Executory Contracts Rejected In Chapter 11 Bankruptcy; How Does This Impact Midstream Providers?

A recent bankruptcy court decision could have wide-reaching implications for pipeline operators. Judge Shelley C. Chapman of the United States Bankruptcy Court, Southern District of New York, ruled last week that Sabine Oil & Gas, a bankrupt independent producer, could withdraw from its contract obligations with midstream providers to ship hydrocarbons through the pipelines of two different companies, even though the agreements governing their relations specifically stated that debtor/trustee Sabine's obligation to dedicate acreage to the agreements were covenants running with the land. This decision, which is at odds with rulings from other courts, sent shockwaves throughout the industry as shares of major pipeline operators fell upon news of the ruling, with the Dow Jones index of pipeline operators ending down more than five percent.

The ruling by the Bankruptcy Court is the first major test of whether Chapter 11 can be utilized to terminate an executory contract with midstream providers. Section 365(a) of the Bankruptcy Code provides that a trustee (or debtor-in-possession) may, subject to court approval, assume or reject any executory contract of the debtor. An executory contract is a contract under which there are material, unperformed obligations of both the debtor and the other party to the contract. A debtor's decision to assume or reject an executory contract must be based on sound business judgment. In this case both contracts declared that the debtor's obligations "run with the land."

While the Court decided that the contracts could be rejected as a "reasonable exercise of business judgment," for procedural reasons it did not make a final determination on whether Sabine's obligations under the contracts were covenants running with the land. Nevertheless, Judge Chapman devoted ten pages to an analysis of Texas property law before concluding that "the Court preliminary finds that none of the covenants runs with the land either as a real covenant or as an equitable servitude." The decision is not binding on any other court, but it may encourage other struggling producers to follow suit at a time when many oil and gas companies are one step ahead of bankruptcy.

Ultimately, last week's ruling covered four specific midstream agreements entered into by a single debtor. More debtors may attempt rejection and trial and appellate courts will have to consider the laws of the oil producing states before the issues raised in Sabine are fully settled.

In light of this decision, mid-stream providers should consider taking actions that can strengthen their position and bargaining leverage in the event of a bankruptcy filing.

If you have any questions, please contact Risa Wolf-Smith and Matt Ochs (Bankruptcy), or Chris Jones (Oil & Gas).


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