Directors are responsible for managing or supervising the management of the business and affairs of a corporation. They are elected by shareholders, but their fiduciary duties are to the corporation, not just the shareholders. It is difficult enough to discharge these duties, but when the business environment gets tricky, the job becomes more demanding. A perfect example of this is currently taking place in the oil and gas industry and is being felt by most oil and gas companies, but especially the juniors.
Current Oil and Gas Industry Climate
The very nature of the oil and gas industry attracts risk taking entrepreneurs. Find reserves and if their value exceeds their finding and production costs, the increased value will go to the owner. However, for oil and gas companies in the exploration, development and production (E&P) phase of the industry to continue in business, one fundamental principle must be respected: replace production to survive. Reserves being produced are a wasting asset, but if things go well, and produced reserves are more than replaced by additions, survival can lead to growth.
Recently, however, the combined effect of events that are beyond the ability of the management and directors of E&P companies to control have affected the ability to follow this principle.
Dramatically reduced commodity prices and difficulty in raising funds through equity issues and bank financing between late 2007 and the end of 2009 for oil and gas companies in the E&P phase has resulted in a very close-up exposure to that fundamental principle. For some E&P companies, funds have not been available to replace reserves and commodity price declines have hit the gas producers particularly hard and that means a majority of the junior E&P companies in the western sedimentary basin.
The effect of reduced commodity prices can be seen in four main ways. First, it will result in reduced net present values of discounted cash flows for reserves. Second, it may result in a reduction of a company's estimated current reserves because of the reduced recoverability factor caused by lower commodity prices. Third, it may result in a reduction in the company's cash flow from both reduced revenues from sales and further as uneconomic wells are shut-in. Finally, it may result in a reduction of a company's ability to borrow as most lenders use the company's estimated current reserves to establish the borrowing base for credit facilities.
Because equity has been difficult to raise over that same period, many companies that did not have sufficient cash flow have had to reduce their drilling programs and focus on improving production from existing wells by adding production facilities. However, where facilities needed to be financed on debt, lenders weren't always there to help and if lines of credit were at or near their maximums, those plans had to be reviewed.
There is a longer term effect that arises from producing reserves without replacing them, resulting in lower volumes against which net present values of discounted cash flows would be determined.
Lenders are not usually keen to take remedial steps under their lending arrangements, but they must respond to circumstances as they change. This can include steps such as reducing borrowing limits based on reduced reserves evaluations, demanding repayment, encouraging or assisting in locating business combination candidates or in more severe cases, resorting to security enforcement, such as the appointment of a receiver.
Furthermore, recent market uncertainty and volatility has caused equity investors to demand a 'risk premium' from issuers, if funds are available at all, making the raising of funds through equity issues considerably more dilutive than before.
Then, let's not forget the situation some junior E&P companies find themselves in of having unfulfilled flow through drilling obligations, but no funds to meet those commitments.
As a result, most junior E&P companies have seen significant changes in their fortunes and many have had to devote most of their efforts to learning new skills which they may not have been prepared for in order to survive or salvage something from the results of these changes.
Those skills involve understanding the complexities of corporate governance, corporate reorganization and responding to pressures to sell assets, merge or be placed in receivership.
Directors Duties and Liabilities
Next to the CEO and CFO, the first people to learn of a change in a corporation's circumstances have to be the directors. That may not always be the case. They, along with the senior officers, are under significant legal obligations to the corporation, its stakeholders and regulators and must be in a position to perform those duties. This is a time when senior management and the board must work together.1
Hopefully, long before the situation becomes dire, the directors and officers will have considered their own protection and entered into indemnity agreements, and where possible obtained directors and officers liability insurance.2 This is useful in providing a degree of comfort in dealing with the challenges they face, but is not absolute protection and they still need to apply a great deal of care and attention.
