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Corporate Restructuring & Bankruptcy | MONDAY, JUNE 13, 2016 | S7
(1) the covenant must “touch and concern” the land; (2) the covenant must “relate to a thing in existence” or specifically bind suc- cessors/assigns; (3) the parties must intend for covenant to run with the land; (4) the successor to the burden must have notice of covenant; and (5) privity of estate must exist.11 Privity means some connection must exist between original and enforcing parties.12 The Texas Supreme Court has not squarely addressed what level of privity is required, and other courts have muddied the waters.13
Problem Presented in Recent Oil, Gas Cases
The analysis of covenants running with the land in connection with a §365 rejec- tion analysis has presented in three recent cases—In re Sabine Oil & Gas, No. 15–11835 (Bankr. S.D.N.Y.); In re Quicksilver Resources, No. 15-10585 (Bankr. D. Del.); and In re Mag- num Hunter Resources, No. 15-2533 (Bankr. D. Del.). In each case, the respective debtors are exploration and production companies and party to gas gathering and dedication agree- ments with midstream pipeline companies.
Each of the relevant agreements are gov- erned by Texas law and generally contain terms common to the industry. For example, in Sabine, the debtor agreed to dedicate all gas produced in a designated area and deliver that gas to the pipeline company. Failure to deliver contractual minimums would trig- ger deficiency payments. In exchange, the pipeline companies agreed to construct systems of gathering stations to transport the gas, and the contracts coincided with separate conveyances of land for the stations. The contracts were all recorded in the real property records of the respective counties and explicitly stated that the contracts were “covenants running with land” enforceable against affiliates, successors, and assigns.
Each of the debtors in Sabine, Quicksilver, and Magnum Hunter sought to reject sev- eral of these agreements pursuant to §365. Rejection of such contracts would allow the debtors to convert significant rejection damages into prepetition claims and to either (1) renegotiate lower contract rates or (2) sell
substantially all of the debtors’ assets, as in Quicksilver, to a buyer who intended to use its own pipeline systems.
But a covenant running with land is a property interest under Texas law.14 As a result, if such covenants existed, either (1) the debtors could not reject the contracts under §365 or (2) the rejections would be ineffective to destroy the counterparties’ property interests. In either circumstance, the debtors would remain liable for the post- petition deficiency payments, which would potentially derail a proposed sale or reorga- nization plan.
One particular property inter- est has created a wrinkle in the typical rejection analysis: covenants running with land.
The arguments in the three cases followed similar logic, with some notable deviations. The pipeline companies argued that the con- tracts (1) demonstrated an “intent to run” through clear language binding successors and assigns, and (2) touched and concerned the land due to the gathering stations and the transportation of gas. Additionally, they argued that only “vertical” privity (unity of contract with former owners) was required and was satisfied by identifiable chains of title.
In reply, the debtors in each case argued the “touch and concern” element was not satisfied because gas in a pipeline is personal property and not real property, as is gas in the ground.15 Likewise, the debtors argued “horizontal” privity (unity of estate when the interest was created) was required and not satisfied.
Outcomes
Sabine ruled first, although the timing of the issue in all three cases overlapped. The Sabine court issued a “non-binding” decision, telegraphing that the contracts were not, and
did not contain, covenants running with land.16 The ruling was non-binding because the court also ruled the issue was not prop- erly before the court. Determination of a property interest requires commencement of an adversary proceeding (a civil proceed- ing conducted in bankruptcy court) and not a contested matter (an evidentiary hearing in connection with a bankruptcy case).17 So the Sabine court granted the motion to reject the contracts and left open the possibility of an adversary proceeding to determine the property interest.18
The Quicksilver court did not rule on the issue because the parties settled shortly after the Sabine court announced its non-binding decision. But Quicksilver involved a twist that made for a closer decision. There, the court had already approved a sale under §363(f) of the debtors’ assets free and clear of all interests. The order approving the sale—to which the counterparties did not object— defined “interest” to include “any dedication under any gathering, transportation, treating, purchasing or similar agreements that relates solely to any” contracts to which debtor is counterparty.19 In other words, the court may have already dealt with the issue even assuming the agreements did constitute or include property interests by virtue of cov- enants running with land.
