Oil & Gas Gathering Agreements Can Be Rejected as Executory Contracts

June 15, 2017

Midstream gatherers are probably wishing they were in a court in Texas, after having lost twice in the bankruptcy and district courts in New York on the murky topic of covenants running with the land.

District Judge Jed S. Rakoff wrote an opinion on March 10 upholding decisions made in March and May 2016 by Bankruptcy Judge Shelley C. Chapman holding that midstream gathering agreements are not covenants running with the land and may be rejected like any other executory contract under Section 365.

In the course of handing a victory to oil and gas producers at the expense of pipeline companies, Judge Chapman said that the status of gathering agreements was an “unspeakable quagmire.” If the pipeline companies take another appeal, perhaps they will ask the Second Circuit to certify a question to the Texas Supreme Court, which has not spoken directly to the issue.

The dispute arose soon after commencement of the chapter 11 reorganization of Sabine Oil & Gas Corp. last year. 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. Sabine was required to make deficiency payments if it did not deliver minimum amounts to the pipelines. The gas remained the property of Sabine.

When commodity prices plunged, it was not profitable for Sabine to make minimum deliveries. The company therefore filed motions to reject the agreements as executory contracts under Section 365(a). The gatherers argued that the agreements contained covenants running with the land that would remain enforceable even if the agreements themselves were rejected.

Dissecting the facts and applying state law, Judge Rakoff held that the agreements were not covenants running with the land because they failed the two tests under Texas law. First, he said they “did not increase [the pipeline companies’] real property interests, but rather granted them merely contractual rights to be exclusive providers of certain services.”

Judge Rakoff rejected the argument that the pipeline agreements were similar to royalty agreements. He said that a royalty is a “specified proportionate share of production once minerals are produced,” whereas the pipeline companies “received no right to any share” of the gas that came out of the ground. Instead, they were “entitled to process those minerals in exchange for a fee,” then redeliver the gas to Sabine.

In short, Judge Rakoff said that the gatherers did not “receive any of the other mineral rights or interests recognized under Texas law.”

The agreements likewise failed the second test – that the agreements must “touch and concern the land” – because they did “not reduce Sabine’s ability to make use of or alienate its real property interests.”

Alternatively, the pipeline companies contended that the agreements were equitable servitudes. Affirming Judge Chapman on that score too, Judge Rakoff tersely said the agreements did not limit Sabine’s use of the property and benefitted only the pipeline companies, “not their land.”

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