If time permits, the directors may wish to analyse their governance policies and practices before trouble begins.3
When it becomes apparent that steps must be taken to respond to a deteriorating situation, the board will want to consider what courses of action might be available to the corporation. These will include asset sales, merger or take-over, soft receivership, recapitalization and insolvency or seeking CCAA protection. The course chosen will depend on the seriousness of the problem and the perceived availability of a solution. At this point the board would be wise to seek the assistance of an experienced financial advisor, whether that is an investment banker or accounting firm, and a legal advisor. Choosing the best course will require a considerable amount of expert advice that will go a long way to determining the best course of action. By now, the directors will probably have put their minds to possible claims that they had not acted in the best interests of the corporation or that they did not obtain the best price for any asset sale, reorganization, recapitalization or business combination.4
The directors should also be alert to the possibility of "related parties" in respect of any proposed transaction and the additional steps and considerations that will have to be made. For public companies, these arise under Multilateral Instrument 61-101 Protection of Minority Security Holders in Special Transactions, which will arise in the case of all TSX listed companies and which has been adopted by the TSXV as Policy 5.9.5 In a number of transactions a formal valuation is required and the board or an independent committee of the board must supervise its preparation. Whenever dealing with valuations of the business or its assets, the board would be well advised to obtain competent, independent third party advice, whether or not required by MI 61-101.6
If the securities regulators believe that the corporation or its directors have not properly discharged their obligations under corporate or securities laws, the directors may be faced with an investigation and possibly administrative or court proceedings, which can be time consuming and costly. Class actions have also become an increasingly common part of Canadian corporate life.7
Finally, because of the need to disclose material events on a timely basis, and because of the continuous and event driven public disclosure obligations, the directors and officers need to keep in mind the fact that they are personally liable for all statements issued by the corporation in any document required to be filed with the securities commissions, including such things as: a prospectus, a take-over bid circular, an issuer bid circular, a directors' circular, a rights offering circular, management's discussion and analysis, an annual information form, an information circular, annual financial statements and interim financial statements. This exposure also extends to oral statements that relate to the business or affairs of the corporation.
Courses of Action
Below, we review the different outcomes which may result for oil and gas companies that are impacted by reduced reserves.
Asset Sales
In some cases, if the corporation is not seriously off-side, it may be possible to sell assets to reduce debt or finance more prospective operations. This will, however require the consent of any secured creditor and if it constitutes all or substantially all of the assets of the corporation, the approval of the shareholders under the business corporations act. Shareholder approval is in addition to any conditions imposed by the stock exchange and requires the affirmative vote of ⅔ of the shareholders voting at the meeting called to consider it.
The definition of "all or substantially all" can be quite surprising to many people, however, as the courts have considered it to be a qualitative test, rather than a quantitative test. The test essentially is: would the sale of an asset be the effective destruction of the corporation's business. The question revolves around whether the assets being sold are key to the corporation's core business activities and the property involved in carrying out such activities.
Business Combinations
In some situations, a business combination may solve the problem. This is not without its own unique difficulties because it usually means a change of management and control. The board must therefore consider not just the economic aspects and asset fit of the deal, but also the strengths of the new management and the likelihood of it being able to drive the combined business forward. Business combinations may take the form of a take-over, an amalgamation or a corporate reorganization through a plan of arrangement, including a sale of all or substantially all of the assets of the corporation.
Independent valuations are particularly important and in some situations are required by the securities rules. See footnote 5.
The directors will want to consider their duties and what deal protection techniques in take-over bids and business combinations may be available to them in discharging their fiduciary duties.8
Recapitalization
Recently, a popular form of rescue has come in the form of a recapitalization. This usually involves a new management team with a financier behind them replacing existing management and providing necessary cash to pay out or pay down existing loans. This is often done as a private placement of shares and where a change of control results, either from the change of management or from the change of equity ownership, or both, shareholder approval may be required.9 In the more elaborate schemes, it may also include combining with other businesses or acquiring other assets to create a bigger entity.
This tactic involves the same sort of economic considerations and analysis of the quality of the new management as in the case of a business combination.
