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Assumption and Rejection of Midstream Contracts in Bankruptcy

Empowered

June 10, 2021

The ability to assume or reject executory contracts is one of the primary tools used by debtors in a Chapter 11 reorganization. Where a debtor has a contract with a third party that is “executory”—meaning that ongoing performance obligations remain for both the debtor and the contract counterparty on the date of the bankruptcy filing—the debtor can choose to either assume or reject the contract under 11 USC § 365.

If a debtor chooses to assume the contract, it must cure all defaults under the agreement, and the agreement will “ride through” the bankruptcy unaltered. If the debtor rejects an executory contract, the rejection is treated as a breach by the debtor, and the counterparty to the contract is left with a claim in the bankruptcy for rejection damages caused by the breach. Generally, the standard applied by bankruptcy courts to determine whether rejection of an executory contract should be approved is low. Unless there is bad faith, a bankruptcy court will typically defer to the debtor’s business judgment that rejection is in the best interest of the estate.

In recent years, bankruptcy cases of oil and gas exploration and production (E&P) companies have given rise to litigation concerning the rejection of midstream contracts in bankruptcy. E&P companies may typically have long-term contracts with counterparties that perform midstream services, including gathering and transportation services. These contracts, if entered at times of higher commodity prices, may contain pricing terms that are uneconomic for the debtor at the time of filing, thereby prompting the debtor to seek rejection of the contract as a way to renegotiate pricing terms or seek such midstream service from another party. Rejection of these agreements can be very costly for the counterparty, particularly if the counterparty has expended significant capital upfront to construct gathering, pipeline, and other transportation systems.

Because many of these midstream contracts are written to convey to the counterparty certain real property rights, such as an easement or a dedication of oil and gas, counterparties faced with rejection have argued that the contracts “run with the land” and convey real property rights that cannot be rejected. As discussed below, cases that initially addressed this argument based a debtor’s ability to assume or reject the contract as a whole on whether the contract contained real property covenants. However, recent cases have taken a more nuanced approach. The Sanchez decision from the US Bankruptcy Court for the Southern District of Texas provides parties with a second level of analysis, distinguishing between whether an executory contract containing covenants that run with the land may be rejected (holding that it may) and the resulting effect on those rights granted to the counterparty under the contract that are not terminated by virtue of the debtor’s rejection.

Relevant Cases

The first leading case to address the “runs with the land” argument was Sabine Oil & Gas Corp.[1] In Sabine, a New York bankruptcy court, interpreting Texas law, found that certain gas gathering agreements did not contain real property covenants and therefore could be rejected by the debtor, a holding that was subsequently affirmed by the US Court of Appeals for the Second Circuit. Subsequently, in the cases of Badlands Energy, Inc. (Colorado bankruptcy court, applying Utah law) and Alta Mesa Resources, Inc. (Texas bankruptcy court, applying Oklahoma law), the bankruptcy courts found that the gas gathering agreements at issue did contain real property covenants and, therefore, could not be rejected.[2]

While the above cases each apply different state law, the basic analysis to determine whether the agreements contain covenants running with the land is the same and focuses primarily on three issues:

  1. Do the covenants in the agreements “touch and concern” a real property interest?
  2. Was there “privity” (horizontal and vertical) between the parties when the agreements were entered into?
  3. Did the parties intend to create a real property covenant, i.e., that the agreements would “run with the land”?

If all three of these elements are present, then the court will find that the agreement contains a real property covenant.

Following these cases, a trio of cases decided in 2020 both more narrowly construed what constitutes a covenant running with the land and either suggested or found that even if a midstream contract does contain a covenant running with the land, it can still be rejected.

In Chesapeake Energy Corp.,[3] the court found that Chesapeake’s gas purchase agreement with the ETC Texas Pipeline did not contain a covenant running with the land under Texas law. Despite express contractual language stating that the parties agreed there was a “covenant running with the land,” the court found that there were other provisions indicating that the parties intended the contract to be personal in nature, including a liquidated damages provision providing for monetary damages and a provision acknowledging that the contract was a forward contract for the sale of gas. In dicta, the Chesapeake court (Jones, J.) also suggested that even if the contract did contain a covenant running with the land, it was not clear that this would preclude rejection.

In Extraction Oil & Gas,[4] a Delaware bankruptcy court found that certain transportation services agreements could be rejected even if they contained covenants running with the land, and that the rights of counterparties under those covenants would be satisfied through the claims process—thereby extinguishing any rights the counterparty had to enforce the covenants against the debtor or subsequent owners of the property to which the covenants attached.

