In In re Sanchez Energy Corporation, a recent Memorandum Opinion by the United States Bankruptcy Court for the Southern District of Texas (the “Court”), the Court held for arguably the first time that the presence of a real property covenant in an executory contract does not preclude the debtor from rejecting the contract in bankruptcy.
Over the last several years, whether midstream agreements create real property covenants has been a hot issue, particularly in the bankruptcy context. Under many such agreements, the producer of oil, gas, or water purports to dedicate certain real property interests to the midstream provider and commits to deliver to the midstream provider all of the oil, gas, or water produced from such interests. The midstream provider, in turn, may rely upon this dedication and the anticipated continued revenue stream from such production in agreeing to expend capital to build out midstream systems to provide services to the producer, which the midstream provider may plan to recover over the course of several months or years. It obviously creates a big problem for the midstream provider if the agreement may be rejected by the producer in a subsequent bankruptcy proceeding.
Many have assumed that the presence of real property covenants or “covenants running with the land” in such agreements would mitigate this risk by preventing rejection. Accordingly, much time and energy has been spent by both drafters and courts in ascertaining whether certain dedications meet the elements necessary to form real property covenants. In many cases addressing the issue, bankruptcy courts have found that such agreements failed to form real property covenants in the first instance.[1] This characterization has allowed courts to largely avoid the more overarching issue of whether a contract that forms a real property covenant can still be rejected by the debtor in bankruptcy.
In In re Sanchez Energy Corporation, the Court squarely addressed this question for arguably the first time and held that the presence of a real property covenant in an executory contract does not preclude the debtor from rejecting the contract in bankruptcy.[2] As discussed below, this statement of law is contrary to those in other cases. However, the Court further held that the real property covenant formed by the executory contract survived the rejection.
Background
In 2017, SN Maverick (“Maverick”), a subsidiary of Sanchez Energy Corporation (“Sanchez”), purchased from Anadarko assets (the “Comanche Assets”) in the Comanche Field area of the Eagle Ford shale (the “Comanche Transaction”). In conjunction with the Comanche Transaction, Maverick entered into an Oil Gathering Agreement and a Gas Gathering Agreement (the “Gathering Agreements”) whereby it dedicated hydrocarbon production from the Comanche Assets to a pipeline network owned by Springfield Pipeline, LLC (a wholly owned subsidiary of Anadarko). The Gathering Agreements explicitly expressed the intent of the parties to form covenants running with the land of their respective primary obligations. On August 11, 2019, Sanchez and its affiliates filed voluntary petitions under chapter 11 of the Bankruptcy Code.[3] The debtor proposed rejection of the Gathering Agreements, and Occidental, Anadarko’s successor-in-interest, objected.
The Court’s Holdings
With respect to the executory contract rejection issues, the Court first addressed whether executory contracts containing real property covenants could be rejected at all. The Court held that the existence of a real property covenant in an executory contract does not preclude a debtor from rejecting the contract.[4] The Court noted that section 365 of the Bankruptcy Code allows a debtor-in-possession to reject “any executory contract.” Therefore, the Court stated, since executory contracts containing real property covenants still fall within the purview of “any executory contract,” they can be still be rejected.
The Court reasoned that “rejection mirrors a breach of contract outside of bankruptcy” and that a “counterparty retains those contract rights that would survive a breach under applicable non-bankruptcy law.”[5] Because a breach of a contract granting a real property covenant does not terminate such covenant outside of bankruptcy, rejection of that same contract does not terminate the covenant in bankruptcy. Instead, the Court reasoned, rejection of the Gathering Agreements would alleviate the debtor’s burdens under those contracts, but would not affect Occidental’s rights that would survive a breach outside of bankruptcy. That is, despite rejection of the Gathering Agreements, Occidental still held any rights it would have had outside of bankruptcy, including the real property covenants.
The Court next determined that rejection of the Gathering Agreements satisfied the business judgment rule, holding that the debtor’s “decision to reject the [Gathering] Agreements, presumably with the goal of negotiating more favorable gathering terms with Springfield, is a reasonable exercise of its business judgment.”[6] The Court went through each of the elements required to form a real property covenant running with the land and concluded that the Gathering Agreements formed real property covenants that run with the land. Since, as the Court held earlier, rejection of an executory contract in bankruptcy does not eliminate real property covenants contained in the contract, the property rights that Occidental owned under the Gathering Agreements persisted.
Analysis
While the Court’s holding in Sanchez that a contract which forms a real property covenant can be executory and therefore rejected under section 365 is well reasoned, it is at odds with statements of law made in other cases addressing similar agreements. In Alta Mesa, for example, the Court stated expressly what had been the assumption of many that “[c]ontracts forming real property covenants are not executory.”[7] Similarly, the court in In re Sabine Oil & Gas Corp, a New York bankruptcy case applying Texas law, framed the question in that case as “whether the Agreements run with the land and therefore cannot be rejected pursuant to § 365(a).”[8] The Court in Sanchez spent some time attempting to reconcile the differences between the statements of law in Alta Mesa and Sanchez noting that “[t]hat point of the Alta Mesa decision could lead one to believe that a debtor cannot reject an executory contract which creates a real property covenant. Although real property covenants are not terminated by rejection, the existence of a real property covenant does not prevent a debtor from rejecting its executory obligations in a contract.”[9]
Prior to Sanchez, no court had clearly made a distinction between rejecting an executory contract containing a real property covenant and rejecting the actual real property covenant. Sanchez provides clarity as to what kinds of contracts debtors can reject in bankruptcy. The Court makes clear that while executory contracts that form real property covenants can be rejected in bankruptcy, the real property covenants will continue to exist outside of bankruptcy, although, one may wonder, to what practical effect for the midstream provider.
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[1] See, i.e. In re Sabine Oil & Gas Co., 550 B.R. 59 (Bankr. S.D.N.Y. 2016); In re Chesapeake Energy Corp., No. 20-33233, 2020 WL 6325535 (Bankr. S.D. Tex. Oct. 28, 2020).
[2] In re Sanchez Energy Corp., No. 19-34508, 2021 WL 1822708 (Bankr. S.D. Tex. May 6, 2021).
[3] Id. at *4.
[4] Id. at *8.
[5] Id.
[6] Id.. at *11.
[7] In re Alta Mesa Res., Inc., 613 B.R. 90, 99 (Bankr. S.D. Tex. 2019); (Alta Mesa drew some criticism for its reasoning from the court in In re Extraction Oil & Gas, 622 B.R. 608, 620-23, n.34 (Bankr. D. Del. 2020)).
[8] In re Sabine Oil at 76 (emphasis added).
[9]In re Sanchez Energy Corp. at *8.
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