Soft Receiverships
Occasionally, lenders or significant shareholders will suggest to management that they consider a business combination, recapitalization or other reorganization with another corporation that may have a stronger balance sheet or management team. They avoid the costs and losses that accompany an insolvency proceeding and offer the shareholders the opportunity to salvage something from their investments. One of the difficulties with this approach will be finding a suitable acquiror from a dwindling list of candidates. Because cash is usually needed to rescue the distressed business, the acquiror must either have a clean enough balance sheet or access to cash to make the combination attractive.
Insolvency
In cases where the corporation has reached its borrowing limits or is facing a decline in revenues and has negative working capital, insolvency is very often the only solution for its creditors. In this situation, it is particularly important for the directors to retain knowledgeable legal, accounting and financial advice as there will be a number of challenges facing the board.10
One of the consequences of a receivership is the removal of most of the powers of the board to oversee the management of the corporation. However, in the case of a proceeding under the Companies Creditors Arrangement Act, the situation is a little different.11
Hostile Bids
One of the harsh realities about publicly listed shares is that from the moment they begin trading they are potentially the object of an unwelcome attempt to acquire control of the corporation. This is especially so when the corporation is in distress and shareholders are getting restless. If the corporation is on someone's radar, it will be noticed when it begins showing signs of weakness. Often the approach begins as a friendly, although probably somewhat aggressive one, and if an easy deal cannot be made, is followed by a hostile bid.12
Directors will be called upon to represent the best interests of shareholders in these cases, which can be made more difficult than usual when responding to an obviously undervalued offer. In these cases, independent advice for the directors is essential, both in terms of discharging their duties and in limiting their personal exposure to claims against them. However, the board is limited in the kinds of defensive tactics it may employ to fight of an opportunistic bid.
This can be one of the most difficult situations for the directors to respond to because of the complexity of the rules surrounding their duties, the rights of the shareholders to receive an offer for their shares if a reasonable proposal is put forward and the regulators' requirement that a fair auction be held. Again, it is particularly important for the directors to retain knowledgeable legal, accounting and financial advice because of the risks the directors face in responding to a hostile bid.
Entrenched Management
One topic which seems to come up regularly in dealing with junior E&P companies and one that can make the directors' job even more difficult in any of the scenarios mentioned above, is that of an entrenched management. Typically this is the result of one or two people taking the initiative in launching the business. Often they begin with a private company, raising capital from family and friends, and from themselves, before going to the public. When the situation starts to deteriorate, they are not willing or able to accept the possibility of the loss of their investment, in cash and sweat, and therefore take positions which tend to prevent the orderly reorganization of the business, including a change of control.
This can be particularly dangerous for the other directors because, if they do not discharge their duties in an impartial manner they may find themselves as the defendants in actions taken by creditors and others to collect money and regulatory or court proceedings. In many cases, with junior E&P companies, the board is hand picked by the president. For these directors, this is the time to put relationships aside and respond to the situation in an impartial manner.
It's not just about the Oil and Gas Industry
The current conditions in the oil and gas industry have presented a particularly dramatic example of how the duties of directors can be much more challenging than most directors expected. While the reasons for them may be different, the challenges can arise in any other industry. Hopefully some of the thoughts discussed above will also be useful to those directors.
