Oil & Gas Distress: Bankruptcy Issues Deep Dive - PowerPoint Presentation

1. Oil & Gas Distress: Bankruptcy Issues Deep DiveApril 13, 2016www.velaw.comEnergy Finance Series

2. Oil and gas distress: bankruptcy issues deep diveSummary of presentationZone of insolvency/bankruptcy dutiesOptions and preparing for the potential Chapter 11 bankruptcy caseExecutory contracts and rejection issues…midstream revisitedPlan strategies, from consensual to cram up and cram downLoan to own issuesUse of liquidation and litigation trusts following Chapter 11

3. Solvent Corporations – Directors and officers owe fiduciary duties to the corporation with the stockholders being the residual stakeholdersZone of Insolvency – Directors and officers continue to owe fiduciary duties to the corporation, and the residual stakeholders can be in a state of fluxInsolvency – Directors and officers owe fiduciary duties to the corporation with the creditors being the residual stakeholdersHow do duties change when a corporation approaches insolvency?Zone of insolvency

4. Duty of Loyalty and Duty of CareUnder Delaware law, directors and officers have same dutiesA corporation’s charter may contain an exculpation of directors and officers for breaches of the duty of care – but not for breaches of the duty of loyaltySo long as their duties are complied with, directors and officers are generally entitled to protections of the business judgment ruleUnder business judgment rule, courts do not substitute their own views for those of directors and officers or second guess outcome of business decisions by holding director or officer liable for a mistake in judgmentTransactions benefiting insiders generally will shift the burden to show “entire fairness”, that is, the presumption of the business judgment rule may not applyClaims for breach of fiduciary duty become property of the bankruptcy estateDirectors’ and officers’ fiduciary duties GenerallyZone of Insolvency

5. There is no exact definition of “Zone of Insolvency” Generally, a corporation is considered in the Zone of Insolvency when it is near or approaches the point where:the sum of such corporation’s debts is greater than the fair value of all of such corporation’s assets, with no reasonable prospect that the business can be successfully continued (the Balance Sheet Test)the corporation lacks sufficient assets to pay its existing debts as they mature (the Cash Flow Test)Note also that an entity with unreasonably small capital may be in the Zone of InsolvencyBoard of directors often consult with advisors in making a determination as to whether a corporation is in the Zone of InsolvencyNote, entering the Zone of Insolvency generally does not require any specific actionHow do duties change when a corporation approaches insolvency?Zone of insolvency

6. Under Delaware Law – the Zone of Insolvency does not change the duties of officers and directorsIn Credit Lyonnais, the DE Chancery Court noted that directors of a solvent corporation operating in the “vicinity of insolvency” owe fiduciary duties to the corporation not only for the benefit of shareholders, but also for the benefit of the community of interests that the corporation represents, to include creditors. See Credit Lyonnais Bank Nederland, N.V. v. Pathe Commc'ns Corp., No. CIV. A. 12150, 1991 WL 277613, at *34 n. 55 (Del. Ch. Dec. 30, 1991).Clarifications from Gheewalla: Directors of corporations in “zone of insolvency” do not owe fiduciary duties to creditors of corporation.Creditors do not have standing to bring a direct claim against directors when a corporation is in the “zone of insolvency.”Did NOT address whether a creditor could bring a derivative action in zone of insolvency See, North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007)How do duties change when a corporation approaches insolvency?Zone of insolvency

7. Theory of liability based on fraudulent or negligent prolongation of the life of a corporation, thereby increasing the corporation’s debt and exposure of creditors, essentially a way to assert liability for management judged in hindsightThis theory has been asserted not only against directors and officers, but also a corporation’s lenders and professionalsCrux of the issue for directors and officers is whether actions that taken or not taken created a worsening situation for the corporation’s creditorsDeepening insolvency was rejected in Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006). Thus, in Delaware, if the board of directors or management team of an insolvent company, acting with due diligence and good faith, pursues a business strategy that it believes will increase a corporation’s value, but that also involves the incurrence of additional risk to creditors, it does not become a guarantor of that strategy’s success. That a business strategy results in an even more insolvent entity does not in and of itself give rise to a cause of action. Rather, in such a scenario, the directors are protected by the business judgment rule, absent a material economic interest in the strategy (e.g., strategy prolongs life of corporation and permits payment on debt instrument held by a director, officer and any affiliate of such director or officer). Quadrant Structured Products Co. v. Vertin, 102 A.3rd 155 (Del. Ch. 2014)Nonetheless, given that the theory has not been universally rejected, something to keep in mind – judgment of actions and decisions judged in hindsight“Deepening insolvency”Zone of insolvency

