Canada: In re Sabine Oil & Gas Corp. – Bankruptcy And The Rejection Of Pipeline Contracts

A recent decision made by the U.S. Bankruptcy Court ("the Court") has the potential for widespread ramifications in the North American midstream sector. On March 8, 2016, the Court controversially ruled that Sabine Oil & Gas Corp. ("Sabine"), a Houston-based oil and gas exploration and production company, was permitted to withdraw from its long-term pipeline agreements with two midstream companies.1 While the decision comes from the influential U.S. Bankruptcy Court in Manhattan, the Court clarified that Texas law was not clear enough for her decision to be binding, which was instead meant to offer a "non-binding" analysis.2


Sabine filed for Chapter 11 protection on July 15, 2015, in order to facilitate the restructuring of its nearly $3 billion debt. Shortly thereafter, in September of 2015, Sabine filed a motion to reject two gathering and handling agreements with each of Nordheim Eagle Ford Gathering, LLC ("Nordheim") and HPIP Gonzales Holdings LLC ("HPIP").

The two agreements with Nordheim specifically provided that the agreement itself is a "covenant running with the [land]" within the designated area.3 Similarly, each of the two agreements with HPIP provided that Sabine's undertaking to deliver the products to HPIP is a covenant "running with the lands and leaseholds interests" identified in the agreement.4

The Motion

The Court heard oral arguments on February 2, 2016, where it considered whether Sabine had exercised reasonable business judgment in its rejection of the agreements, and whether the covenants did in fact run with the land as expressly indicated in all four agreements.

Sabine's lawyers argued that potentially $115 million could be saved by repudiating the contracts with Nordheim and HPIP, referring to the agreements as "unnecessarily burdensome".

The midstream companies naturally rejected Sabine's argument, largely on the basis that the contracts in question gave them certain rights to the land. While bankruptcy law usually permits the bankrupt to sever some agreements, Nordheim and HPIP argued that their agreements with Sabine were unique. HPIP claimed that its contract included certain covenants "attaching to and running with the lands", which continued to be binding on Sabine and any successor. Similarly, Nordheim objected on the grounds that Sabine's right to transport gas on particular lands was transferred to Nordheim. Sabine's relied on the language of its contracts to counter-argue, claiming that ownership rights were never transferred, and if they were, only rights pertaining to minerals – not land – were transferred.

The Law and the Decision

Pursuant to Section 365(a) of the U.S. Bankruptcy Code, a debtor is permitted to reject executory contracts or unexpired leases with the approval of the court.5 Bankruptcy courts have allowed such rejection, so long as it constitutes an exercise of "sound business judgment". Typically, U.S. courts have been quite liberal in determining whether a debtor should be entitled to reject a contract, absent any indication of bad faith, whim or caprice.6 The test requires the court to look at whether the debtor's decision to reject the contract in question is beneficial to the estate.7

Sabine argued that its rejection of the agreements was reasonable because it was not "financially viable" for it to deliver on the obligations under the contracts. Furthermore, absent rejection, Sabine would be required to make contractual deficiency payments, which would impose a substantial drain on the estate's resources. Sabine argued that if it were permitted to reject the existing contracts, it would enter into new gathering agreements with other midstream companies on more favourable terms. The Court agreed with the foregoing and ultimately concluded that Sabine had in fact satisfied the standard for rejection of the contracts. It ruled that Sabine's decision to reject the agreements was a "reasonable exercise of [Sabine's] business judgment".8

While the Court concluded it was able to rule on Sabine's act of rejecting the contracts, it clarified that it could not "decide substantive legal issues, including whether the covenants at issue run with the land, in the context of a motion to reject, unless such motion is scheduled simultaneously with an adversary proceeding . . . to determine the merits of the substantive legal disputes . . ."9.

Nonetheless, the Court provided a "non-binding" analysis of whether the covenants ran with the land, noting this was a question of Texas state law. Under Texas law, a covenant runs with land when:

  • it touches and concerns the land;
  • it relates to a thing in existence or specifically binds the parties and their assigns;
  • it is intended by the original parties to run with the land; and
  • the successor to the burden has notice.10

The Court ruled that the first requirement was not satisfied, as the covenants did not appear to "touch and concern" the land. It was insufficient for the covenant to merely affect the value of the land. Rather, the covenant must affect the owner's interest in the property or its use. In the case of gathering and handling agreements, the minerals, once extracted from the ground, cease to be real property and become personal property. Accordingly, the covenants in this case failed the test, and were determined not to run with the land, allowing Sabine to reject the agreements like any other contract under Section 365(a).

In concluding, the Court made no final determination as to whether the covenants in question ran with the land, or as to any other substantive legal dispute save for allowing rejection of the contracts. Commentators have noted that this conclusion likely leaves the case open to further litigation between the parties for definitive direction.

Application in Canada

Prior to the 2009 amendments to the Companies' Creditors Arrangement Act11 (the "CCAA"), the ability of a debtor to disclaim a contract was entirely within the discretion of the court. Section 32(1) of the CCAA now allows a debtor company, on notice to the other parties to the agreement and to the monitor, to disclaim or resiliate any agreement to which it was a party at the commencement of the CCAA proceeding. The bankruptcy monitor must approve the disclaimer, failing which, the debtor must obtain a court order for the disclaimer or resiliation. In deciding whether to make the order, the court must consider whether the monitor approved the proposed disclaimer or resiliation; whether it would enhance the prospects of a viable compromise or arrangement; and whether the disclaimer or resiliation would likely cause significant financial hardship to a party to the agreement.12

Certain categories of agreements are exempt from the foregoing provisions. In particular, all of the following are exempt from section 32(1)13 - that is, they cannot be disclaimed: (i) eligible financial contracts, (ii) collective agreements, (iii) financing agreements if the company is the borrower, and (iv) leases of real property or of an immovable if the company is the lessor. While intellectual property agreements where the company is the grantor of rights can be disclaimed, the grantee's right to use the intellectual property is not affected by the disclaimer.14 Notably absent from this list is any category under which midstream contracts might fit.14 Accordingly, such contracts are vulnerable to the risk of disclaimer and resiliation in the same way they are in the U.S.

