Rising oil prices may mean more bankruptcies
STRANGE BUT TRUE: E&PS AND SERVICE PROVIDERS CONTINUE TO FILE FOR CHAPTER 11
JASON B. BINFORD, GARDERE WYNNE SEWELL LLP, DALLAS
The slowly rising price of oil is a welcome change to an industry that experienced its most recent catastrophic price collapse in 2014. Production has resumed and ramped up both onshore and offshore. The trip through the price trough, however, has resulted in likely permanent changes to the industry.
Onshore production has increased at a faster rate than offshore, generally because it is less capital-intensive. Thus, onshore production once again becomes profitable at a lower commodity price point. In contrast, offshore production is a capital-intensive enterprise due to the logistical hurdles of moving equipment and labor several miles offshore in order to pull oil and gas from the ocean floor and bring it to market.
While offshore production remains expensive and logistically complicated, it has become significantly more efficient in recent years. Some of the efficiencies are the result of technological advances, while other efficiencies are the result of intense competitive pressure on service providers to lower the prices charged for their services.
Industry participants have also changed in the recent past. It is now common for financing to be provided by private equity investors who, generally speaking, have taken an opportunistic approach. Private equity investors and other sophisticated parties (such as institutional bondholders) understand that rising commodity prices are an opportunity and that Chapter 11 bankruptcy may provide the means to take control of the debtor and to maximize the future upside value that will be realized if prices continue to rise.
Intuitively speaking, bankruptcy is associated with an industry experiencing a downturn as companies rush to seek refuge from their creditors. However, the use of Chapter 11 bankruptcy as a tool by sophisticated parties to lock in upside in the recovering oil and gas industry may result in more, not less, exploration and production company bankruptcy filings.
In addition, the recent Chapter 11 bankruptcy filings by GulfMark Offshore Inc. and Tidewater Inc. (among others) demonstrate that industry service providers continue to file bankruptcy. That said, service provider bankruptcy filings appear to be the result of continued downward pressure on production costs, rather than an effort by parties to obtain control of the debtor. Many service providers have negotiated terms that allow them to raise their prices as the price of oil goes up. Therefore, in contrast to exploration and production company bankruptcy filings, higher oil prices ultimately may mean less service provider bankruptcy filings.
A number of recent E&P company Chapter 11 bankruptcy filings have been pre-negotiated. Pre-negotiated bankruptcy cases are sometimes loosely referred to as "pre-packaged" cases, but the terms are not synonymous.
Chapter 11 bankruptcy cases involve a plan of reorganization that is confirmed by a bankruptcy court. A plan of reorganization can be a powerful tool for cleaning up a company's balance sheet by, among other things, converting debt to equity, cancelling "old" equity in the company, and/or paying creditors less than what they were contractually entitled to receive. Plan proponents must draft a disclosure statement that describes the treatment of creditors under the plan.
In a pre-packaged bankruptcy case, the disclosure statement and plan are negotiated and circulated prior to the bankruptcy filing and creditors actually submit their votes in favor or against the plan. In the case of companies subject to SEC reporting, the plan and disclosure statement are publicly filed, typically as part of an S-4 registration statement. If consent is not received sufficient to meet a certain threshold pursuant to the terms of the corporate organizational documents or the trust indenture (in the case of bonds), the plan is then filed with the bankruptcy court seeking approval under the less-onerous voting terms of the Bankruptcy Code.
While pre-packaged bankruptcy cases have the advantage of going through bankruptcy very quickly (and thus are much less expensive than traditional Chapter 11 cases), such cases do involve a certain amount of risk. For example, if the bankruptcy court determines that the pre-filing vote solicitation was not conducted properly, the plan proponents may be forced to start the process over, thus defeating the purpose of a pre-packaged bankruptcy case.
