In our June 8, 2016 column, we discussed the U.S. Bankruptcy Court for the Southern District of New York's (the Bankruptcy Court) opinion in the Sabine Chapter 11 cases allowing Sabine (a large Houston-based “upstream operator”) to reject “gathering agreements” with certain “midstream operators.” The decision was noteworthy because the midstream operators alleged that the gathering agreements contained covenants that “run with the land,” which could not be shed through exercise of a debtor's right to reject executory contracts and unexpired leases under Bankruptcy Code Section 365, see In re Sabine Oil & Gas, 550-B.R. 59 (Bankr. S.D.N.Y. 2016). Recently, the Second Circuit affirmed this conclusion and held that Sabine could reject the gathering agreements in their entirety because “horizontal privity of estate,” which is required to create enforceable real property covenants in certain states, did not exist at the time the gathering agreements were executed, In re Sabine Oil & Gas Corp., 2018 WL 2386902 (2d Cir. May 25, 2018).

Gathering Agreements

In the oil and gas world, midstream operators provide a critical bridge between “upstream” exploration and production companies and “downstream” operators who handle marketing and delivery of the oil and gas extracted by the upstream operator.

Under the typical gathering agreement documenting the relationship between upstream and midstream operators, the upstream operator will “dedicate,” for the benefit of the “midstream operator,” all oil and gas produced from certain designated sites. In return, the midstream operator will agree to gather and process the oil and gas received from the upstream operator and deliver the processed hydrocarbons to a downstream company or other specified location in exchange for minimum monthly or annual payments. In order to perform these services, the midstream operator is required to construct pipeline systems, treatment facilities and other infrastructure, often at a significant upfront expense (Nordheim, the midstream operator at issue in Sabine, spent in excess of $80 million constructing the infrastructure necessary to perform its obligations under the gathering agreements).

To protect its significant upfront capital investment, the midstream operator will generally require that the gathering agreement identify the upstream operator's dedication and payment obligations as covenants that “run with the land.” If properly structured, these real property covenants will be binding on future successors of the covenanting parties and future owners of the burdened real property. The requirements necessary to create enforceable covenants that “run with the land” vary from state to state, but all applicable requirements must be satisfied in order to create an enforceable covenant.

Contract Rejection

In Sabine and other recent Chapter 11 cases commenced by upstream operators, the debtors have attempted to shed certain off-market gathering agreements under Bankruptcy Code Section 365, which provides a debtor wide latitude to reject executory contracts and unexpired leases. Any properly structured covenants running with the land will survive rejection of the gathering agreement and remain binding on the reorganized company or any other party that acquires the real property burdened by the covenants in connection with the upstream operator's Chapter 11 case. However, if a bankruptcy court determines that any of the applicable state law requirements were not satisfied at the time the gathering agreement was executed, the dedication and payment covenants can be rejected along with all other parts of the gathering agreement. In this case, a midstream operator would be left only with an unsecured rejection damages claim entitling it to a pro rata share of any distributions to unsecured creditors.

Texas Law and 'Sabine'

Under Texas law, which governs the gathering agreements at issue in Sabine, it is well settled that a covenant “runs with the land” when “it touches and concerns the land; it relates to a thing in existence or specifically binds the parties and their assigns; it is intended by the original parties to 'run with the land'; and the successor to the burden has notice.” The Bankruptcy Court in Sabine observed that many Texas state courts have treated “horizontal privity” as a fifth requirement for the creation of an enforceable covenant and therefore included horizontal privity as part of its analysis. The litigation in Sabine, both before the Bankruptcy Court and on appeal, focused on the touch and concern and horizontal privity requirements.

Touch and Concern

Under Texas law, a covenant “touches and concerns” real property when it affects either “the value of the real property or the owner's interest in or use of the real property.” However, in Sabine both the Bankruptcy Court (and the U.S. District Court for the Southern District of New York (the district court) on appeal) found that the covenants at issue burdened personal property and not real property. Both courts noted that Texas law draws an important distinction between underground oil and gas reserves (which are treated as real property) and produced oil and gas (which is treated as personal property immediately upon extraction).

Critically, Nordheim's pipeline systems connected to Sabine's pipelines at above-ground “central delivery” points (and were not directly attached to Sabine's wells). As such, both the Bankruptcy and District Courts characterized the Sabine gathering agreements as personal property services agreements and stressed that even though Sabine's dedication and payment covenants were labeled as covenants that run with the land in the agreements, the covenants did not have a “direct impact upon the real property” from which oil and gas was produced. This deficiency alone was sufficient to defeat Nordheim's argument that Sabine's dedication and payment obligations were enforceable real property covenants.

