Oil and Gas Industry Update: Second Circuit Upholds Rejection of Sabine Gas Gathering Agreements

In a highly anticipated decision—Sabine Oil & Gas Corp. v. Nordheim Eagle Ford Gathering, LLC (In re Sabine Oil & Gas Corp.), 734 Fed. Appx. 64, 2018 WL 2386902 (2d Cir. May 25, 2018)—the U.S. Court of Appeals for the Second Circuit in a summary order upheld a 2017 ruling by district judge Jed S. Rakoff that affirmed 2016 bankruptcy court rulings authorizing chapter 11 debtor Sabine Oil & Gas Corp. ("Sabine") to reject certain gas gathering and handling agreements under section 365 of the Bankruptcy Code. See HPIP Gonzales Holdings, LLC v. Sabine Oil & Gas Corp. (In re Sabine Oil & Gas Corp.), 567 B.R. 869 (S.D.N.Y. 2017). According to the Second Circuit, the lower courts did not err in finding that the agreements could be rejected because, under applicable non-bankruptcy law, the agreements contained neither real covenants running with the land nor equitable servitudes.

The Bankruptcy Court's Rulings

Prior to filing for chapter 11 protection in the Southern District of New York in July 2015, Sabine entered into three gas gathering and handling agreements with Nordheim Ford Gathering, LLC ("Nordheim") and HPIP Gonzales Holdings, LLC ("HPIP"). All of the agreements were governed by Texas law.

In connection with its efforts to restructure in chapter 11, Sabine filed a motion to reject the gathering agreements. Sabine argued that it could not deliver the required minimum amounts of gas and condensate under the agreements and that rejection would save it as much as $115 million. In addition, Sabine had the ability to deliver the gas through other avenues, an option that is not always available to producers. Nordheim opposed the motion to reject, arguing that rejection was not a proper exercise of Sabine's business judgment because the agreements included dedications that Nordheim alleged were covenants running with the land, which would continue to burden the debtor's interests following rejection.

Although HPIP did not oppose rejection, it too argued that the relevant hydrocarbon dedications were covenants running with the land which would survive rejection. Sabine countered that the purported dedications lacked the requisite intent and privity to establish covenants running with the land and were not consistent with real property conveyances under Texas law, since they lacked traditional real property terms and were instead more consistent with services agreements.

In 2016, bankruptcy judge Shelley C. Chapman held that Sabine's rejection of the midstream agreements was a proper exercise of Sabine's business judgment, but she determined that the questions of Texas real property law were not properly before the court because those issues could not be adjudicated in the context of a motion to reject an executory contract. See In re Sabine Oil & Gas Corp., 547 B.R. 66 (Bankr. S.D.N.Y. 2016). In a nonbinding portion of her ruling, however, Judge Chapman noted that the agreements failed to meet Texas's test for covenants running with the land.

Under Texas law, four conditions must be met for a covenant to run with the land: (i) it "touches and concerns the land"; (ii) it relates to a thing in existence or specifically binds the parties and their assigns; (iii) the covenant is intended by the original parties to run with the land; and (iv) the successor to the burden has notice of the covenant. A covenant "touches and concerns" land if: (a) it lessens the promisor's legal relations or increases the promisee's legal relations with respect to the land; or (b) it affects the nature, quality, or value of the subject of the covenant or affects the mode of enjoying it.

In dicta, Judge Chapman wrote that "none of the covenants runs with the land either as a real covenant or as an equitable servitude." In particular, she explained that the covenants merely identified the rights and obligations related to the services to be provided under the agreements and did not convey interests in the underlying real property.

Sabine later commenced adversary proceedings against Nordheim and HPIP before Judge Chapman, seeking a declaratory judgment that the covenants included in the agreements did not run with the land.

In Sabine Oil & Gas Corp. v. HPIP Gonzales Holdings, LLC (In re Sabine Oil & Gas Corp.), 550 B.R. 59 (Bankr. S.D.N.Y. 2016), Judge Chapman granted Sabine's motion for summary judgment in those adversary proceedings, ruling, for substantially the same reasons articulated in her earlier opinion, that the covenants in the rejected midstream gathering agreements "do not run with the land either as real covenants or as equitable servitudes."