8. Duties of Chapter 11 debtor-in-possession (“DIP”) are two-fold:Duties prescribed by state lawDuty of CareDuty of LoyaltyDuties imposed under federal bankruptcy law, if there is a conflict, federal bankruptcy law prevailsBusiness judgment rule does not change, limitations on rule availability for insiders remains as wellBankruptcy Court approval of decisions utilized to confirm business judgment and obtain relief necessary to administer bankruptcy caseDIP owes fiduciary duties to all interested parties – creditors and stockholders alike – to maximize value of the estate, refrain from self dealing and treat all parties fairlyCorporation effectively “put into play” upon a filing (i.e., duty to shop and consider third party proposals; should not “chill” competitive bidding)Decision-making process of directors and officers are transparent with approval by the bankruptcy court and bankruptcy court approval can provide protection for directors and officers of the DIPNot atypical for bankruptcy plans to include exculpation of the DIP’s directors and officers that have acted in good faith, and discharged their fiduciary duties in a context of restructuring-related decisionsthe court supervised processDuties in bankruptcy

9. Options and preparing for chapter 11Summary of optionsOut of court exchange offer to market test and determine whether out of court exchange can be effectuated to restructure the businessRestructuring pursuant to a confirmed bankruptcy plan of reorganizationPre-Packaged planPre-Arranged planPlan support agreementDistress sale transactions

10. Options and preparing for chapter 11Out of court exchange offersCompany makes an offer to holders of its outstanding securities to exchange the existing debt for newly issued debt securities, equity securities or combination of the two  The offered debt may include lower face amounts, reduced interest rates, extended maturities, or different priority/security compared to the old debtAn exchange offer is an offering of new securities and must be registered with the SEC unless an exemption from registration is availableRegistered Exchange OfferExempt OffersSection 3(a)(9) Exchange OfferPrivate ExchangeRegulation DPrivate PlacementHoldouts: under Trust Indenture Act of 1939, fundamental economic terms of bonds cannot be amended without the consent of each holder. Thus an existing debt holder can always preserve its economic terms – although not necessarily its covenant protections – simply by declining to make the exchange

11. Options and preparing for chapter 11Out of court exchange offers deal issuesIndenture/covenant amendmentsShareholder approvals/ Amendment of organizational documents limitations on equity issuances under NYSE/Nasdaq rules and limited by authorized shares under company charterNOLs/Tax limitationsTime to tenderInducements to tenderThresholds of participationTargeted holdersWithdrawal rightsChange of control diligenceRatings implications

12. Summary of a Traditional Chapter 11 CaseTHE PATH FORWARD – Out of court not achievableCompany files for chapter 11Formulate business plan and execute restructuring transactionsNegotiate PlanDisclosure Statement approvedCreditors approve PlanCourt confirms PlanPreparationFiling and stabilizationRestructuringPlan formulation and confirmationExitIn a typical “traditional” chapter 11 case, the chapter 11 filing occurs first, then a business plan is developed, and then the debtor formulates and solicits acceptances of a chapter 11 plan of reorganization. A “traditional” chapter 11 case generally lasts an extended period of time.Time TBD

13. Options and preparing for chapter 11Prepackaged plansEnables a debtor to minimize the impact to its ongoing business operations by combining many of the best aspects of out-of-court workouts (cost-efficiency, speed, flexibility and cooperation) with the binding effect and structure of a conventional bankruptcy.Unlike a traditional chapter 11, a pre-pack is negotiated and voted on by creditors before a proceeding is commenced in the bankruptcy court.Bankruptcy Code § 1126(b) Solicitation must be in compliance with any applicable nonbankruptcy law, rule, or regulation governing the adequacy of disclosure in connection with the solicitation; or If there is not any such law, rule, or regulation, the acceptance or rejection must be solicited after disclosure of “adequate information”Bankruptcy Rule 3018 Must transmit plan to substantially all creditors and equity security holders of the same classCannot have an unreasonably short time for creditors and equity security holders to accept or reject the planConfirmation can occur promptly, e.g. Southcross 15 days in S.D. of Houston.

