Monday, June 19, 2017

Oil & Gas Gathering Agreements Can Be Rejected as Executory Contracts

By Bill Siegel

The oil and gas industry is usually divided into three major components: upstream, midstream and downstream. The midstream sector involves the transportation either by pipeline, rail, barge, oil tanker or truck, storage, and wholesale marketing of crude or refined petroleum products.

Midstream gatherers are facing issues they did not anticipate in bankruptcy proceedings.  Moreover, bankruptcy courts in Texas are treating midstream gatherers differently than in New York.  

Under the United States Bankruptcy Code, a debtor may assume its beneficial executory contracts and reject those that are burdensome to the estate. See 11 U.S.C. § 365.  An executory contract is a contract made by two parties in which the terms are set to be fulfilled at a later date. The contract stipulates that both sides still have duties to perform before it becomes fully executed.

In bankruptcy, oil and gas companies are filing motions to reject the midstream gathering agreements, arguing that the agreements are executory contracts that can be accepted or rejected and that rejection is well within a company's business judgment to reject the agreements because the agreements are unduly burdensome and such rejection would benefit the estate.  

The midstream gathering parties typically object, arguing that the covenants in the agreements run with the land under applicable Texas law and should therefore not be rejected in bankruptcy because any agreement that conveys a real property interest is not subject to rejection as an executory contract.

The Texas Courts typically have ruled in favor of the midstream gatherers, which is why the decision in Sabine Oil and Gas Corp., **1  has created a bit of a controversy.  

In Sabine, the gathering agreements obligated the pipeline companies to build pipelines to transport and treat Sabine’s products. The agreements obligated Sabine to pay monthly gathering fees. When the oil and gas prices plunged, it was no longer profitable for Sabine to make minimum deliveries.  Sabine therefore filed a motion to reject the agreement as an executory contract under Section 365(a).

In HPIP Gonzales Holdings LLC v. Sabine Oil & Gas Corp, **2  the United States District Court held that the agreements were not covenants running with the land because they failed two specific tests under Texas law.   In its analysis, the court focused on two tests to determine whether the rights of the midstream gatherers “touches and concerns the land", which if it did, meant that the contracts were NOT executory.

In making that determination, courts in Texas have applied 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." Westland, 637 S.W.2d 903, 911 (Tex. 1982). 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." Id. Meeting one of the two tests will satisfy the "touch and concern" requirement.  **3

Thus, first the Court noted that the contracts did not grant the midstream gatherers real property interests but instead “merely contractual rights to be exclusive providers of certain services.”  **4  In its analysis, the Court analogized whether the mid-stream gathering agreements were like royalty agreements and ruled they were not.  Whereas a royalty is a “specified proportionate share of production once minerals are produced,” **5 the mid-stream gatherers “received no right to any share” **6of the gas that came out of the ground.  Instead,  the court ruled that the midstream gatherers were only “entitled to process those minerals in exchange for a fee,” **7 then redeliver the gas to Sabine.  The court further noted the mid-stream gatherers have no right to receive any of the other mineral rights or interests recognized under Texas law.

The court further noted that the midstream  agreements also failed the second test in that the agreements did not “touch and concern the land” because they did “not reduce Sabine’s ability to make use of or alienate its real property interests.” **8

As a result, the court ruled that the midstream contracts were executory and could be rejected.  Thus, the decision as to whether or not a mid-stream gathering contract is executory may very well be determined by where the bankruptcy proceeding is pending.

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  1. In re Sabine Oil & Gas Corp., Case No.15-11835 (Bankr. N. D. N.Y. 2015).
  2. HPIP Gonzales Holdings LLC v. Sabine Oil & Gas Corp. (In re Sabine Oil & Gas Corp.), 16-4127 (S.D.N.Y. March 10, 2017)
  3. Id. at 8.
  4. Id. at 11.
  5. Id. at 9.
  6. Id. at 9.
  7. Id. at 10.
  8. Id. at 14.
     

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