the district court rejected assertions that the Nordheim and HPIP agreements affected the value of Sabine’s property interests, as the agreements did not affect the ability to use or transfer any interest in real property. Nordheim appealed this decision to the Second Circuit.

The Second Circuit’s Decision

On May 25, 2018, in an unpublished decision, a three-judge panel of the Second Circuit Court of Appeals affirmed the district court’s decision. The argument had been distilled to a single issue: whether the lower courts had erred in construing the contracts as creating personal obligations rather than covenants that run with the land. Pivoting from the district court’s analysis, the Second Circuit affirmed solely on a finding that the contractual agreements lacked horizontal privity.

Conceding a general trend toward abolishing the horizontal privity requirement, the Second Circuit noted that there was no Texas law that supported adoption of this trend. Agreeing with the bankruptcy court, in the absence of a statute or case law formally abolishing the requirement, the Second Circuit found horizontal privity to remain a requirement of Texas law.

Nordheim’s argument that horizontal privity was established was also rejected. Nordheim asserted that separate agreements conveying easements for pipelines satisfied the requirement because pipelines were necessary to comply with the rejected agreements. However, the Second Circuit rejected the idea that a separate conveyance could be used to establish horizontal privity.

Finally, the Second Circuit rejected Nordheim’s argument that the covenants could be considered equitable servitudes, explaining that no colorable claim could be made because the agreements did not affect any real property owned by Nordheim.

Issues for Future Cases

In the context of a pure gathering arrangement, in which the hydrocarbons have already been harvested and need to be processed before being sent to a refiner, the requirement of horizontal privity will never be met. Such an agreement is a service agreement concerning personal property. The absence of a conveyance of a property interest will be fatal to meeting that requirement.

However, for states having abolished the horizontal privity requirement, the inquiry will turn on whether the covenant “touches and concerns” the land. This is a much closer call and will depend on the specific services being rendered and whether they can be characterized to provide a benefit to real property or an ownership interest in the hydrocarbons while they are still in the ground.