The "test" that courts have adopted is the demonstration by the debtor company that the termination was fair and reasonable in all of the circumstances.15 Accordingly, the analysis is case-specific and will depend on each debtor's set of facts. Courts have, however, considered authorizing termination where a company would become substantially more profitable by terminating an agreement and entering into a new one on more favourable terms permitted by the market.16 As such, the possibility of a Canadian court arriving at a result similar to Sabine is not only possible, but likely. While obviously entitled to stray from U.S. jurisprudence, it would not be surprising for a Canadian court to borrow principles from Sabine given the similarities in law. Regardless, the CCAA is designed to be debtor-friendly, and as such, a Canadian court could very well arrive at the same result as Sabine without specifically borrowing from it. Canadian midstream companies should be cognizant of the risk to midstream contracts under the CCAA and Sabine, and consider the possibility of struggling upstream counterparts disclaiming or repudiating existing pipeline contracts.

Impact and Further Developments

The ability to disclaim or repudiate a contract serves a useful purpose to upstream debtor corporations, in that it may withdraw from unprofitable or prejudicial contractual obligations. However, the Sabine decision sets a troublesome precedent for pipeline operators and the midstream sector generally, in both the United States and Canada. As counterparties to those contracts, the decision is likely to create uncertainty and instability for midstream companies, otherwise beloved to investors for secure and steady streams of revenue.

Given the current state of the market, the ability to repudiate or disclaim pipeline agreements may become a persuasive factor in a producer's decision whether or not to pursue Chapter 11 filing or restructuring under the CCAA. Producers who previously avoided the insolvency route may go so far as to file for bankruptcy protection simply to be liberated from unfavourable pipeline contracts. By the same token, midstream companies may see the incentive to renegotiate or amend existing contracts with producers to ensure their continuation. Midstream companies should be advised to review their agreements with upstream counterparties to assess whether any rejection risks exist, and accordingly, whether renegotiation should be considered.

While not binding, the Court's decision has already made waves in the industry. The decision provides some welcome guidance for courts considering similar cases. However, it is certainly less than precedential, and courts will continue to consider the issue on a case- and contract-specific basis. Although we have yet to see a similar case decided or initiated in Canada, other U.S. producers have already filed motions similar to Sabine's. Quicksilver Resources Inc. ("Quicksilver") filed an application in the Delaware Bankruptcy Court to reject a contract with Crestwood Equity Partners. However, on April 6, 2016, the parties announced they had reached a new 10-year deal, in connection with which Quicksilver withdrew its motion.

Similar to Sabine, another producer, Magnum Hunter Resources Corp. ("Magnum"), sought to reject four agreements with Texas Gas Transmission Inc. ("Texas Gas"), calling them an "undue burden" on its operations. It was announced on March 10, 2016 that Magnum reached an agreement in Delaware bankruptcy court with Texas Gas, resolving the latter's objections to the termination of certain pipeline contracts. The agreement, which is expected to receive approval of the U.S. Bankruptcy Court, provides that Magnum subsidiary Triad Hunter will terminate the four agreements with Texas Gas relating to the use of pipelines to transport gas. A separate credit agreement, pursuant to which Magnum agreed to provide a number of letters of credit to Texas Gas totalling $65 million, will be converted into an unsecured claim worth $15 million in Magnum's Chapter 11 proceedings.


1. In re Sabine Oil & Gas Corp., 15-11835, U.S. Bankruptcy Court, Southern District of New York (Manhattan) ("Sabine")

2. Sabine at p. 8-9

3. Sabine at p. 5

4. Ibid.

5. 11 U.S.C. §365(a)

6. Westbury Real Estate Ventures v. Bradlees, Inc. (In re Bradlees Stores, Inc.), 194 B.R. 555, 558 n.1 (Bankr. S.D.N.Y. 1996).

7. In re Enron Corp., No. 01-16034 (AJG), 2006 WL 898033, at *4 (Bankr. S.D.N.Y. Mar. 24, 2006).

8. Sabine at p. 20

9. Sabine at p. 9

10. Inwood North Homeowners' Ass'n, Inc. v. Harris, 736 S.W.2d 632, 635 (Tex. 1987).

11. RSC 1985, c. C-36 [CCAA]

12. CCAA, s. 32(4)

13. CCAA, s. 32(6)

14. CCAA, s. 32(9)

14. Note: There is no bright-line test for whether an agreement constitutes an "eligible financial contract"; however, the Ontario Court of Appeal has held that a contract which has as its primary thrust the physical supply and transmission of oil and gas is not an "eligible financial contract" for the purposes of the CCAA (Re Androscoggin Energy LLC, [2005] OJ No. 592, 75 OR (3d) 552)

15. Re Skeena Cellulose Inc., 2003 BCCA 344

16. Re Doman Industries Ltd., 2004 BCSC at paras 35-36

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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