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Recent volatility in the energy markets has put increasing
stress on the capital structures of companies operating in those
markets. When commodity prices were higher between 2010 and 2014,
many of those companies took on significant amounts of debt to
pursue new opportunities.1 Starting in 2014, oil prices
dropped precipitously, and since then have remained at record
lows.
This unique economic environment presents companies operating in
this space (and their directors and officers) with numerous
challenges involving complicated business and legal issues. This
article focuses on three scenarios that an energy company may face
depending on its particular financial
situation—over-leverage, risk isolation, and strategic
opportunities—and discusses some of the legal considerations
with respect to each. Indeed, many of these scenarios have played
out in one form or another across a variety of companies over the
past 18 months.
The range of issues a company may confront depends to some extent
on its overall financial position. At one end of the spectrum,
highly-levered companies with significant debt loads may have
difficulty complying with their current obligations (or may expect
those difficulties on the horizon), but they may also be able to
mitigate their financial situation by seeking to refinance or
restructure a portion of their existing debt. Companies that are
financially healthy, at least on an overall basis, often face
different issues. Those companies may want to isolate or divest
potential sources of financial stress to stem losses or to minimize
the risk that they could adversely affect the enterprise as a
whole. Finally, at the other end of the spectrum are companies
that, given their relatively strong current financial condition,
may in a position to take advantage of current market opportunities
presented by the abundance of businesses that are not as healthy.
Companies in these situations should focus on the risks attendant
to taking such opportunities.
Highly-Levered Companies May Face Obstacles and
Opportunities
As noted above, many energy companies took on substantial amounts
of debt during a period of higher commodity prices and more
generous credit availability. By way of background, it is helpful
to consider an example of a typical capital structure of an energy
company, for example an oil or gas exploration and production
(E&P) company. The top level of the capital structure of many
energy companies consists of first lien secured debt, often in the
form of a revolving asset-based loan facility. Lower levels of the
capital structure may consist of secured or unsecured notes issued
pursuant to an indenture.
The typical E&P company's debt capacity is linked to the
value of its oil and gas reserves, a critical element of its
revolving credit facility borrowing base and its high-yield
indenture covenant measure of adjusted consolidated net tangible
assets.2 Lower commodity prices and declining
investments in new reserves have combined to reduce the value of
reserves precipitously, thus restricting borrowing ability. With
limited borrowing capacity and no viable refinancing options,
E&P companies have been seeking other ways to increase
liquidity, including the reduction or elimination of dividends,
asset sales, and cost-cutting measures. With their remaining
projected liquidity, E&P companies must weigh the risks and
benefits of reinvestment, deleveraging through market debt
purchases of their own debt now trading well below par, and a host
of other in- and out-of-court restructuring options.
Out-of-court options may include, among other things, consent
solicitations, private exchanges, tender offers, and negotiating
waivers or modified terms with credit facility lenders. Each of
these options raises numerous complex business and legal issues
that are beyond the scope of this article. In the context of
private exchanges, one critical issue is that it is often difficult
or impossible to get all noteholders to agree to any proposed
restructuring. Recent litigation involving noteholder invocation of
the Trust Indenture Act (TIA), which requires unanimous consent
before an issuer can alter the basic payment terms of notes outside
of bankruptcy,3 has brought into focus some potential
limits of out-of-court note restructurings. Even when an
overwhelming majority of (but not all) noteholders are in
favor of an exchange, it may be difficult to consummate certain
types of restructurings without the compulsive features of chapter
11.4
When out-of-court options are not viable or sufficient, chapter 11
bankruptcy restructuring, of course, is also one such option, and
it carries with it both advantages and disadvantages that should be
thoroughly considered. In the energy company context, certain
bankruptcy rules may apply differently, and in ways that a borrower
thinking about chapter 11 should fully consider in advance. For
example, the general rules regarding the treatment of contracts
apply in unique ways to contractual arrangements like joint
operating agreements and oil and gas leases, which can be essential
to an energy company's ability to continue operations. The
presence of significant regulatory obligations, which are often
treated differently in bankruptcy than run-of-the-mill creditor
claims, should also be considered. And of course, even when chapter
11 might be a suitable solution from a legal perspective, its
financial and other costs may weigh against pursuing
bankruptcy.