14. Options and preparing for chapter 11Pre-arranged plansDebtor enters chapter 11 after negotiating the terms of a restructuring with certain of its major stakeholders and having entered into an agreement with such stakeholders setting forth the key terms of the proposed restructuring.A pre-arranged case might take 75-90 days from filing to effective date (as opposed to a pre-packaged case which might be completed in only 30-45 days). Avoids securities law issues of a pre-pack Use of Plan Support Agreements (also known as Restructuring Support Agreements/RSAs or Lock-up Agreements)Typically have a fiduciary out and a requirement that they be assumed by the debtors 

15. Options and preparing for chapter 11Chapter 11 process summarizedReach agreement with certain creditors Execute restructuring support agreement or “RSA,” which contains key plan termsFile chapter 11 casesCourt approves disclosure statementCourt confirms planCompany solicits votes on planExit chapter 11Finalize plan and disclosure statement90 Days60 Days150 DaysNegotiate plan with RBL lenders and noteholders Reach agreement with creditorsCourt approves disclosure statement and confirms planExit chapter 11Finalize plan and disclosure statement90 Days60 Days60 DaysNegotiate plan with RBL lenders and noteholders Company solicits votes on planFile chapter 11 casesPrepackagedPrearranged210 Days Total300 Days Total

16. Options and preparing for chapter 11Distress Sale transactionsOut of court sale transactions note, must consider risks in sale process such as risk of default and fraudulent transfer risks (i.e. paying reasonably equivalent value when dealing with a distressed seller)Chapter 11 sale pursuant to section 363 of the Bankruptcy CodeChapter 11 sale pursuant to a confirmed bankruptcy plan (asset sale or plan synthetic asset sale)

17. Options and preparing for chapter 11Distressed sale transactionsTimeCost and RiskBenefitOut of CourtNo Court process time limitations.Fraudulent transfer and preference risk could cause transaction to be unwound or result in unexpected costs; no Court ordered relief or findings; cannot deal with unconsenting creditors; successor liability risks.Avoids time and costs of bankruptcy process and potential overbidding if there is an agreement on exclusivity.Bankruptcy 363 Sale45-90 day Court process if not heavily contested.More expensive than out of Court but less expensive than a plan sale; will be subject to higher or better offers.Receive assets free and clear of liens and claims by Court order; no fraudulent transfer or preference risk; potential for stalking horse break-up fee; can bind unconsenting creditors; mitigates certain successor liability risks.Asset Plan Sale or Synthetic Plan Asset Sale90-120 day Court process unless Pre-Packaged or Pre-Arranged and if not heavily contested.More expensive than other options; often subject to higher or better offers; must meet confirmation requirements in the Bankruptcy Code.No fraudulent transfer or preference risk; the most transactional flexibility of any acquisition option; potential for stalking horse break-up fee; can bind unconsenting creditors; can address issues that cannot be addressed in a 363 sale.

18. Options and preparing for chapter 11Chapter 11 363 salesAcquire assets free and clear of liens and claims (potentially including certain successor liabilities)Subject to higher/better offers, typically including a marketing process and auctionPotential stalking horse with a break-up feeNo-shops are inconsistent with Debtor’s fiduciary duty, but may have short “go dark” periods prior to the approval of bidding procedures and formal commencement of the marketing processTypically, Debtor promptly seeks Court approval of bidding procedures and break-up feeMinimum bid and minimum bid incrementDeposit and evidence of financial abilityDue diligence scope and access/confidentiality agreements/data roomRequirements of a qualified bidProcedures for including/excluding assets and for assumption of contractsProcedures regarding preferential rights to purchase, consent rights, and rights of first refusalNotice procedures, including potential publication noticeProcess timing (usually 60-90 days)

19. Options and preparing for chapter 11Chapter 11 Plan sales and exitPlan asset sales and plan synthetic asset sales free and clear of interests/claimsPre-Arranged vs. Pre-Packaged PlanDisclosure and solicitationAcceptance thresholds of voting creditors (greater than 50% in number, at least 2/3 in amount)Stalking horses and bidding and sale proceduresPlan process timingTransactional flexibilityOften avoids issues relating to preferential rights to purchase and conveyances of oil and gas interestsAdditional optionality in structuring transactionSecurities issuance exemptionThe plan sets up the “new contract” for the debtor upon which it exits bankruptcy

20. Options and preparing for chapter 11Chapter 11 Executory contracts and unexpired leasesBankruptcy Code § 365 authorizes the Debtor to assume or reject executory contracts and unexpired leasesRequires cure of certain defaults before assumptionRequires adequate assurance of future performancePermits assignment notwithstanding limiting contractual provisionsRejection constitutes a breach of the contract or lease immediately before the date of the filing of the petitionPermits seller to shed onerous contractsOften converts claims under rejected contracts into unsecured pre-petition claims that may not have a full recovery

21. Options and preparing for chapter 11Midstream contract issuesOutline of issues:Practical reality: alternatives to the gathering system?Bankruptcy filing impact, the “twilight” periodRestrictions on assignment of the GPA by the producerRestrictions on assignment/sale by producer of the dedicated propertiesCovenants running with the landBankruptcy sales free and clear of interestsDedicationsMinimum volume commitmentsNo uniform answer, differing contracts, application of bankruptcy and non-bankruptcy lawEconomic realities will drive the negotiation, level of co-dependency, replacement options, GPA so burdensome as to render production not economical?

