Assumption and Rejection of Midstream Contracts in Bankruptcy | Morgan Lewis
The ability to assume or reject enforceable contracts is one of the primary tools used by debtors in a Chapter 11 reorganization. When a debtor has a contract with a third party that is “enforceable”, that is, – to say that the outstanding performance obligations remain for both the debtor and the counterparty to the contract at the date of filing for bankruptcy, the debtor can choose to assume or reject the contract under 11 USC § 365.
If a debtor chooses to assume the contract, it must remedy any breaches under the agreement, and the agreement will “review” the bankruptcy without modification. If the debtor rejects an enforceable contract, the rejection is treated as a breach by the debtor, and the counterparty to the contract is left with a claim in bankruptcy for rejection damages caused by the breach. Generally, the standard applied by bankruptcy courts in determining whether the rejection of a binding contract should be approved is low. Except in bad faith, a bankruptcy court will usually rely on the debtor’s business judgment that rejection is in the best interest of the estate.
In recent years, cases of bankruptcy of oil and gas (E&P) exploration and production companies have given rise to disputes over the rejection of intermediary contracts in the event of bankruptcy. E&P companies can generally have long-term contracts with counterparties that provide intermediary services, including collection and transportation services. These contracts, if entered into at times when commodity prices are higher, may contain tariff conditions that are not profitable for the debtor at the time of filing, thus prompting the debtor to request rejection of the contract as means of renegotiating the tariff conditions or of seeking such an intermediary service. from another party. The rejection of these agreements can be very costly for the counterparty, especially if the counterparty spent large amounts of capital up front to build collection, pipeline and other transportation systems.
Since many of these interim contracts are written to pass certain beneficial ownership rights, such as an easement or an oil and gas assignment, to the counterparty, counterparties facing rejection argued that the contracts “work with it. the land ”and transfer beneficial ownership rights. which cannot be rejected. As we will see below, the cases which initially dealt with this argument based a debtor’s ability to assume or reject the contract as a whole on whether the contract contained restrictive real estate covenants. . However, recent cases have taken a more nuanced approach. the Sanchez The U.S. Bankruptcy Court decision for the Southern District of Texas offers parties a second level of analysis, distinguishing whether a binding contract containing restrictive land covenants can be rejected (believing that it can. ) and the result effect on the rights granted to the counterparty under the contract which are not terminated due to the refusal of the debtor.
The first prominent case to bring up the “races with the land” argument was Sabine Oil & Gas Corp. In Sabine, a New York bankruptcy court, interpreting Texas law, found that some gas collection agreements did not contain real estate covenants and therefore could be dismissed by the debtor, a decision which then went on been upheld by the United States Court of Appeals for the Second Circuit. Subsequently, in cases of Badlands Energy, Inc. (Colorado bankruptcy court, applying Utah law) and Alta Mesa Resources, Inc. (Texas Bankruptcy Court, applying Oklahoma law), the bankruptcy courts found that the gas collection agreements at issue did contain restrictive clauses relating to real estate and, therefore, could not be rejected.
Although the above cases each apply a different state law, the basic analysis to determine whether the agreements contain restrictive covenants in effect with the land is the same and focuses primarily on three questions:
- Do restrictive clauses in agreements “affect and relate to” a real estate interest?
- Is there a “link” (horizontal and vertical) between the parties at the time of the conclusion of the agreements?
- Did the parties intend to create a real estate pact, that is to say that the agreements “follow the ground”?
If these three elements are present, the court will then rule that the agreement contains a restrictive clause relating to real estate.
As a result of these cases, three cases decided in 2020 both interpreted more narrowly what constitutes an alliance with the land and suggested or found that even if an intermediate contract contains an alliance with the land, it can still be rejected.
In Chesapeake Energy Corp., the court found that the Chesapeake gas purchase agreement with the ETC Texas pipeline did not contain an existing commitment with the land under Texas law. Despite express contractual language indicating that the parties had agreed that there was an “engagement in force with the land”, the court found that there were other provisions indicating that the parties wanted the contract to be personal in nature. , including a damages provision for pecuniary damages and a provision recognizing that the contract was a forward contract for the sale of gas. In dicta, the Chesapeake The court (Jones, J.) also suggested that even if the contract contained a restrictive covenant in effect with the land, it was not clear that this would prevent rejection.
In Oil & Gas Extraction, a Delaware bankruptcy court found that some transportation service agreements could be rejected even if they contained land-related restrictive covenants, and that the rights of counterparties under those covenants would be satisfied through the process of claim, thus eliminating any right that the counterparty had to enforce against the debtor or the subsequent owners of the goods to which the obligations attached.