Financially Sound Companies May Nevertheless Seek to
Isolate Risks
A company that is financially sound may nevertheless have
subsidiaries or divisions under financial stress, or that are
likely to come under financial stress, and it may want to make sure
that stress is isolated.
In many situations, a company may make a strategic commitment to
maintain its existing business, including underperforming
divisions, during a period of depressed commodity prices, so that
it can take advantage of any future rebound. This approach may
carry with it an increased business cost, but may also present
fewer legal risks than its alternatives.
As an alternative to maintaining distressed divisions through a
downcycle, there may be instances where a company needs to
wind-down or divest assets that it has determined are not worth its
continuing investment. Implementing such divestitures can involve
unexpected complications and risks.
Three primary considerations come to mind. First, certain
intercompany arrangements like guaranties or co-liability on
contracts can result in the continuing enterprise remaining liable
as a contractual matter for the divested entity's debts. A
company considering such a transaction should fully analyze which
liabilities can be minimized or eliminated, and which may remain.
Second, a buyer of a distressed business segment may insist on
obtaining contractual indemnities from the seller as a condition to
consummating the sale. From a seller's perspective, such
provisions should be thoughtfully tailored to mitigate and contain
the risk of continuing liability. Third, even putting aside
intercompany and contractual liabilities, there may be
extra-contractual liabilities that will remain with the seller
following a divestiture. In particular, environmental regulations,
which often impose strict liability, pose a risk of trailing a sale
or wind-down.
Thriving Companies May Seek to Take Advantage of Market
Opportunities
A company that is in a strong financial position may seek to
capitalize on opportunities presented by companies that are not as
financially healthy by acquiring those companies or their assets.
But the acquirer needs to approach such transactions with its eyes
wide open.
The general rule is that a buyer does not take on liability for
claims against a seller. However, the doctrine of successor
liability can operate as an "exception" to that rule.
Under the doctrine of successor liability, a creditor may be
permitted to assert against a purchaser a claim based on the
seller's pre-sale actions. It is important to diligence these
potential liabilities, but in a distressed scenario, it is often
difficult to obtain a full picture of the potential liabilities. In
some circumstances, bankruptcy can help. The Bankruptcy Code
allows, under certain circumstances, a sale "free and
clear" of certain liabilities. But there are exceptions. As
one example (and there are more), environmental liability cannot
always be cleansed entirely in bankruptcy, and buyers can often be
held strictly liable for clean-up obligations.
Even in situations where successor liability and debt concerns are
contained, there are additional risks to consider. Where a
transaction leaves creditors of the acquired entity with
insufficient recoveries, they may seek to challenge the
transaction. For example, in 2014, Sabine Oil & Gas LLC
combined with and then merged into a publicly traded oil and
exploration and production company, Forest Oil Corporation.
Ultimately, the combined enterprise filed for chapter 11
bankruptcy.5 The Official Committee of Unsecured
Creditors is seeking to assert a myriad of claims stemming from the
business combination. The claims include fraudulent transfer claims
against the company's lenders, as well as breach of duty claims
against the directors and officers, and claims against the private
equity owner of Sabine. This highlights the risk that a transaction
will be put under a microscope in a distressed context, and
emphasizes the care that must go into diligence and structure for
these types of transactions.
Conclusion
Each of the scenarios discussed above (which are only some of the
scenarios that companies in the current market may be facing)
raises varied and complex issues (only some of which are previewed
above). In addressing these scenarios, directors and officers often
must consider the interests of various stakeholders, including
shareholders, creditors, and other constituencies. Accordingly, it
is important to involve legal counsel early in the process to
strategize about ways to approach these and other scenarios to
mitigate risk and maximize benefits while balancing the interests
of various stakeholders.
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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.