THE RULES OF REJECTION–IN RE SANCHEZ ’S NEW TAKE ON REAL PROPERTY COVENANTS

On May 6, 2021, the United States Bankruptcy Court for the Southern District of Texas (the “Court”) issued a Memorandum Opinion in In re Sanchez Energy Corp., adding to the emerging jurisprudence concerning a producer’s ability to reject a midstream agreement that purportedly creates real property covenants that run with the land.^[1] In it, Judge Marvin Isgur ruled Sanchez could indeed reject the executory contracts at issue, but also that the real property covenants those agreements created were valid under Texas law and would survive rejection under section 365 of the Bankruptcy Code. This bifurcation, while analytically sound, begs the question of how these surviving covenants are to be carried out without the underpinnings of the rejected agreements.

Background

Sanchez Energy Corporation, its affiliate SN EF Maverick, LLC (“Maverick”), and certain of its other affiliates (collectively “Sanchez”) filed voluntary chapter 11 petitions on August 11, 2019. Sanchez sought to reject executory contracts under its confirmed chapter 11 plan, including gathering and development agreements with Occidental Petroleum (“Occidental”), as successor-in-interest to Anadarko Petroleum (“Anadarko”). The agreements with Occidental included dedications of Sanchez’s interest in hydrocarbons to Anadarko’s Springfield gathering system. The gathering agreements expressly provided that these dedications constituted covenants running with the land. Occidental, as Anadarko’s successor-in-interest, objected to the rejection of the gathering agreements and commenced an adversary proceeding, seeking declarations from the Bankruptcy Court that the agreements contained real property covenants and equitable servitudes, and therefore could not be rejected.

While the specifics depend on the state law at issue, generally an obligation must satisfy some articulation of the following elements to be a valid covenant running with the land: (1) it must touch and concern the land; (2) there is vertical and/or horizontal privity of estate; (3) it relates to a thing in existence or binds the parties and their assigns; (4) the parties intended for the obligation to run with the land; and (5) the successor to the burden has notice of the obligation.^[2] When presented with a dispute like that in Sanchez, a bankruptcy court must first decide whether the dedication satisfies these elements, and then apply the law to determine what that real property covenant means in the context of rejection. The Court’s decision as to whether the real property covenants preclude rejection and bind successive owners of the dedicated assets to the contractual midstream economics can materially affect the value of the bankruptcy estate and creditor recoveries.

In the last five years, several courts have considered whether a producer can reject a gathering agreement with a dedication. The first such case was In re Sabine Oil & Gas Corp., which held that the debtor could reject the gathering agreements in question, which sent shockwaves through the midstream industry.^[3] The Sabine court concluded that the dedication was limited to produced (i.e., severed) hydrocarbons, which are personal property, and thus did not satisfy the privity and touch and concern elements.^[4] In contrast, in In re Alta Mesa Resources Inc., the Court ruled in favor of the midstream counterparty. Jude Isgur ruled there that the dedication constituted a valid covenant running with the land^[5] under Oklahoma law and that the debtors could not reject the associated agreements.^[6] The Court seemed to embrace a fairly bright-line rule based on the facts presented, suggesting that contracts containing valid covenants running with the land are not subject to rejection.^[7]

Shortly thereafter, the United States Bankruptcy Court for the District of Delaware weighed in with two pertinent decisions. In In re Southland Royalty Co. LLC, the court held that the dedications at issue did not satisfy the requirements of Wyoming law, and that Southland could reject the midstream agreement at issue.^[8] The Southland court also ruled, however, that even if the real property covenants had been valid and enforceable, the contract itself could still be rejected under section 365 of the Bankruptcy Code.^[9] In other words, the existence of a valid real property covenant in an executory contract does not preclude rejection of the contract. The Southland court reasoned that even if rejection excuses the debtor from performance covenants, the counterparty would have a prepetition claim for damages resulting from nonperformance to properly account for and satisfy the covenants.^[10] Coming to a similar conclusion, In re Extraction Oil & Gas ruled that the debtor could reject the contracts at hand even if they contained real property covenants.^[11] The court in Extraction reasoned that following rejection the claims of the counterparty, including in respect of the real property covenants, would be satisfied in connection with the claims allowance and plan recoveries.^[12]

Holding in In re Sanchez

After considering the elements to form a real property obligation under Texas law, the Court determined that the Anadarko agreements created valid covenants running with the land. The Court ruled that while the agreements could be rejected, that the real property covenants would survive and remain enforceable. Judge Isgur explained that his ruling in Alta Mesa should not be construed to mean that executory contracts containing real property covenants cannot ever be rejected. Rather, the executory obligations of the debtor are subject to rejection, while the covenants running with the land are not and remain enforceable as to the dedicated assets. Rejection is deemed a breach of the agreement as of the petition date, but it does not terminate or rescind the agreement so as to deprive the non-debtor counterparty of those rights that would survive a contract breach.^[13] Real property covenants—if valid and enforceable under applicable state law—are one such surviving right, as they “are so connected to the underlying land that the benefit and burden pass to successors by operation of law.”^[14] As such, a party conveying one of its proverbial ‘bundle of sticks’ by creating a real property covenant cannot snatch it back simply by breaching its contract. The creation of a real property covenant burdens the real property estate en rem, separate and apart from the debtor’s obligations under contact law.

Analysis

Sanchez thus clarifies the Alta Mesa decision, and more closely aligns the Southern District of Texas with the Delaware decisions of Southland and Extraction.^[15] Whereas previous courts and practitioners may have at times conflated rejection of a contract and the extinguishment of a real property covenant provided therein, Sanchez makes clear that these are independent issues. Unlike in Southland, where the court also ruled that the debtor could sell its assets free and clear of the purported covenants, Sanchez left open the scope of the enforceable covenants that would remain in place, notwithstanding the rejection of the contract. Allowing a debtor to reject a contract, but preserving the go-forward enforceability of the real property covenants it contains, creates real uncertainty. One the one hand, it seems clear that Occidental retained the benefit of the exclusivity covenant. Sanchez cannot build its own midstream infrastructure or contract with another company for transportation within the dedication area. On the other hand, in the absence of a contract, it is unclear what rates Sanchez must pay Occidental for gathering services, or what other commercial terms apply. Presumably, Sanchez no longer needs to satisfy the minimum volume commitments in the contract, although midstream parties have argued elsewhere that such terms are within the scope of a real property covenant.

Properly perfected real property dedications that duly comply with the elements of applicable state law can survive a producer bankruptcy and remain enforceable against successor owners of dedicated oil and gas assets. However, financial and other commercial terms arising solely as a matter of contract law are not immune from rejection under section 365 of the Bankruptcy Code. The question of whether particular terms or obligations arise solely as a matter of contract law, or separately arise and are enforceable en rem as a matter of real property law, will likely be the subject of future litigation. Until the courts further clarify these issues, producers and their mid-stream counterparties will continue to wrestle with similar predicaments.