Emerging themes in bankruptcies
More than 200 US oil and gas exploration and production companies carrying more than $100 billion in debt have filed for bankruptcy since late 2015.
Most are trying to restructure their debts and reemerge from bankruptcy.
Common themes have emerged in the strategies these companies are using to do so.
Beginning in mid-2014, prices of crude oil and other commodities experienced sharp declines from the historically high prices of preceding years. As low crude prices persisted throughout 2015, a significant portion of the US oil and gas oil exploration and production industry became distressed.
By late 2015, a large number of Ef&P companies had filed for chapter 11 protection (and, in some instances, chapter 7 liquidation).
The trend accelerated into 2016 as scheduled borrowing base redeterminations drove production companies into bankruptcy. The financial distress of production companies caused immediate spillover distress for oilfield services companies, which have sought bankruptcy protection at a comparable rate, albeit with less aggregate debt. Nor have mid-stream companies been spared from the wave of bankruptcies.
Given the sheer number of E&P bankruptcy filings, and the prevalence of “repeat players” among investors, lenders and restructuring advisors, it is unsurprising that common themes have emerged in the strategies these companies are using to exit bankruptcy.
This article addresses those themes so that company managers, equity investors, and lenders involved in the sector can better prepare.
Most chapter 11 restructurings rely on either a debt-for-equity exchange where old lenders become new equity holders and old equity holders’ rights are substantially diluted or even extinguished, or on a sale of the company’s assets usually free and clear of all liens, claims and other encumbrances.
Outside the E&P field, asset sales have become increasingly popular because they allow the restructured business to move forward quickly while leaving creditors, the shell company and the bankruptcy court to work out how the sale proceeds should be divided.
As an added bonus, asset sales can often be accomplished through a relatively straightforward motion in courts that usually takes just weeks to be approved, rather than a more complicated plan of reorganization that usually takes many months, if not years to work through the court.
Debt-for-equity swaps tend to be a slower option than asset sales for exiting bankruptcy. By their nature, they require heavy negotiation among the company and the various tiers and types of creditors, and they need to be approved through a plan of reorganization.
Despite the growing popularity of asset sales, E&P sector bankruptcies have strongly favored debt-to-equity conversions for various reasons.
First, for most of the last two years, continuously falling crude oil prices made it difficult to lock in sale prices. While rapidly falling prices can also hinder proposed debt-to-equity conversions, they pose less of a problem where junior creditors and equity holders are in a loss position.
Second, E&P companies face a number of regulatory and permitting issues, described in the sidebar below, that can hinder asset sales in some instances.
Third, and perhaps most significantly, the sheer volume of E&P bankruptcy cases has led to the development of unusually clear bargaining parameters around debt-for-equity swaps. With the help of these clearer negotiating boundaries, parties have been increasingly able to avoid value-destroying litigation and to short circuit otherwise lengthy reorganization plan negotiations around the terms of proposed debt-for-equity exchanges.
While asset sales are still employed in E&P bankruptcies, they have mostly been limited to smaller companies, with notable exceptions, such as Quicksilver Resources, which adopted an asset-sale approach after determining that it could not obtain enough creditor support to confirm a debt-for-equity exchange plan.
A major advantage to the asset-sale approach is that squabbling creditors can be left to resolve later how a fixed pie of sale proceeds should be divided.
In a debt-for-equity swap, this issue has to be resolved up front. As a result, parties to debt-for-equity swaps focus on how to keep the deal from being disrupted by junior creditors and equity holders. That task is made more difficult by the fact that junior creditors and equity holders whose investments stand to be extinguished have every incentive to make long-shot valuation arguments to put themselves in the money, or to threaten litigation alleging lien imperfections or pre-bankruptcy misconduct by the company or senior lenders.
After a few high-profile examples of value-destroying litigation in the E&P sector, most parties (outside of a few particularly disgruntled equity holders) have tentatively settled on a solution: distributions of reorganized equity for junior classes of creditors or even old shareholders that exceed what would be implied by a strict “waterfall” distribution of value.
For example, in the Magnum Hunter bankruptcy, three tiers of debt were converted into equity in the company: a first lien debtor-in-possession bankruptcy loan, a second lien term loan and unsecured notes. While the first lien facility was converted at a rate that implied a 100% recovery, the second lien facility was converted at a rate projected, at the time of creditor voting, to result in a 78% to 89% recovery. Despite the fact that secured creditors were not being made whole, unsecured noteholders who would normally recover little or nothing were allowed to convert their notes at a rate expected to yield a 35% to 41% recovery.
Taking this approach a step further, a number of E&P restructurings have been built around debt-for-equity swaps that grant specified stakeholders — often unsecured creditors and occasionally old shareholders — the opportunity to participate in rights offerings or to receive warrants for a specified portion of the reorganized company’s equity.
