Two recent bankruptcy cases could affect billions of dollars of oil and gas pipeline infrastructure investments. On March 8, 2016, Judge Chapman of the United States Bankruptcy Court for the Southern District of New York issued an opinion allowing bankruptcy debtor Sabine Oil & Gas Corporation to reject gathering agreements with two midstream pipeline companies. The gathering agreements required Sabine to “dedicate” all of the gas “produced” by Sabine in a designated area to the pipelines owned by the midstream pipeline companies. The agreements also required Sabine to pay a fee to the pipeline companies for the use of the pipelines.
Just a few days earlier, Judge Silverstein held an oral argument on a similar motion to reject gathering agreements in the Quicksilver Resources, Inc. bankruptcy case pending in the United States Bankruptcy Court for the District of Delaware. The agreements, like those in Sabine, required Quicksilver to “dedicate” all of the gas “produced” by Quicksilver. Judge Silverstein asked a number of questions at the argument but has not rendered a decision yet.
The ramifications of the decisions from these two influential courts could be far-reaching. If other courts follow Sabine, oil and gas producers are likely to seek to renegotiate gathering and pipeline agreements using the threat of filing a bankruptcy and rejecting the gathering agreements. The Sabine decision provides leverage to the gas producers to negotiate better terms with the midstream pipeline companies.1 It may also chill investment in the industry, which could limit the alternatives available to producers in finding other midstream partners.
An understanding of the industry structure is important. Gas producers like Sabine and Quicksilver enter into oil and gas leases with property owners that allow the producers to drill wells and extract oil and gas from the land. The oil and gas leases typically grant surface rights to the producers to occupy the land in order to drill and operate the well. The leases also give the producers an interest in the minerals under the surface, and the mineral interest is usually considered a real property interest under local law. Under the lease, the producer is required to pay the land owner a royalty on the oil or gas produced by the well.
The gas producers finance the acquisition of the lease and the costs associated with the exploration and drilling with loans that are secured by leasehold mortgages and other liens on the producer’s surface and mineral rights.
The producers need a pipeline to get the oil and gas to market. In modern practice, the pipeline is typically owned by the third-party midstream company, and there is a “gathering agreement” between the producer and the midstream company to “dedicate” all of the oil and gas “produced” from the well to the pipeline, with the producer obligated to pay for the use of the pipeline.
Until the Sabine decision, the oil and gas producers had less leverage to renegotiate the gathering agreements because there is typically only one pipeline to each well and the oil and gas leases frequently expire if production stops for an extended period of time. The producer needs the pipeline in order to keep operating and to get the oil and gas to market.
The issues in Quicksilver and Sabine are playing out under section 365 of the Bankruptcy Code, which allows a debtor to reject any executory contract or lease. If the gathering agreements may be rejected, section 365 gives the producers more leverage, but it remains a giant game of “chicken” because the producer still needs a pipeline to move the oil and gas to market. The cost and practicalities of building a second pipeline favor a resolution that keeps the current pipeline in operation.
The problem is the midstream pipeline companies typically have debt service requirements that are dependent upon the revenue stream originally contemplated by the gathering agreements. This puts some midstream companies in the perilous position of risking the loss of their revenue through the rejection process or defaulting on their loans after renegotiating for reduced revenue. Neither are good results for the midstream companies.
As a result, midstream companies contest attempts to reject the gathering agreements in bankruptcy court. There is no established body of law regarding rejection of gathering agreements because the pipelines either didn’t exist or were owned by the gas producers during the last downturn and there were no gathering agreements to reject. Sabine and Quicksilver are important because they are the first cases dealing with the rejection of gathering agreements, and both are in highly respected and influential bankruptcy courts.
The primary defense raised by the midstream companies in Sabine and Quicksilver is the gathering agreements contain covenants running with the land that cannot be rejected in a bankruptcy. The covenants are based on a “dedication” of the oil and gas “produced” to the pipeline, but the term “dedication” is not well-defined in the law. There are no decisions that determine whether a dedication is a contractual right that could be rejected or a real property interest in the land that may not be rejected. It is also not clear that rejection of the executory contract will invalidate a covenant running with the land and whether the covenant running with the land survives rejection. To further complicate matters, the determination whether the covenant runs with the land is a matter of state law. As a result, the answer could be different depending on the law of the state where the well and the pipeline are located.
