Emerging trends in distressed oil patch

Given the massive uptick in bankruptcy filings in the oil and gas sector, players searching for investment opportunities should have a basic understanding of the processes for purchasing assets in Chapter 11. In a bankruptcy situation, investment opportunities are most likely to arise in two situations-a "363 sale" (occurring under section 363 of the Bankruptcy Code) or a plan of reorganization/liquidation.

A 363 sale, which typically involves a robust public auction process, can range from a sale of substantially all of a company's assets to a strategic sale of a division, parcel of property, or subset of equipment.

In a plan scenario, pre-existing investors can see their debt, in whatever form, converted into equity (typically, stock) in a reorganized company or the equity interests in, or assets of, the debtor can be sold to third parties through the plan, which may or may not involve an auction process. This article focuses primarily on the first option for investment opportunities-the 363 sale and the trends emerging in this distressed asset sales environment.

363 SALES

Section 363 of the Bankruptcy Code governs the use, sale, or lease of property in a bankruptcy proceeding and permits sales in the ordinary or non-ordinary course of a debtor's business. The majority of 363 sales involve non-ordinary course sales pursuant to section 363(b), which provides that the debtor "after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate. . . ." In determining whether to approve a sale under 363(b), the Court defers to the debtor's business judgment. Meaning that, so long as the debtor has a reasonable business justification for the proposed sale and the sale is in the best interests of the estate, it will be approved.

The benefits of section 363 are numerous. First, while the Bankruptcy Code requires Court approval of non-ordinary course sales, the consent of all affected parties, such as lien holders, is not required. Further, section 363(f) of the Bankruptcy Code specifically provides for the sale of property "free and clear of any interest in such property" provided that certain requirements are met. This "free and clear" provision provides a mechanism for a debtor to consummate a sale quickly, as competing interests, such as secured creditor liens or encumbrances, in the property need not be resolved as a condition to the sale. Section 363 sales are also attractive to buyers who can obtain protection from successor liability, subject to certain exceptions. Further, of particular relevance to the oil and gas sector, certain obligations cannot be discarded through a 363 bankruptcy sale, including but not limited to, covenants running with the land and certain environmental liabilities (such as costs for plugging, abandonment, and site restoration).

Additionally, as part of the 363 sale process, purchasers are able to evaluate a debtor's executory contracts and unexpired leases and cherry-pick certain contracts that it wants on a forward looking basis, notwithstanding contractual clauses that prohibit the assignment of such contract or lease. However, as is typical in bankruptcy, there are certain exceptions for IP or government contracts. Purchasers often take on profitable or sole source provider contracts and reject non-profitable contracts, with no liability for the rejection damages. Note, that contracts must be taken in their entirety-a purchaser may not cut unfavorable provisions in a contract.

The 363 sale process is relatively straightforward: the moving party, typically the debtor, files a motion with the Bankruptcy Court to approve a structure for bidding on the sale assets. In many cases, the debtor will have already chosen a "stalking horse" bid for the assets as a result of pre-bankruptcy solicitation from its investment banker and will request the approval of certain protections for the stalking horse (such as an expense reimbursement or break-up free, which are awarded to the stalking horse if its bid does not prevail). The bid procedures, among other things, will (i) include a minimum initial bid (intended to cover the amount of the stalking horse break-up fee) and minimum bid increments for topping bids; (ii) establish requirements for accessing a data room and submitting a qualifying bid; (iii) set dates for bids, the auction, and the sale hearing; and (vi) establish parameters for the auction. Bidding procedures are designed to create a fair and open process and eliminate scenarios that may chill bidding (such as secret bidding agreements or insider sweet heart deals, though there is no outright prohibition on insider sales).

The debtor must provide notice of the sale to all interested parties in compliance with the Bankruptcy Code. Interested parties then have an opportunity to object to the bidding procedures or the sale-whether that sale is ultimately to the stalking horse or another higher and better bid. Upon the conclusion of the sale, the Court holds a hearing to determine whether the proposed sale is a proper exercise of the debtor's business judgment and in the best interests of the estate. As part of that determination, the Court will evaluate whether the sale proceeded in a fair and open manner as intended or whether collusion or unfair practices permeated the process.

With the benefits, come the burdens. True exigent circumstances (such as dwindling cash or perishable product) can justify a sale process that plays out over the span of a few days rather than the typical weeks or months long process. A 363 sale cannot be used solely as a tool to transfer title to a secured creditor-the bankruptcy estate must also benefit from the sale. What qualifies as a benefit depends on the facts of each case, but, typically, the sale must generate at least enough cash to pay administrative claims (estate professionals, post-petition expenses of maintaining the business, etc.).

All too often, debtors view their financial predicament as a temporary condition, causing them to resist the sale assets they perceive as precious, if undervalued. This phenomenon can be particularly persistent in the oil and gas industry, where some debtors insist that they can hold on until commodity prices rebound or "drill their way out of" the current macroeconomic oversupply problem.

In the face of an unrealistic debtor, creditors and other interested parties have options to leverage their investment or create a new one. For example, a creditor can move for the sale of assets; seek the appointment of an independent Chapter 11 trustee due to the debtor's mismanagement of the case, which carries a high evidentiary burden and is often contested; or move to convert the case to a liquidating Chapter 7, though selling the business as a going concern in Chapter 11 generally presents the best opportunity to maximize value.