Footnotes
1. For a discussion of the statutory liability of
directors and their liability to creditors, see: (They're
coming after you)
http://www.fasken.com/files/Event/fac3fc12-d572-465a-ae6a-f3563f950b3b/Presentation/EventAttachment/2cba8cc0-bc1f-41f6-b5a4-1b11845264f4/PDF%20Booklet%20-%20D%26O%20Part%206%20-%20March%2024%202010.pdf
and (Bad news for directors in distressed situations)
http://www.fasken.com/files/Publication/fec69cb7-489d-4ef5-865e-15527891d98f/Presentation/PublicationAttachment/b858039c-ce1c-46e6-ac98-8d5dd0ccea75/INSOLVENCYBULLETINNOV04.PDF
2. For a discussion on this topic, see: (Indemnities and
D&O Insurance)
http://www.fasken.com/files/Event/2aa599b1-044e-4a1e-a348-0da4921f9eff/Presentation/EventAttachment/52a0a028-de1b-4d50-9476-827ae0872a92/PDF%20Booklet%20-%20D%26O%20Part%203%20-%20February%2011%202010.pdf
and (20 questions on indemnification)
http://www.fasken.com/files/Publication/c9935493-ae4d-4bda-8c46-03c6347116df/Presentation/PublicationAttachment/f04bf453-b6bf-4a4d-9704-0896a3e7d964/20Q_Liability.pdf
3. For a discussion on this topic, see (Risk Based Governance): http://www.fasken.com/files/Event/487a55c8-639e-47b0-b9d3-030e5001883a/Presentation/EventAttachment/055f4eba-ee04-4fb0-8c99-e29144621e8f/D%26O%20Part%201%20-%20Material%20-%20January%2014%20and%2019%202010.pdf
4. For a broader discussion of directors liabilities in the face of insolvency, see (D&O liability in insolvency) http://www.fasken.com/files/Publication/68b97810-b69a-4b09-88c0-8f5c1d2a206c/Presentation/PublicationAttachment/8f145a23-5bec-4b54-bc9c-94b62b558270/D%26O_Liability_Exposure_in_an_Insolvency_Environment.pdf
5. See (Protection of Minority Security Holders): http://www.osc.gov.on.ca/en/SecuritiesLaw_rule_20080201_61-101_protect-minority.jsp
6. For a discussion of Special Committees, see (20 Questions for Special Committees): http://www.fasken.com/files/Publication/ecc636b0-9255-45e0-8669-07daaee5b0d7/Presentation/PublicationAttachment/37105d33-907c-4aaa-b291-0bce65d8176b/20_Questions.pdf
7. For a discussion of actions which might be considered in situations where the securities regulators undertake an inquiry, see (What to do when the regulators call): http://www.fasken.com/files/Event/866f7c1d-8f4e-4653-81fe-e3681030daf6/Presentation/EventAttachment/6b13a053-8751-47ae-abc4-b2f7e66f4c73/PDF%20Booklet%20-%20D%26O%20Part%205%20-%20March%2011%202010.pdf
8. For a discussion of directors duties in structuring deals, see (Directors duties on takeovers) http://www.fasken.com/files/Publication/e57d95df-241f-4a48-8ba6-65da8fb619a6/Presentation/PublicationAttachment/ee186595-9738-4736-910e-08b5b4db0403/REVIEWDIRECTORSDUTIES.PDF
9. For a discussion of some of the issues in relation to a private equity investor investing in the corporation, see: http://www.fasken.com/files/Event/24adbc58-fdf1-46f9-bcc3-ba18f12d0893/Presentation/EventAttachment/68ccc57d-55cb-432a-9326-0fd167f40d90/PDF%20Booklet%20-%20Private%20Equity%20-%20March%202%202010.pdf
10. For a discussion on this point, see (Corporate Governance in Insolvency) http://www.fasken.com/files/Event/c1bad32b-5328-4c8e-b18d-150bc5ca9f05/Presentation/EventAttachment/5d73af95-49d1-4e9e-b8af-00a0e843cbab/PDF%20Booklet%20-%20D%26O%20Part%204%20-%20February%2024%202010.pdf
11. For a discussion on this point, see (Whose board is it?) http://www.fasken.com/files/Publication/9ca89d84-cfb3-43d7-b9ba-8f85380c2673/Presentation/PublicationAttachment/d273e87a-ea60-458e-b4fc-91d4390f16fc/INSOLVENCY_APR05.PDF
12. For a discussion see (Directors duties in M&A): http://www.fasken.com/files/Event/debfa258-c705-40a5-aaaf-a055e91c4394/Presentation/EventAttachment/b4ba09fe-539b-4b41-bd55-44397bb1e12b/PDF_Booklet_-_D%26O_Part_2_-_January_28_2010.PDF
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.
