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Can Midstream Contracts Survive Bankruptcy Court?

08/16/16 | Karyl Patredis

What is horizontal privity and why is it important?

It’s Saturday night. By a miracle, your child’s favorite babysitter is available and you are out to dinner with an all-adult group of friends. Without warning, one of your friends starts talking about a recent job interview and how she got stumped when asked what the integral of a sine curve from negative infinity to infinity was. She says, “I should have known it was zero!” and everyone else starts nodding in agreement and chatting about math. Secretly, you are googling “sine curve” on your phone under the table because you have no idea what is going on. Has this ever happened to you? If it has, don’t feel alone. Google is my best friend.

During a recent Latham & Watkins presentation discussing covenants running with the land, I was Fast Thumbs Thelma on my smartphone. Privity – is this an English word? Turns out, this is, in fact, a word used by lawyers in America that, when decoded, results in some useful knowledge regarding covenants running with the land.

Before you open a new tab to Google “privity,” stay with me.

You might remember the Sabine Oil and Gas Corporation bankruptcy case from earlier this year. As a quick refresher, Sabine filed for bankruptcy in 2015 and faced lots of opposition to its restructuring plan. The company went to bankruptcy court to settle disagreements with its creditors at the beginning of 2016. One particularly interesting item that came up in the proceedings was if Sabine must pay for gathering and processing contracts that it was subject to as a result of “dedications.” Dedications are contracts that grant midstream gathering and processing companies exclusivity in a geographic area. Midstream providers argued that these dedications were covenants running with the land and could not be rejected in bankruptcy court. In the end, the court said these dedications did not qualify as covenants running with the land and could be rejected due to lack of horizontal privity. This shocked the midstream community because these contracts were previously viewed as iron clad.

Now, let me try to explain what happened in non-lawyer words.

My son, Preston, is obsessed with a little playhouse at his day school. For the sake of this example, let’s say he owns the 4×4 patch of land beneath the plastic house. When Preston goes to Kindergarten and won’t be able to hang out in his favorite spot any longer, he decides to grant the land to a kid a year younger than him, Nolan, provided that Nolan promises never to move the treasured playhouse from the land. They sign a deed in crayons that contains the promise about the house. At this point, there is horizontal privity between Preston and Nolan because they are the original parties in this agreement and have shared interest in the land as the grantor (Preston) and grantee (Nolan).

The court in the Sabine case found that in order for a covenant to run with the land:

  1. The covenant must touch and concern the land.
  2. The covenant must relate to a thing in existence or specifically bind the parties or anyone to whom a right or liability is legally transferred.
  3. The covenant must be intended by the original parties to run with the land.
  4. The burden of the covenant must be explained to the successor.
  5. There must be horizontal privity.

Where the problem would come in (and where it came in for the midstream gatherers in the Sabine case) would be if Preston (think of Preston as Sabine) had never actually granted the land to Nolan (think of Nolan as the midstream providers). Instead Preston and Nolan signed a contract ensuring that Nolan would keep someone from moving the house in exchange for a fee from Preston. If Preston went bankrupt from all his kindergarten real estate deals and didn’t want to pay Nolan anymore, Nolan couldn’t prove a covenant running with the land (and continue to collect his fee) because there wasn’t a grantor/grantee relationship between them. And while there was a contract with covenants made within it, the lack of horizontal privity means Preston can use a different home protector for a lower fee and reject his agreement with Nolan.

You may be left wondering how midstream companies can tailor contracts going forward to assure that all the listed requirements can be proven in court. Unfortunately, because the Sabine case was litigated in the state of Texas and there isn’t clear guidance from the Supreme Court, Latham & Watkins says there is no fool proof way to “fix” covenants in existing agreements. But obviously, drafting future agreements to meet the five requirements is strongly encouraged.

As a final word, while the Sabine ruling has resulted in additional uncertainty over the enforceability of existing gathering and processing (G&P) contracts in a bankruptcy court, remember that often times, these G&P companies operate monopolistic footprints. Rare and lucky is the producer with multiple pipeline takeaway options. Therefore, more times than not, producers will have good reason to work with their midstream provider to avoid stranding production.