Finally, in Magnum Hunter, the debtors heeded the Sabine ruling and filed both a motion to reject the contracts and an adversary proceeding to avoid an interest in property.20 Although the par- ties settled, Magnum Hunter presented another situation likely to repeat—the “dual debtor” prob- lem. There, both the party seeking to reject the contract and the counterparty opposing rejec- tion were debtors in pending Chapter 11 cases. In that situation, a debtor may file a motion to reject without seeking permission in the coun- terparty’s bankruptcy,21 although the standard of review may shift from business judgment to a balancing of the equities.22
Conclusion
Contracts negotiated before the recent downturn in oil and gas are often ripe for
rejection upon a Chapter 11 filing. Arguing that such contracts include covenants run- ning with land is one of the few retorts to a debtor’s ability to wield §365. Look for future cases to build on the arguments (and ample briefing) set forth in Sabine, Quicksilver, and Magnum Hunter, and possibly even certify a question to the Texas Supreme Court on the issue.
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1. Haynes & Boone, Oil Patch Bankruptcy Monitor (May 1, 2016). These numbers do not include a rash of fil- ings in May that included Penn Virginia and Linn Energy.
2. 11 U.S.C. §362(a) (2012).
3. In re Siciliano, 13 F.3d 748, 750 (3d Cir. 1994).
4. In most cases, the debtor functions as a “debtor in
possession” and continues to operate the business. 11 U.S.C. §§1107, 1108. The distinction is immaterial in this article, so we refer only to “debtors.”
5. 11 U.S.C. §365(a).
6. Id. §365(g).
7. See, e.g., Orion Pictures v. Showtime Networks (In
re Orion Pictures), 4 F.3d 1095, 1099 (2d Cir. 1993); Byrd v. Gardinier (In re Gardinier), 831 F.2d 974, 975 n.2 (11th Cir. 1987).
8. Vern Countryman, “Executory Contracts in Bank- ruptcy: Part I,” 57 Minn. L. R. 439, 460 (1973). Prof. Coun- tryman’s definition has been widely-adopted, including in the Second, Third, and Fifth Circuits. Phx. Exploration v. Yaquinto (In re Murexco Petroleum), 15 F.3d 60, 62-63 & n.8 (5th Cir. 1994); Sharon Steel v. Nat’l Fuel Gas Distrib., 872 F.2d 36, 39 (3d Cir. 1989); S. Chi. Disposal v. LTV Steel Co. (In re Chateaugay, 130 B.R. 162, 164 (S.D.N.Y. 1991).
9. Butner v. United States, 440 U.S. 48, 55 (1979).
10. 11 U.S.C. §365(f).
11. Inwood N. Homeowners’ Ass’n v. Harris, 736 S.W.2d
632, 635 (Tex. 1987).
12. In re Sabine Oil & Gas, 547 B.R. 66, 76 (Bankr.
S.D.N.Y. 2016) (citing 53 Rocky Mtn. Min. L. Inst. §19.03 (2007)).
13. See Newco Energy v. Energytec (In re Energytec), 739 F.3d 215, 222-23 (5th Cir. 2013).
14. Harris, 736 S.W.2d at 635-36.
15. See Sabine Oil & Gas, 547 B.R. at 78 & n.44.
16. Id. at 74.
17. See Fed. R. Bankr. P. 7001(2).
18. Sabine Oil & Gas, 547 B.R. at 74.
19. In re Quicksilver Res., No. 15-10585 (Bankr. D. Del.
Jan. 1, 2016), ECF No. 1095.
20. Magnum Hunter Res. v. Oneok Rockies Midstream,
LLC (In re Magnum Hunter Res.), Adv. No. 16-50376 (Bankr. D. Del. Filed March 18, 2016) (adversary proceed- ing); In re Magnum Hunter Res., No. 15-2533 (Bankr. D. Del. March 4, 2016), ECF No. 738 (rejection motion).
21. E.g., In re Old Carco, 406 B.R. 180, 211-12 (Bankr. S.D.N.Y. 2009).
22. E.g., In re Midwest Polychem, 61 B.R. 559, 562 (Bankr. N.D. Ill. 1986).
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