Assuming the debtor's exclusive time period to file a plan has lapsed or otherwise been terminated, a creditor can also file its own plan that provides for an involuntary sale of assets or an equity infusion that wipes out existing equity and funds future operations. If a party is not a creditor but wishes to become involved in the bankruptcy process, it can purchase a claim from another party or become a lender to the debtor-in-possession (known as a DIP lender). As a DIP lender, a party has significant leverage over the course of a case by virtue of its control over the debtor's purse strings.

What then should a potential purchaser consider when positioning their bid? First, is it economically feasible to become the DIP lender? As a DIP lender, you have access to information and other diligence, which is being provided at the expense of the estate and influence over the course and pace of the bankruptcy case. More importantly, to the extent your loan is secured by liens on the debtor's property, you can "credit bid" up to the amount of your secured claim (i.e., the value of your collateral). Given the chilling effect that credit bidding can have, other parties may dispute the value of your claim or otherwise try to limit your ability to credit bid.

If becoming a DIP lender is not feasible, a party can purchase a claim (preferably a secured claim) from a third party. If a party purchases an unsecured claim or is otherwise an unsecured creditor by virtue of its pre-existing relationship with the debtor, that party should consider carefully whether to serve on the unsecured creditors committee. As a committee member you have access to insider information regarding the debtor and its potential plans (depending on the level of cooperation between the parties). On the other hand, serving on the committee will subject your bid to greater scrutiny by the Court and, potentially, invite litigation over potential conflicts of interest.

With respect to the auction itself, purchasers must focus on the target assets and ask themselves several questions. First, what interest am I buying-the land (surface, subsurface, or surface and subsurface rights), leases, or options to drill; the business as a going concern; a specific division; or specified equipment? In a similar vein, are there any disputes regarding the ownership of the property? Once the assets and potential ownership disputes are outlined, then consider how to use the assets moving forward. Which potential contracts or leases do you want to assume and which do you want to leave behind? Is the property encumbered by environmental or other obligations so that it cannot be transferred free and clear? Experienced bankruptcy counsel can help you frame these issues for consideration. While every case presents a unique set of facts, several trends have emerged in this recent downturn.

TRENDS IMPACTING CHAPTER 11 ASSET SALES

To better understand 363 sales in oil and gas bankruptcies, it is helpful to consider some recent events and trends in the market. Interestingly, most of the current cycle has been characterized by a general reluctance on the part of investors to scoop up distressed oil and gas assets. Indeed, much has been written about the substantial "dry powder" that private equity funds and other investors have kept on the sidelines in the face of crashing commodity prices - owing primarily to uncertainties about identifying a bottom in an incredibly turbulent market.

Of course, some of the hesitance on the part of private equity groups may have resulted from the volume of their own troubled energy portfolio companies. But now, it appears that the distressed investment tides may be changing. The Wall Street Journal recently reported that WL Ross & Co. has purchased hundreds of millions of dollars in distressed energy debt, specifically in Breitburn Energy Partners and Permian Resources. WL Ross is expected to try to swap its debt for equity in a reorganized Breitburn. If WL Ross's moves are representative of the broader market, it is only a matter of time before these investments begin to put upward pressure on 363 sale asset prices.

E&P debtor efforts to reject burdensome gas gathering contracts are also likely to have an impact on 363 sales. Until recently, most gas gathering contracts were considered immune from rejection in bankruptcy (i.e. "bankruptcy proof"), because they contained essential language creating a real property interest in the contract that runs with the land. As a result, most E&P asset buyers may have presumed that debtors would be unable to reject expensive long-term gas gathering contracts, and thus, buyers would be unable to demand such rejections as part of their bid package. However, in her decision in the Sabine bankruptcy, Judge Chapman determined that the Sabine contract did not create an interest running with the land, and therefore, it could be rejected.

In the aftermath of the Sabine decision, we see buyers aggressively negotiating for the rejection of "above market" gas gathering contracts in order to squeeze the best economics out of their purchases. But interested buyers should beware, as the rule is far from universal. As the Sabine Court made clear, the ability to reject will turn on the confluence of the specific contract language and applicable state law. It is easy to imagine a different court coming to the opposite conclusion with a different contract, and a Texas bankruptcy judge has already suggested as much.

Purchasing assets out of bankruptcy presents opportunities for realizing substantial value, but as we have seen, it is imperative that buyer's understand the 363 sale process as well as their target assets. As always, advice from experienced counsel is essential, and the importance of a rigorous diligence process to vet the target assets cannot be overstated.

ABOUT THE AUTHORS

Ryan Purpura ([email protected]) is a partner at McGuireWoods where he leads the firm's oil and gas practice with offices in Pittsburgh, Dallas, and Houston. He represents oil and gas companies, private equity and hedge funds and other financial institutions in mergers and acquisitions, finance, project development and other transactions related to the energy industry.

Partner John Thompson ([email protected]) represents clients in complex Chapter 11 cases and advises on debtor and creditor rights. He handles business reorganizations and cross-border insolvency matters, and has extensive experience representing debtors, creditors, acquirers, landlords and equity holders, both in and out of court, across a broad range of industries, including the energy industry. He is based in Washington, DC.

Associate Kathryn Keane ([email protected]) represents debtors, fiduciaries, including Chapter 11 trustees and plan administrators, and other parties through all stages of the bankruptcy process. She regularly advises clients on out-of-court workouts and related insolvency matters in federal and state courts. She is based in Tysons, Va.