Lower for longer

May 16, 2016
How US Chapter 11 and UK Schemes will help solve the oil industry's debt issues

How US Chapter 11 and UK Schemes will help solve the oil industry's debt issues

STEPHEN PHILLIPS, ORRICK HERRINGTON & SUTCLIFFE LLP, LONDON
RANIERO D'AVERSA, ORRICK HERRINGTON &SUTCLIFFE LLP, NEW YORK

MARKET COMMENTATORS are now in agreement. Low oil prices are here to stay over the medium term and this means that many oil exploration, production and service companies (referred to below as "oil focused companies") that borrowed in a more benign environment are now seriously over-leveraged.

Debt service and covenant compliance will be a challenge for all but the biggest companies. In this article, we consider how oil focused companies are going to be able to implement strategies to address their debt loads.

In 2015 we saw a considerable number of liability management exercises implementing amendments to debt covenants and maturities. Given the continued depressed oil price, we expect that some more fundamental methods such as debt for equity swaps will be needed. To accomplish this, a number of companies are likely to find they will need to use formal insolvency tools to reduce their leverage and emerge from a restructuring with much less debt so that their debt service and debt maintenance covenants will be appropriate for this "lower for longer" oil price environment.

Use of Chapter 11 for oil services companies

We have analyzed the capital structure of a considerable number of oil focused companies for clients interested in buying distressed debt and equity and have noted a number of structural issues. These lead us to the conclusion that we are going to see a high volume of US Chapter 11 filings, particularly in respect of multinational oil service companies, even where the US is not the primary place of business.

Firstly, many oil service groups are multi-jurisdictional, with assets (for example) in the North Sea, Middle East, Africa and the US. This means that an insolvency filing in the jurisdiction where the borrower is located is not likely to fix the problem. An insolvency filing provides a mechanism to compromise the debt of a company. If debt of, for example, a French oil services company, is supported by guarantees from other group companies in other jurisdictions across the world, a French insolvency process of the French debtor is unlikely to compromise those guarantees. Accordingly, one approach will be to file all the companies in the group in insolvency processes in one jurisdiction.

This is where Chapter 11 may come in. It is fairly easy to obtain jurisdiction for a non-US company to enter Chapter 11; cash in a US bank account may be enough. Judges in the US bankruptcy court are sophisticated and used to the concept that they may need to take jurisdiction over foreign companies with a fairly tenuous connection to the US in order to get a restructuring deal done for a large international group.

US style documentation

Further supporting reasons for our thesis of an increase in Chapter 11 filings is that many international oil focused companies have entered into documentation structures that will be difficult for the senior lenders to enforce their share security. For example, a group may have entered into a number of separate loans or bonds where either there are no intercreditor agreements governing the relationships between the separate tranches of debt, an intercreditor agreement exists but not all creditors are party to it, or the intercreditor agreement is silent when it comes to the release of liens, debts or guarantees on share security enforcement by a senior lender. In LMA-style intercreditor agreements, which tend to govern European leverage finance deals, on an enforcement of share security granted by a holding company the instructing group of creditors, usually the senior lenders, are empowered to release debts, security and guarantees of junior lenders. Intercreditor agreements governed by New York law do not usually have such a feature, and therefore a compromise of debt is usually implemented by a Chapter 11 process, as opposed to contractually via the so called 'release mechanics' embedded in the intercreditor agreement.

Many international oil focused companies have raised debt in the US. Where much of the documentation for an international group is governed by New York law, New York lawyers are likely to have documented the deal under their standard documents without 'release provisions'. This may well drive borrowers and senior lenders to use the debt compromise mechanics of a Chapter 11 process as there may be no other way to deal with the junior debt or junior security using the documentation. Many counterparties - such as suppliers - are very conscious of the power of the US bankruptcy courts and extra-territorial effect of the US Bankruptcy Code: taking enforcement action when a company is in Chapter 11 is a violation of the bankruptcy court's automatic stay imposed when a company enters a Chapter 11 process. Non-US institutions taking action against the automatic stay may find themselves held in contempt of court in the US-an uncomfortable position to be in, given that most large creditors will have some presence in that jurisdiction. This far-reaching extraterritorial effect of Chapter 11 and the US bankruptcy courts was a factor in the successful Chapter 11 filing of German alumina group Almatis in 2010. The effect was also a key reason for many non-US shipping companies with substantial assets in many jurisdictions, such as Marco Polo Seatrade and Omega Navigation Enterprises, filing for Chapter 11.

