US decision rattles pipeline owners

Midstream companies advised to review pipeline contracts after bankruptcy ruling

A US bankruptcy judge’s ruling that midstream gatherer contracts can be rejected in insolvency cases sounds a warning note for Canadian owners of pipelines and other midstream assets.

“We’re already seeing a chilling effect because this decision, if followed in Canada, represents a new threat to midstream stakeholders that didn’t exist before,” says Randal Van de Mosselaer of Norton Rose Fulbright Canada LLP in Calgary.

So much so that Torys LLP is advising both midstream gatherers and producers to review their contracts.

“Midstream companies should review pipeline contracts to evaluate the risk of rejection in the event of a bankruptcy by the upstream producers,” says Alison Bauer, who practises at the firm’s New York office. “Conversely, oil and gas producers should consider negotiating reductions in price and volume commitment in unfavourable contracts that originated when oil and gas prices were higher or threaten bankruptcy rejection.”

The issue arose when Sabine Oil & Gas Corporation, an independent energy company engaged in developing onshore oil and natural gas properties, found itself in Chapter 11 proceedings. Chapter 11 of the United States Bankruptcy Code allows debtors to apply for court approval to terminate existing agreements in certain circumstances. Similar provisions are found in Canada’s Companies’ Creditors Arrangement Act and the Bankruptcy and Insolvency Act.

Sabine applied to terminate gas gathering and handling agreements it had with Nordheim Eagle Ford Gathering LLC and High Point Infrastructure Partners LLC. Sabine maintained that it could not restructure its operations without rejecting these contracts, which it claimed were too expensive to maintain.

The pipeline owners countered with the argument that the dedication of production under the agreements created an interest that ran with the land and therefore the contract could not be rejected under the applicable Texas law.

But Judge Shelley Chapman of the United States Bankruptcy Court for the Southern District of New York ruled that the agreements could be rejected as a reasonable exercise of business judgment by Sabine’s management. While she did not – for procedural reasons – make a final ruling on the issue, she did indicate that she was disinclined to find that the agreements ran with the land. Among other things, she reasoned that the agreements only affected Sabine’s personal property interests in products that had already been extracted.

As it turns out, a bankruptcy court in Delaware is poised to render a decision relating to a substantially similar issue in a case involving Quicksilver Resources.

“Meanwhile, the important legal question of whether gathering contracts run with the land remain to be determined in both the US and Canada,” Van de Mosselaer says. “It’s also unclear whether a finding that an interest in land was created would mean that the contracts could be rejected but the particular covenants running with the land would survive.”

In another Delaware case, the issue is whether individual transaction confirmations can be severed and rejected as distinct from the umbrella gathering agreement.

“But regardless of the way in which the midstream companies are defending these applications, they are the ones who stand to lose when these types of agreements are rejected, missing out on the benefit of their bargain in the agreements as well as failing to recover the costs for their own often substantial infrastructure development,” Bauer says.

A decision from US courts would not, of course, be binding in Canada. But Canadian courts will take notice.

“Given the importance that is placed on the decisions of the United States Bankruptcy Court for the Southern District of New York in both the United States and Canada, any ruling Judge Chapman makes on this issue may well be influential in the mid-stream industries in both countries,” Van de Mosselaer says.

Still, the CCCA does require courts that are deciding whether to reject contracts to consider whether the disclaimer would create serious financial hardship to the debtor’s counterparty.

“That doesn’t appear to have been a consideration in Sabine, but it would be the primary argument in Canada,” Van de Mosselaer says.

This being said, it is also true that the land titles and real estate legal regimes vary greatly from state to state and province to province in both countries.

“No doubt the real estate law of each jurisdiction will bear heavily on these questions,” Van de Mosselaer adds.