The bankruptcy court in the Sabine case determined that Sabine had the right to reject the gathering agreements. The court declined to make a final determination whether the contracts included a covenant running because, in the Second Circuit,2 the process to reject contracts is a summary proceeding that cannot be used to resolve the contested factual issues. Because the determination of whether the covenants run with the land involves contested issues, it is not appropriate for a summary resolution, and more formal litigation would be required before the court would make a final determination.
However, the Sabine judge did make a non-binding determination that the covenants do not run with the land because they were service contracts that did not grant the midstream companies any real property rights recognized by the applicable Texas law. In addition, the Sabine court observed that two of the elements required for covenants to run with the land were not met: (1) there was no privity at the time the gathering agreements were entered into; and (2) the covenants did not “touch and concern” the real estate because they dealt with extracted gas which is personal property, and not real property, under Texas law. Under Texas law, the term “produced” does create an interest in land when used in royalty agreements. However, the Sabine judge refused to extend that meaning to gathering agreements, and the Quicksilver judge expressed doubt about doing so.3
Neither judge addressed a potentially more fundamental issue: whether the bankruptcy court has the ability to divest the property interest, if it exists. This issue is lurking in Quicksilver because the bankruptcy court previously issued an order allowing Quicksilver to sell the wells and the oil and gas leases free and clear of any interests pursuant to section 363(f) of the Bankruptcy Code. The Quicksilver free and clear sale was not contested by the midstream companies who reserved their rights with respect to the rejection issue. If the Quicksilver court follows the Sabine lead, it may decline to determine if the gathering agreements run with the land, and the midstream companies may be stuck with the sale order, which may divest their interests in the property, if the interests exist.
It remains for future cases to address the circumstances in which a gathering agreement covenant running with the land may be divested in a section 363(f) free and clear sale. Generally, section 363(f) permits sales free and clear of “interests”4 in the property being sold provided the sale satisfies the requirements for a free and clear sale.5 Some courts have determined that covenants running with the land cannot be divested in a 363(f) sale.6 However, these cases are decided based on the particular circumstances and the applicability of the sub-parts of section 363(f) to the sale. Section 363(f)(4) permits free and clear sales if the interest is subject to a bona fide dispute. It is not clear whether the courts that have refused to divest covenants running with the land would rule the same way if the property right was subject to a bona fide dispute.
There are limits on divesting interests in property pursuant to a 363(f) sale. One of the limitations requires the party whose interest is divested to receive adequate protection of the interest.8 This usually means that, where the party can be fully compensated by money, funds are set aside to compensate the party for the loss of the interest. However, if there is first priority secured debt exceeding the sale price, there may be little or no adequate protection needed because the secured lender could divest the junior interest in a foreclosure sale.
Given the magnitude of the investments involved in the oil and gas industry and the potential trickle-down effect through the supply chain, these cases involving attempts to reject or divest midstream pipeline agreements are worthy of close attention.
1 Just two days after the Sabine decision, a midstream company reached a tentative agreement permitting Magnum Hunter Resources to reject four pipeline contracts in a bankruptcy case pending in Delaware.
2 Orion Pictures Corp. v. Showtime Network, 4 F. 3d 1095 (2d. Cir. 1993).
3 Although at least one of the gathering agreements expressly provided that it was intended to run with the land, the Sabine court did not address whether the parties intended to create covenants running with the land.
4 “Interests” that may be divested are generally defined broadly to include any that relate to obligations that are connected to, or arise from, the property being sold. In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003); Folger Adam Security, Inc. v. DeMatteis/MacGregor, JV, 209 F.3d 252 (3rd Cir 2000).
5 The applicable sub-parts are: a) section 363(f)(1), which allows the interest to be divested to the extent permitted by applicable non-bankruptcy law; b) section 363(f)(4), which allows an interest to be divested if it is in bona fide dispute; and c) section 363(f)(5), which allows divestment if the holder of the interest could be compelled to accept a money satisfaction of the interest in a legal or equitable proceeding.
6 In re 523 E. Fifth St. Housing Pres. Dev. Fund, 79 B.R. 568 (Bkrtcy.S.D.N.Y.1987); Gouveia v. Tazbir, 37 F.3d 295 (7th Cir. 1994)
7 In re 523 E. Fifth St. Housing Pres. Dev. Fund, 79 B.R. 568 (Bkrtcy.S.D.N.Y.1987); Gouveia v. Tazbir, 37 F.3d 295 (7th Cir. 1994)(recognizing there was no bona fide dispute concerning the interest)
8 11 U.S.C. § 363(e)