In Southland Royalty Co. LLC, another Delaware bankruptcy court (applying Wyoming law) found that a gas collection agreement did not contain a land-related commitment because the agreement was for “produced” gas (which was property personal) and therefore did not “touch and affect” the terrain. the Southern countries court also followed the decision of Extraction, considering that even if the agreement contained an enforceable clause with the land, the contract could still be rejected.
THE SANCHEZ DECISION
In a nuanced opinion analyzing a debtor’s ability to reject an enforceable contract containing a covenant that goes with the land and the effect of that rejection, Judge Marvin Isgur of the U.S. Bankruptcy Court for the Southern District of Texas ruled on 6 May 2021., that an interim contract including restrictive covenants in force with the land may be rejected. However, since rejection does not constitute termination, but rather is considered a infringe of the contract by the debtor, Judge Isgur further considered that the debtor’s rejection of the intermediate contracts in question would not deprive the counterparty of the rights of assignment previously granted by the debtor.
Judge Isgur’s analysis was guided by the decision of the United States Supreme Court in Tempnology, in which the court considered the effect of rejection on rights that cannot be canceled by breach of contract. In ruling thus, Judge Isgur distinguished his decision by Alta Mesa, in which he considered that “[r]beneficial ownership covenants are not enforceable and are not subject to rejection. In Sanchez, Judge Isgur found that “[a]Although real estate commitments are not terminated by rejection, the existence of a real estate commitment does not prevent a debtor from rejecting its enforceable obligations in a contract.
Sanchez teaches that the susceptibility of a contract to rejection is only the first part of the analysis; we must look at the consequences of this violation. In Sanchez, certain real estate interests, the transfer rights, had been transferred to the co-contracting party. Judge Isgur held that although the contract may be rejected, such rejection “does not remove [the counterparty] rights that would survive violations outside of bankruptcy. The court ruled that “a party who transmits a real estate commitment does not recover the transferred property rights by simply violating the contract. Likewise, when that party rejects the contract under § 365, these rights remain with the non-refusing party.
While the Sanchez decision provides more clarity on a debtor’s ability to reject interim agreements containing covenants that accompany the land, the importance of retention of property rights by the counterparty is perhaps more obscure. In the Sanchez case, the dedication survived the rejection, but not the tariff conditions, including the minimum volume requirements. As a result, the debtor must continue to deliver to the collection system, which gives the counterparty rights greater than rejection damages, but the case does not provide any answer as to how much the debtor must pay for the services provided. .
Note also that this is not the last of the Sanchez decisions that could impact the rejection analysis. A number of rejection issues remain, including integration and business judgment considerations, which will be addressed by Judge Isgur in the weeks or months to come, unless the parties are able to resolve them at the end of the day. prior. It remains to be seen how debtors rejecting interim agreements and contractual counterparties will navigate the practicalities of rejection, and how this will affect the ability of counterparties to monetize their property rights in the future.
 In re Sabine Oil & Gas Corp., 547 BR 66 (Bankr. SDNY 2016), confirmed, 567 BR 869 (SDNY 2017), confirmed, 734 F. App’x 64 (2d Cir. 2018); Sabine Oil & Gas Corp. vs. HPIP Gonzales Holdings, LLC, 550 BR 59 (Bankr. SDNY 2016), confirmed, 567 BR 869 (SDNY 2017), confirmed, 734 F. App’x 64 (2d Cir. 2018).
 Regarding Badlands Energy, Inc., 608 BR 854 (Bankr. D. Colo. 2019); In re Alta Mesa Res., Inc., 613 BR 90 (Bankr. SD Tex. 2019).
 With regard to Chesapeake Energy Corp., 622 BR 274 (Bankr. SD Tex. 2020).
 In terms of oil and gas extraction, 622 BR 608 (Bankr. D. Del. 2020).
 Regarding Southland Royalty Co. LLC, 623 BR 64 (Bankr. D. Del. 2020).
 In re Sanchez Energy Corp., et al., Memorandum Opinion, Case No. 19-34508-MI (Bank. SD Tex., May 6, 2021) [Dkt. No. 1923]. This decision is currently under appeal.
 Mission Prod. Holdings, Inc. v Tempnology, LLC, 139 S. Ct. 1652 (2019).
 Alta Mesa, 613 BR at 98.
 Sanchez Energy, Notice of memorandum to 15.
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