22. Options and preparing for chapter 11Midstream contract issues…sabine and quicksilver casesSabineDelaware Bankruptcy Court approved rejection of gathering agreement based on business judgment and issues a non-binding ruling on CRWTL issuesMidstream providers had dedications in their gathering agreementsDedication observed not to equal conveyance to meet privity testBurden via dedication was as to severed minerals, thus no touching and concerning “land” in any eventOrion 2nd Circuit ruling mandates adversary proceeding, determine an interest in propertyAdversary proceedings have been commenced by the debtors seeking to invalidate the asserted CRWTLQuicksilverRejection motion was withdrawn effective upon payment of the $245 million purchase price by Blue StoneCourt seemed willing to approve rejection in order to consummate saleCourt cited potential waiver of challenge to free and clear sale based on language of sale order being free and clear of dedications, etc.

23. Options and preparing for chapter 11Plan strategies…cram ups…cram downs…The Bankruptcy Code permits the confirmation of plans of reorganization that may not be acceptable to all classes of creditorsThis is the so-call “cram” feature of plan confirmation“Cram up” means putting the “cram” on a creditor class or classes higher in the capital structure, often the senior secured lender (e.g. the Momentive ruling)“Cram down” means putting the “cram” on a creditor/equity class or classes lower in the capital structure, often the unsecured creditors and old equityKey features to invoke the cram power:At least on impaired class must vote for the planThe plan must not unfairly discriminate among like creditorsSecured creditors are entitle to receive the value of their collateral, retain their liens, and be paid a rate of interest determined by the Bankruptcy CourtThe terms of the absolute priority rule must be met, lesser priority creditors or equity may not receive property under the plan unless those more senior get property equal to the allowed amount of such claim as of the plan effective dateThese provisions apply to the oversecured creditor and the undersecured creditor

24. Loan to own (if need be)Entering the capital structure as a potentially willing buyerIn general, purchased loans can be enforced at face amount for recovery purposes in a bankruptcy case and the lender would be willing to own assets if need bePurchaser generally steps into shoes of original creditor with all benefits and detrimentsThe “fulcrum” security (i.e., the first undersecured creditor in the hierarchy of absolute priority) often has increased influence in the bankruptcy case, particularly when credit bidding debt purchased at a discountThe fulcrum security creditor (including a secured provider of new-money financing to a distressed borrower) can have many advantages both in terms of ultimate recovery and practical benefits particularly early in the case The fulcrum may have blocking power in its class, that is, in bankruptcy case, to approve a plan without resort to cram down, each class of impaired claims must approveApproval requires at least 2/3 in amount and more than one-half in number of allowed claims in the classThus, greater than 1/3 in amount is normally considered to be a blocking position for a creditor class in the approval of a chapter 11 plan, and can provide substantial leverage to effect a desired outcome

25. Loan to own (if need be)Transactional considerationsPerform due diligence to understand target’s profile and identify key considerations relating to distressed debt investmentAnalyze capital structure Identify “fulcrum” security and its current holdersReview terms of existing debt documentationReview information relating to target’s assets and operationsDetailed analysis of value of target’s assets (e.g., analysis of acreage position and profile of leases held-by-production versus leases that may expire during pendency of bankruptcy proceedings)Material contracts and related commercial terms (e.g., joint operating agreements, gathering agreements, joint venture agreements, etc.)Analyze lien/covenant running with land issuesAssess whether material contracts are executory contracts and ability to reject/replace in bankruptcyKey trade creditors and payment terms, accounts payable, current delinquenciesCounterparty riskExposure to distressed customers/suppliers/vendors

26. Loan to own (if need be)The fulcrum security and secured debt purchasesProvides opportunity to acquire debt at a discount, although fulcrum security may be difficult to ascertain and can shift over time, “hey, who moved my fulcrum”Acquisition of secured debt can confer substantial rights in a chapter 11 bankruptcy, including the right to “credit bid” the amount of the claim and receive adequate protectionPurchasers of bank debt typically made on basis of standard LSTA terms for trading syndicated debtImportant factors to consider in evaluating purchase:Voting rights under debt documents (e.g., the ability to enforce remedies and grant waivers)Priming lien and pari passu debt capacityAbility under debt documents to raise liquidity through asset salesAbility to make investments and restricted paymentsPotential affiliate transactionsSecurities law issues