Pre-negotiated bankruptcy cases, in contrast, do not encompass pre-filing plan vote solicitation and balloting. Rather, pre-negotiated cases typically involve significant negotiations among certain of the principal debt-holders whereby such parties agree to support a plan of reorganization that contains certain specific elements. The agreement is frequently documented in a restructuring support agreement that is executed prior to the filing and that sets forth defined milestones that the debtor must meet along the path to plan confirmation. The plan itself is sometimes - but not always - drafted prior to the filing of a pre-negotiated Chapter 11 case. Pre-negotiated cases are not able to get to plan confirmation quite as quickly as a pre-packaged case, but the process can be significantly faster than a traditional case where there was little or no pre-filing negotiation.
As to E&P exploration and production companies, bankruptcy practitioners are seeing a significant number of pre-negotiated Chapter 11 cases that bear remarkable similarities and provide a roadmap for how activist creditors may use the process to their considerable advantage. A hypothetical example, generally based on the facts in a number of recent cases, demonstrates the process. OffshoreCo is an offshore production company with a viable core business model and positive EBITDA (earnings before interest, taxes, depreciation, and amortization). But, OffshoreCo is heavily leveraged with multiple strata of various debt holders including secured asset based lenders, a private equity mezzanine lender (PE Firm), bondholders, and trade debt. PE Firm predicts that commodity prices will continue to trend upward and that, therefore, whoever owns the equity in OffshoreCo will realize on that gain. PE Firm negotiates with OffshoreCo management and the other debt holders to propose a plan of reorganization that allows management to stay in place, reinstates the asset-based lenders' loans on the same terms, and pays all other creditors in full (or perhaps make a meaningful, but less than full, payment to unsecured creditors). OffshoreCo's current equity, on the other hand, is canceled. As for PE Firm's debt, the plan provides that it is converted into new equity in reorganized OffshoreCo, thus transferring control of OffshoreCo to PE Firm. PE Firm locks up support for the plan via a restructuring support agreement and the Chapter 11 case is filed to effectuate the deal.
If creditors are getting paid in full, or nearly in full, and the plan cleans up OffshoreCo's balance sheet by cancelling a significant amount of mezzanine debt, everyone wins... right? Not so fast. The original equity in OffshoreCo doesn't win. In fact, they lose their interest in OffshoreCo and receive nothing on account of such interest. PE Firm will justify such a result by arguing that, based on the current value of OffshoreCo's assets, old equity was "out of the money" and was not entitled to any recovery. It is a fundamental rule of bankruptcy law (known as the absolute priority rule) that a junior class of debt or equity holders will receive payment on account of their interest only if every senior class is paid in full. The accepted hierarchy is that secured creditors come first, followed by administrative expense claimants, priority creditors, and unsecured creditors. Equity holders come at the bottom of the list, after unsecured creditors.
PE Firm will argue that the resources to pay creditors in the OffshoreCo case were such that payments flowed down to unsecured creditors, but that nothing was left over for old equity holders. If the value of OffshoreCo is less than or equal to the debt, then that argument will be accepted because there was, in fact, no equity in the company. However, if the value of OffshoreCo is more (perhaps significantly more) than the value of the debt, then the old equity holders would have a strong argument that there is equity in OffshoreCo and that it is unjust to cancel such equity for no value.
Thus, these cases often boil down to a dispute over the company's value. Bankruptcy courts sometimes choose to appoint a committee of equity holders to advocate on behalf of the entire class of equity. In other cases, ad hoc equity committees form to protect such interests. The fact that such disputes are intense and hard-fought makes sense. In the OffshoreCo example, PE Firm stands to realize all of the upside gain associated with OffshoreCo's post-bankruptcy success in a recovering industry. From the old equity's perspective, PE Firm is essentially using Chapter 11 to lock in that upside gain at old equity's expense.
This upswing dynamic, coupled with sophisticated industry participants who understand the opportunities at hand, help explain why Chapter 11 seems to be a popular choice for overleveraged companies in the oil patch. Successfully using Chapter 11 to lock in the upswing value of such a company will depend largely on the true value of the company and whether parties on the losing end of a proposed plan timely organize to advocate for and protect their interests.
ABOUT THE AUTHOR
Jason Binford is a partner in the financial restructuring and reorganization practice group at Gardere Wynne Sewell LLP. Binford earned a bachelor's degree from Texas A&M University, a master's degree from St. Mary's University, and a JD from St. Mary's School of Law.