The judge concluded, among other things, that in accordance with Texas law, the covenants in the agreements do not "touch and concern" Sabine's real property. "By the plain terms of the [agreements]," Judge Chapman wrote, "the mineral dedications concern only minerals extracted from the ground, which indisputably constitute personal property, not real property, under Texas law."

The judge also concluded that, even if "horizontal privity of estate" were an additional (fifth) requirement under Texas law for a covenant to run with the land, such privity did not exist between Sabine and Nordheim or between Sabine and HPIP. She explained that horizontal privity is created by "the conveyance of an interest in property that itself is being burdened with the relevant covenant, not the conveyance of an interest in property that is distinct from (even if somewhat related to) the property burdened by the covenant."

Finally, Judge Chapman ruled that the covenants at issue did not limit the use of or burden Sabine's mineral estate such that they could run with the land as equitable servitudes, because the agreements with Nordheim and HPIP "are fundamentally service contracts relating to personal property of Sabine."

In May 2016, Judge Chapman separately entered an order authorizing Sabine to enter into an alternative gas gathering agreement with DCP South Central Texas LLC. She later denied Nordheim's motion seeking a stay of that order pending appeal as well as permission to appeal her rulings directly to the U.S. Court of Appeals for the Second Circuit. Nordheim and HPIP appealed Judge Chapman's rulings authorizing rejection of the gas gathering agreements to the district court.

The District Court's Ruling

The district court affirmed those rulings in March 2017. Judge Rakoff held that the gas gathering agreements did not include covenants which "touch and concern" the land because the agreements neither "increased [Nordheim's and HPIP's] legal relations to the real property interests at issue [n]or decreased Sabine's." The judge rejected Nordheim's assertion that Sabine's "dedication" of the gas and condensate which was produced and saved in the Nordheim dedicated areas for gathering conveyed an interest in minerals in the ground, which under Texas law is a property interest. "[T]he nature of the interest that Nordheim received," he wrote, "is different from a royalty interest" because Nordheim did not receive the right to any share of the gas that came from the designated areas, but merely the right to process the gas and redeliver it to Sabine in exchange for a fee. Judge Rakoff also found that Sabine did not convey any real property interests to Nordheim or HPIP by dedicating leases to performance of the agreements.

Judge Rakoff concluded that the agreements did not decrease Sabine's legal relation to its real property interests. Sabine's obligation under the agreements, he wrote, "is simply to use Nordheim's and HPIP's respective gathering and processing services when it does not produce and deliver gas and condensate, and that restriction does not limit Sabine's enjoyment of the land itself."

Judge Rakoff also concluded that the covenants in the agreements did not "affect[] the nature, quality or value of the thing demised, independently of collateral circumstances" or affect the mode of enjoying it. He found, among other things, that the agreements did not reduce Sabine's ability to make use of its real property interests. Given his finding that the covenants did not satisfy the "touch and concern" requirement, Judge Rakoff declined to address whether a real covenant under Texas law requires horizontal privity and, if so, whether such privity existed in the case before him.

Finally, Judge Rakoff ruled that the bankruptcy court did not err in concluding that the gas gathering agreements did not contain equitable servitudes as a matter of Texas law. He explained that the gas gathering agreements "do not limit Sabine's use of its property interests in the Dedicated Areas" and that the agreements themselves "do not render more valuable the land on which appellants have located their processing facilities."

Nordheim and HPIP appealed Judge Rakoff's ruling to the U.S. Court of Appeals for the Second Circuit.

The Second Circuit's Ruling

In its summary (nonprecedential) order, the Second Circuit affirmed the rulings below.

The court explained that it need not determine whether the gas gathering agreements "touch and concern" the land "because we find that Texas still requires horizontal privity and that it was not satisfied in this case." Agreeing with the bankruptcy court and finding that decisions cited by Nordheim were inapposite, the Second Circuit rejected Nordheim's argument (HPIP having withdrawn from the appeal) that horizontal privity of estate is established through the separate agreements conveying the pipeline easement and a separate parcel of land.

The Second Circuit also rejected Nordheim's argument that the agreements created equitable servitudes creating a property interest which could not be rejected under section 365. According to the court, "There is simply no colorable argument that these agreements created an equitable servitude because there is no benefit to the real property of Nordheim."

On June 27, 2018, the Second Circuit denied Nordheim's motion seeking reconsideration of the court's ruling.

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