27. Loan to own (if need be)LOAN-TO-OWN FINANCING TECHNIQUES INVOLVING PRE-PETITION DEBTProvide secured loan to distressed borrower:Positions lender for potential out-of-court debt-to-equity swap or to help facilitate an prepackaged or pre-arranged Chapter 11 caseSecured position may provide substantial influence in the bankruptcy processCovenants structured to transfer “control” to lender“Make-whole” payment potentially owing upon bankruptcy maximizes value of secured claimSecured claims may be credit bidSecured creditor can be stalking horse bidder for assets using its claim to credit bid versus cash bidsSome courts have limited credit bidding if there is a concern that the credit bid will chill bidding for the assetSome courts have suggested that claims may be limited to purchase price for purposes of credit bidding (rather than face amount of the claim)

28. Loan to own (if need be)Post-petition dip financingAs an alternative to or as part of above strategies, creditor can provide Debtor-in-possession (DIP) financing during caseDIP Financing can be converted into equity in reorganized entity if not paid in fullGiven lender status of provider of DIP Financing, the terms of DIP Financing may provide for milestones and other provisions intended to effectuate a payoff of financing DIP lender may want to retain some debt as prepetition secured debt in order to be the impaired accepting class for cramdown, and such retained debt should not be primed by the DIP Financing in order to retain secured status, may raise technical impairment issuesDIP financing can be provided in several waysEnabling DIP to facilitate acquisition by DIP lender/potential purchaserDone in conjunction with purchase agreement and is part of purchase price consideration (fees, interest may provide some price advantage)Set sale process milestones via the DIP and sale proceduresDetermine whether priming or subordinate to secured lenders, priming preferred, although purchase may justify accepting a subordinate positionPreservation DIP by the existing secured lender(s)Purchase of secured debt at discount may offer path to DIP lending with advantageous credit bid rightsOpportunistic DIP by new lender if value supports new priming lendingPotential for competitive process to be selected as DIP lenderMay be subject to valuation contest by secured lenders being primed

29. liquidation trustsDealing with left behind assets and estate claimsLiquidation trusts are created to deal with, among other things, assets not disposed of in the Chapter 11 bankruptcy case, and the pursuit of claims of the bankruptcy estateBankruptcy Code Section 1123 authorizes the framework for the liquidation trustThe liquidation trust is authorized under the plan of reorganization as a required means for implementation of the planThe trust itself will be established via the trust agreementLiquidation trusts are often pass through grantor trustsDuration of the liquidation trust is typically 3 to 5 years under the applicable IRS revenue guidelinesKey have tax advice when establishing the liquidation trust

30. liquidation trustsDealing with left behind assets and estate claimsThe primary purpose of the trust must be liquidation with no objective to conduct a trade or business, and can also include litigationThe liquidation trust should not receive marketable securities or operating assets of a going concern business, and cash transferred to the trust should be limited to meeting the trust’s obligationsThe liquidation trust is required to distribute proceeds from asset sales at least annually and will typically have a waterfall for the distribution of property of the trustThe liquidation trustee will be empowered to bring claims of the bankruptcy estate and to assert interests of the bankruptcy estateCommon liquidation trustee litigation includes fraudulent transfers, preferential transfers, D&O liability claims, and other litigation claimsThe liquidation trustee may also litigate to prove interests in property of the estate disputed by other parties

31. Today’s panelEnergy TransactionsBryan e. loockePartner, HoustonCapital Markets and Mergers & AcquisitionsSarah k. morganPartner, HoustonRestructuring & ReorganizationBill wallanderPartner, Dallas+1.713.758.3281bloocke@velaw.com+1.713.758.2977smorgan@velaw.com+1.214.220.7905bwallander@velaw.comRestructuring & ReorganizationPaul E. HeathPartner, Dallas+1.214.220.7976pheath@velaw.com

32. We have prepared this summary to provide an overview of issues that may arise in connection with gathering and processing agreements related to a producer in the financial restructuring process. This is a broad summary not intended to cover every issue which may affect the company or industry.This is not intended to be and is not legal advice or an opinion of any of Vinson & Elkins LLP. This presentation was not written or intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. This presentation is informational only and is not a legal opinion as to any specific matter or issue.Disclaimer

33. Thank you