While this approach is potentially dilutive to senior creditors, it can have the dual benefits of buying peace with junior stakeholders and simultaneously bolstering the reorganized company’s liquidity. High-profile examples of this approach include Energy & Exploration Partners, Inc. (rights offering for secured creditors, warrants for unsecured noteholders), Sabine Oil & Gas Corp. (warrants for second lien noteholders), and Bonanza Creek, Inc. (rights offering for unsecured noteholders, warrants for old equity holders).
A company voluntarily filing for chapter 11 has three options.
First, it can file for bankruptcy without first obtaining creditor support for a proposed restructuring. These “free fall” bankruptcies tend to be the longest, most contentious and most expensive. Unfortunately, they are often unavoidable, particularly when a company has multiple tiers of debt and an uncertain valuation, which together virtually guarantee strong clashes of creditor and equity holder interests.
Second, a company can agree with key creditors, pre-bankruptcy, to a restructuring support agreement that sets out the general terms of a proposed reorganization and binds the parties to support any deal that meets the specified criteria. These “pre-arranged” bankruptcies still require the company to obtain court approval for the restructuring support agreement once the bankruptcy case has been filed, and then to move through the other plan disclosure and confirmation requirements. However, by “locking up” key stakeholders ahead of a bankruptcy filing, a company can greatly accelerate negotiations with other creditors and ultimate approval of the restructuring.
Finally, a company can fully solicit creditor votes in favor of a proposed restructuring plan pre-bankruptcy. In these prepackaged bankruptcies, the debtor will file a plan of reorganization on the first day of the case, and ask to schedule a hearing to approve the plan as quickly as possible. If all goes smoothly, a company going through a prepackaged bankruptcy can emerge from chapter 11 in two months or even less. Obviously, this puts the onus on the company, and key stakeholders, to be fully engaged well before a bankruptcy filing becomes necessary.
Over the last 10 years, major restructurings have been moving in the direction of prepackaged and prearranged bankruptcies.
E&P companies are following the trend even more strongly than the broader market. This is again enabled, in part, by the now well-developed E&P restructuring playbook. It makes little sense for a company or its creditors to spend more time in the expensive and necessarily uncertain chapter 11 process than is strictly necessary, particularly where the broad contours of a potential value-maximizing restructuring can quickly be determined.
Notably, these themes increasingly come together in a single bankruptcy case. For example, on January 4, Bonanza Creek, Inc. and its affiliates filed for chapter 11 protection and proposed to emerge from bankruptcy as rapidly as possible through a prepackaged plan of reorganization (theme 3). The prepackaged plan proposed a straightforward debt-to-equity swap (theme 1) pursuant to which $867 million of bond debt would be converted into 95.5% of the reorganized company’s equity, with the remaining 4.5% going to old equity holders. Finally, the plan incorporated tools for existing stakeholders to bolster the reorganized company’s capital position (theme 2) via a $200 million rights offering to unsecured creditors and three-year warrants offered to old equity for up to 7.5% of the reorganized equity based on a total equity value of $1.45 billion.
For now, crude prices have recovered to some degree, and the E&P industry appears to be beyond the peak of its distress. Nevertheless, the industry can expect to see elevated levels of bankruptcy filings for some time as the aftershocks of the price collapse play out. Stakeholders should be aware of the three themes described in this article as those bankruptcies unfold.
Projects with Government Contracts
The power to restructure a company through bankruptcy is sweeping, but there are potentially two important limitations when regulators and other government entities are involved.
First, a restructuring, whether through an asset sale or a plan of reorganization, in most cases cannot interfere with or limit existing state or federal regulatory regimes.
This has broad implications for restructurings in the heavily regulated energy sector. For example, if Federal Energy Regulatory Commission approval of a transaction is required outside of bankruptcy, then FERC approval may still be required in bankruptcy. While government entities are prohibited from discriminating against bankrupt companies or denying regulatory approval or permitting as a result of a bankruptcy filing, regulators may be able to deny, limit or condition approval of restructurings where they find fault with the merits of the underlying proposed transaction.
Second, asset sales that contemplate the assignment of government contracts to a new operator are often impossible without the consent of the government entity. To facilitate reorganizations, bankruptcy law generally invalidates “anti-assignment” provisions in contracts. However, the relevant law may bar the assignment. Many government entities, including the federal government, have moved to protect themselves by enacting laws or adopting regulations that broadly prohibit the assignment of government contracts without the consent of the government entity that is party to the contract. Government-issued permits often face similar restrictions on assignments or transfers. As a result, it may be impossible to complete an asset sale of regulated or permit-dependent energy businesses without the affirmative consent of the relevant regulatory authorities.
Company managers, investors and lenders should bear these restrictions in mind when negotiating potential restructurings in the energy sector.