Attractive features of Chapter 11

In addition, Chapter 11 has a number of attractive features. Firstly, it prohibits a party from terminating a contract as a result of the entry into an insolvency process. Secondly, it provides for so called "debtor in possession" or "DIP" financing. This enables lenders to lend to a company in a Chapter 11 process in priority to the existing secured creditors (a priming lien) and with a claim which has a super priority over administrative expenses (including vendor and employee claims). There is a fairly established market for this type of lending in the US and where a company has a large capex spend which will enable it to increase production and the existing lenders have cut off new lending, perhaps because of a covenant or payment in default a "DIP" loan may be the solution. Thirdly, it is possible to "pre-package" a Chapter 11 bankruptcy where, before filing for bankruptcy, the company negotiates, documents and has creditors vote on a restructuring plan. This minimizes the time spent in Chapter 11 and the associated cost.

License termination issues

Notwithstanding the benefits of a Chapter 11 filing, the entry into any insolvency process may lead to some negative implications for a group. Oil focused companies may find that the license/concession granted by a government may be terminable by a government authority or allow a joint operating partner certain rights against the defaulting partner on entry into an insolvency process. While (as discussed above) Chapter 11 may prevent certain contractual rights from being used by non-defaulting counterparties, we doubt whether government regulators would be persuaded not to use their remedies of termination if a company with an oil license enters Chapter 11. Therefore, it is possible that the negative impact may be so severe that any bankruptcy process should be avoided to maintain value at the level of the operating entity which holds the license. Accordingly, the Chapter 11 route may be less likely to be used for explorers and producers worried about their licenses and so our view regarding the rise in Chapter 11 filings for international groups is more orientated towards oil service companies which are unlikely to have the same license issue and where the benefits of a Chapter 11 process are clearer.

Benefits of UK Schemes of Arrangement

For international oil explorers and producers concerned about maintaining their licenses, borrowers might look to a UK scheme of arrangement process to compromise the debt. A scheme is a statutory UK procedure which allows a company to propose a compromise or arrangement with its creditors if approved by a requisite threshold. One major benefit of a scheme is that it is not an insolvency process and arguably will not trigger a right of the government to terminate the license (and quite likely not trigger the rights of a joint operating partner to use some of its rights on insolvency of a counterparty, for example, the right to insist on a transfer of an insolvent counterparty's interest).

Importantly, UK judges have decided that a scheme can compromise a guarantee granted by a subsidiary of a company which is undertaking a scheme, even if that subsidiary is in a foreign jurisdiction. For example, in a recent case involving a Dutch issuer of debt (Magyar Telecom BV), a UK scheme was used to compromise the debt at the Dutch issuer level and to compromise the guarantees given by the operating companies, which were in Hungary. A similar plan was envisaged for Afren plc, a London-listed oil company, which held assets in Nigeria and had a number of Nigerian subsidiaries that issued guarantees in favor of its high-yield bonds.

Conclusion

Chapter 11 will likely be the tool of choice for many international oil focused companies where there is a US nexus. However, those companies with license concerns may decide to use schemes of arrangement as the implementation mechanic for a restructuring. Schemes may not have all the features of Chapter 11, such as the "automatic stay" and "DIP financing," but a scheme may be seen as a pragmatic, cost effective way of compromising an international group's debt.

What remains to be seen is whether if a scheme is proposed for an international group with a US guarantor, objecting creditors may seek to prevent the implementation of the scheme in the US on the basis that the only court which can compromise the liabilities of a US company is a US bankruptcy court. Given the considerable cost differential between implementing a compromise via Chapter 11 and via a UK scheme we expect an international group (probably an oil focused company) to test this in the near term.

ABOUT THE AUTHORS

Stephen Phillips is co-head of the European restructuring team and is based in London. He has extensive experience in advising banks, bondholders and corporate groups on restructuring, corporate and banking matters. He holds an LPC from College of Law of England and Wales, York, and an LLB from the University of Bristol.

Raniero (Ron) D'Aversa is chair of Orrick's restructuring group. His focus is bankruptcies, out-of-court restructurings and creditors' rights controversies. He brings years of experience representing DIP lenders, secured lenders, bank groups and hedge funds in those capacities. He holds a JD from New York University School of Law.