Horizontal Privity

As noted above, the Bankruptcy Court cited several Texas cases recognizing “horizontal privity” of estate as a fifth requirement for creating enforceable covenants under Texas law.

Horizontal privity requires that, at the time a covenant is agreed upon, the covenanting parties share some existing interest in the burdened real property independent of the covenant (most commonly as purchaser and seller). For example, assume that the deed transferring title to a parcel of land contains a covenant requiring the purchaser to refrain from taking certain actions in respect of the land (such as a restriction on the height of any future buildings). In this example, because the seller and the purchaser share an interest in the land as a result of the sale, horizontal privity exists between them. Additionally, in a recent Fifth Circuit case highlighted by the Bankruptcy Code, horizontal privity existed in a pipeline sale where the seller retained the right to a fee based on future amounts transferred through the pipeline and the right to consent to future sales of the pipeline, (citing Newco Energy v. Energytec, (In re Energytec), 739 F.3d 215, 222 (5th Cir.2013)).

Second Circuit Opinion

The Second Circuit's Sabine opinion focuses exclusively on the issue of horizontal privity. The decision was entered in the form of a “summary order,” it is not binding precedent under the local rules of the Second Circuit. On appeal, Nordheim argued both that horizontal privity is not required to create an enforceable covenant under Texas law and, alternatively, that horizontal privity existed at the time it contracted with Sabine. With respect to the latter argument, Nordheim stressed that it received both an easement over the land on which its pipelines would run and title to the parcel of land on which it built its gas treatment facility.

In rejecting these arguments, the Second Circuit began its analysis with a clear statement that “horizontal privity remains a requirement of Texas real covenants.”[xv] It then stressed that in order to create horizontal privity, the covenanting parties must convey an interest in the land that is the “subject” of the covenant. In Sabine, the covenants at issue burdened gas extracted from two wells, which was personal property under Texas law at the time it was delivered to Nordheim. Transfer of title to and receipt of an easement over land that was distinct from, even if related to, the burdened personal property did not create horizontal privity in the view of the Second Circuit.

Analysis

The requirements necessary to create covenants that run with the land vary from state to state and, as the Second Circuit noted, there is a “trend across the country toward elimination of the horizontal privity requirement.” However, the Second Circuit's decision should be extremely concerning for midstream operators party to gathering agreements governed by Texas law or the laws of another state that requires privity in order to create enforceable real property covenants.

First, the Second Circuit explicitly held that horizontal privity is required to create an enforceable covenant under Texas law (and declined the opportunity to refer this question to the Texas Supreme Court, as Nordheim had requested). The Second Circuit also affirmed the Bankruptcy Court's finding that horizontal privity does not exist absent a transfer of an interest in property that is the subject of the covenant.

In the context of gathering agreements, this interpretation of horizontal privity would require a midstream operator to receive an interest in an upstream operator's mineral estate in connection with execution of the gathering agreement. Under Texas law, a mineral estate is composed of comprised of “five real property rights, or 'sticks,'” which include: “the right to develop … the right to lease … the right to receive bonus payments, the right to receive delay rentals, [and] the right to receive royalty payments.” As the Bankruptcy Court stressed “a right to transport or gather produced gas is clearly not one of these sticks.” Given that it would be highly unusual for a midstream operator to receive an interest in one of the five “sticks” of an upstream operator's mineral estate, it is highly unlikely that horizontal privity existed at the time most midstream agreements governed by Texas law were created.

Conclusion

Investors in distressed energy companies party to midstream agreements should pay careful attention to the state law governing the agreements. Where privity is required, a Chapter 11 process may provide significant leverage for an upstream operator seeking to terminate a midstream agreement (or as is more often the case, use the threat of termination to renegotiate the existing midstream agreement on more favorable terms). Additionally, the Sabine decisions could lead many midstream operators to either insist upon a transfer of a portion of the upstream operator's mineral estate, in order to create horizontal privity, or looks for ways to shift part of the upfront infrastructure cost to the upstream operator in future contract negotiations.

John J. Rapisardi is a partner and co-chair of the corporate restructuring practice of O'Melveny & Myers. Joseph Zujkowski is a counsel in the restructuring practice at the firm and an adjunct professor of law at Cardozo School of Law.