In Southland Royalty Co. LLC,[5] another Delaware bankruptcy court (applying Wyoming law) found that a gas gathering agreement did not contain a covenant running with the land because the agreement related to “produced” gas (which constituted personal property) and therefore did not “touch and concern” the land. The Southland court also followed the decision in Extraction, finding that even if the agreement contained a covenant running with the land, the contract could still be rejected.

The Sanchez Decision

In a nuanced opinion parsing the ability of a debtor to reject an executory contract containing a covenant that runs with the land and the effect of that rejection, Judge Marvin Isgur of the US Bankruptcy Court for the Southern District of Texas ruled on May 6, 2021, that a midstream contract that includes covenants running with the land can be rejected. However, because rejection does not constitute termination but rather is deemed to be a breach of the contract by the debtor, Judge Isgur further held that the debtor’s rejection of the midstream contracts at issue would not strip the counterparty of dedication rights previously granted by the debtor.[6]

Judge Isgur’s analysis was guided by the US Supreme Court’s decision in Tempnology,[7] in which the court considered the effect of rejection on rights that cannot be rescinded by a breach of contract. In so holding, Judge Isgur distinguished his decision in Alta Mesa, in which he held that “[r]eal property covenants are not executory and are not subject to rejection.”[8] In Sanchez, Judge Isgur found that “[a]lthough real property covenants are not terminated by rejection, the existence of a real property covenant does not prevent a debtor from rejecting its executory obligations in a contract.”[9]

Sanchez teaches that the susceptibility of a contract to rejection is only the first part of the analysis; one must look next to the consequences of that breach. In Sanchez, certain real property interests—the dedication rights—had been conveyed to the contract counterparty. Judge Isgur held that while the contract could be rejected, such rejection “does not strip [the counterparty] of rights that would survive breaches outside of bankruptcy.”[10] The court reasoned that a “party who conveys a real property covenant does not recover the transferred property rights by merely breaching the contract. Likewise, when that party rejects the contract under § 365, those rights remain with the non-rejecting party.”[11]

While the Sanchez decision provides further clarity about the ability of a debtor to reject midstream agreements containing covenants that run with the land, the import of the retention of property rights by the counterparty is perhaps more murky. In the Sanchez case, the dedication survived rejection, but the pricing terms, including minimum volume requirements, did not. Accordingly, the debtor must continue to deliver to the gathering system, which provides the counterparty with rights superior to rejection damages, but the case provides no answer as to how much the debtor must pay for the services provided.

We should also note that this is not the last of the Sanchez decisions that could impact rejection analysis. A number of rejection issues remain, including integration and business judgment considerations, which will be addressed by Judge Isgur over the coming weeks or months, unless the parties are able to settle them first. It remains to be seen how debtors rejecting midstream agreements and contract counterparties will navigate practical considerations attendant to the rejection, and how this will impact the ability of counterparties to monetize their property rights on a go-forward basis.



[1] In re Sabine Oil & Gas Corp., 547 B.R. 66 (Bankr. S.D.N.Y. 2016), aff’d, 567 B.R. 869 (S.D.N.Y. 2017), aff’d, 734 F. App’x 64 (2d Cir. 2018); Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC, 550 B.R. 59 (Bankr. S.D.N.Y. 2016), aff’d, 567 B.R. 869 (S.D.N.Y. 2017), aff’d, 734 F. App’x 64 (2d Cir. 2018).

[2] In re Badlands Energy, Inc., 608 B.R. 854 (Bankr. D. Colo. 2019); In re Alta Mesa Res., Inc., 613 B.R. 90 (Bankr. S.D. Tex. 2019).

[3] In re Chesapeake Energy Corp., 622 B.R. 274 (Bankr. S.D. Tex. 2020).

[4] In re Extraction Oil & Gas, 622 B.R. 608 (Bankr. D. Del. 2020).

[5] In re Southland Royalty Co. LLC, 623 B.R. 64 (Bankr. D. Del. 2020).

[6] In re Sanchez Energy Corp., et al., Memorandum Opinion, Case No. 19-34508-MI (Bank. S.D. Tex., May 6, 2021) [Dkt. No. 1923]. This decision is currently on appeal.

[7] Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019).

[8] Alta Mesa, 613 B.R. at 98.

[9] Sanchez Energy, Memorandum Opinion at 15.

[10] Id. at 17.

[11] Id. at 16.