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Treatment of interim agreements in bankruptcy remains uncertain, but limited consensus may emerge | Skadden, Arps, Slate, Meagher & Flom LLP

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  • Pipeline companies have opposed efforts by oil and gas producers to reject interim collection agreements in the event of bankruptcy, saying the exclusive “dedication” provisions in these agreements “run with the land” under state law and prevent rejection.
  • Bankruptcy and appellate courts have come to different conclusions as to the validity of these dedication clauses under state law.
  • But more recent cases suggest an emerging consensus that a debtor can reject an interim collection contract even if its dedication clause applies to the land under state law.

Volatile and generally depressed oil and gas prices have driven more than 250 North American exploration and production (E&P) operators out of business from 2015 to 2021. Although this wave of energy restructuring has subsided with the recent rising commodity prices, the legal issues left in its wake remain relevant.

Few of these issues have generated greater interest than the ability of an E&P debtor to reject onerous interim agreements in the event of bankruptcy. This issue, which sits at the intersection of federal bankruptcy and state oil and gas law, has played a central role in many E&P restructurings since 2015.

Surprisingly, this issue has generated little case law until recently. A series of decisions, starting in late 2019, resulted in an emerging consensus that interim agreements are not completely immune to rejection in the event of bankruptcy. But a definitive answer remains elusive.

Typical interim agreements include a “dedication” clause

E&P debtors used the bankruptcy not only to restructure their balance sheets, but also to recalibrate their cost structures. Intermediate gathering agreements — long-term contracts to transport oil and gas from the wellhead to central facilities by pipeline — are a popular target. Many producers have sought to dismiss these deals as uneconomical, usually despite vigorous opposition from their counterparties.

In most contexts, a debtor seeking to reject an enforceable contract in bankruptcy need only demonstrate that it has a good business reason to do so. But midstream companies have a unique defense. Most gathering agreements contain a “dedication” clause which appoints the middle party as the exclusive provider of the gathering, transportation and processing services for hydrocarbons produced from leases and wells in a specified area. Contracts generally characterize the provision as a clause that “runs with the land”.

These clauses raise two essential questions:

  1. Do these dedication clauses actually create enforceable clauses that apply to the land under state law?
  2. If so, does the operating commitment prevent rejection or does it simply create a in rem the interest that survives it?

Do “dedication” clauses in interim agreements “work with the land”?

A preliminary question is whether the surrender clauses are what they are supposed to be: real covenants or equitable easements that “accompany the land”.

An execution clause is an agreement between owners of real estate that is deemed to attach to and “operate” with the land, binding subsequent owners, even if contractual confidentiality is lost. These commitments originate in the contract but acquire in rem character only if they meet certain requirements prescribed by state law. These vary from state to state, but at common law there are two basic elements: the covenant (1) is one element of a contemporaneous transfer of real property between the contracting parties (known as a “horizontal lien “); and (2) “touches and relates” to the earth, which basically means that it benefits or weighs on it.

This preliminary issue proved fertile ground for litigation during the first wave of E&P bankruptcies that began in early 2015, but surprisingly resulted in only one reported decision through 2019. In this case, the United States Court of Appeals for the Second Circuit ruled that the dedication clauses in the obligor Sabine Oil & Gas Corp.’s interim collection contracts. did not create valid covenants under Texas law. Sabine and her middle counterparties had no horizontal line of succession, as the purported covenants were not part of a conveyance of real estate. Moreover, the surrender clauses only conferred a personal benefit on the pipeline operators, with no benefit for the territory.

Recent Rulings Provide Guidance, But Leave Plenty of Grounds for Further Disputes Since the end of 2019, at least eight similar disputes have gone to adjudication. These cases reveal no consensus on whether dedication clauses constitute valid covenants. Some courts have interpreted the statutory conditions precedent to such clauses liberally, holding, for example, that (1) (whether or not part of a conveyance) contractual easements created to facilitate the collection of oil and gas creates horizontal intimacy, and (2) a gathering agreement touches and relates to the land by facilitating the production of hydrocarbons and restricting the E&P debtor’s ability to procure alternative gathering services.

Other courts, following Sabine, refused to interpret the dedication clauses as restrictive clauses. Several have dismissed the relevance of surface easements as evidence of horizontal secrecy, pointing out that the surface estate and the underground mining estate are separate estates in fee simple. Likewise, the same courts have carefully distinguished between produced hydrocarbons and unproduced reserves, holding that a collection agreement relates only to the former, which are personal property under state law.

Recent cases have addressed not only the nature of state law of dedications, but the scope of the power to dismiss in bankruptcy.

Some of these courts have questioned the premise (assumed, but not discussed, in Sabina) that a valid operating commitment precludes rejection. They point out that the dedication clause is only one provision of a larger contract; that the assignment clause applies to the land does not necessarily mean that all of the debtor’s obligations apply. From this point of view, the question is not whether the debtor can refuse his collection contract, but whether the contract includes in rem interests that survive rejection. On this basis, a Southern District of Texas bankruptcy court recently allowed a debtor to reject interim agreements despite finding that its assignment clauses applied to the land under state law and would therefore survive the rejection. .

Two recent decisions by Delaware District bankruptcy judges go further, finding not only that a collection contract containing a valid performance clause is likely to be thrown out, but that the performance clause itself can be rejected. These decisions explain that, because restrictive covenants arise by contract and are reducible to claims for damages, they deserve no different treatment in bankruptcy than other contractual obligations.

A consensus that running alliances might survive but not prevent rejection?

Given the recovery in oil and gas prices, it may be some time before the courts again take up these issues. But those planning the next round of distress in the energy sector can draw several tentative conclusions from the recent cases.

For one thing, these cases leave important facets of this issue unresolved — in particular, the validity of purported covenants in interim collection agreements under state law.

On the other hand, the cases suggest an emerging consensus that a valid restrictive covenant in an interim assembly agreement does not prevent its rejection, but rather creates an immovable interest that survives the rejection. Admittedly, the far-reaching conclusion that a valid recognizance in the course of performance can be reduced to a claim for damages and set aside does not sit well with the long-standing case law distinguishing in person complaints and in rem interest in the event of bankruptcy. This conclusion may therefore not enjoy broad support.

But the more modest proposition that a valid undertaking in an interim agreement survives, but does not preclude rejection may represent a point of consensus among courts that differ on other aspects of this controversy.

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