Timothy Hoffmann, Mary Shepro, Jones Day, Chicago
It is no secret that the decline in oil and gas prices has created significant financial distress for oil and gas companies focused on exploration and production (i.e., upstream companies). Bonds issued by energy sector companies are commonly trading at discounts of 30% or more, and bank lending is scarce, as financial institutions brace for losses from their existing loans in the oil and gas sector. In early February 2016, Standard & Poor’s Ratings Services downgraded the junk-territory ratings on 25 oil and gas companies and reaffirmed the junk status of many other energy companies. Moody’s Investors Service has acted similarly, placing 120 oil and gas companies on review for downgrade.
The credit downgrades indicate that sources of cash are, and will continue to be, scarce for potential upstream energy restructurings. One might conclude that this lack of capital would significantly complicate upstream energy restructurings. In reality, however, the lack of new capital sources for upstream energy restructurings appears to have had the opposite effect; in many instances, it has simplified the restructuring process. The lack of new capital has left companies with few alternatives other than existing lenders and noteholders for assistance in a restructuring. Similarly, the depressed market has limited exit strategies for existing lenders and noteholders unwillingly or unable to sell their existing debt holdings at significantly depressed prices. The lack of viable financial alternatives for both upstream energy companies and their existing debt holders appears to have created an environment where relatively straightforward debt exchanges are increasingly common. These exchanges may occur inside or outside of a chapter 11 bankruptcy case and, depending on any particular distressed company’s capital structure and other circumstances, may result in very different outcomes for holders of funded debt obligations.
New Gulf Resources and Cubic Energy are both examples of distressed debt exchanges that occurred within the context of a chapter 11 bankruptcy case. In December 2015, New Gulf Resources filed a voluntary bankruptcy case to facilitate a pre-arranged restructuring of its balance sheet. Prior to commencing its chapter 11 case, New Gulf Resources entered into a Restructuring Support Agreement ("RSA") with an ad hoc committee of creditors. This ad hoc committee consisted of creditors holding more than 72% of New Gulf Resources' second-lien notes and 22% of New Gulf Resources' subordinated PIK notes. Under the RSA, New Gulf Resources and the ad hoc committee agreed to a chapter 11 plan structure that allocated the equity of the reorganized company. If the subordinated PIK noteholders accepted the plan, they would receive a 12.5% equity stake in reorganized New Gulf Resources; if the subordinated PIK noteholders rejected the plan, they would receive only a 5% stake in reorganized New Gulf Resources. The proposed plan would transfer the remaining equity in the reorganized company to the second-lien holders, who agreed to provide at least $125 million of new capital in the form of $75 million in debtor-in-possession financing and a $50 million rights offering in order to permanently pay down the existing first lien debt. The hearing to consider confirmation of New Gulf Resources' plan is currently scheduled for April 11, 2016.
In a similar scenario, Cubic Energy and its affiliates commenced chapter 11 cases in December 2015, and Cubic Energy's prepackaged restructuring plan was confirmed in February 2016. The plan cancelled Cubic Energy's existing equity interests and issued equity in reorganized Cubic Energy to noteholders that held approximately $100 million in outstanding debt.
Other companies have consummated more limited debt exchanges without seeking bankruptcy relief, sometimes with limited utility. For example, in May 2015, Warren Resources entered into a $250 million strategic refinancing facility. The transaction included the exchange of $69.6 million of unsecured notes for $47.2 million of first-lien loans. In October 2015, Warren Resources consummated another financing transaction whereby the company exchanged approximately $63.1 million of unsecured notes. In connection with the second exchange, the exchanging noteholders provided approximately $11 million of new money financing to Warren Resources and received approximately $40 million of second-lien term notes and four million shares of common stock. After consummating both of these exchanges, Warren Resources still had $167 million in unsecured notes outstanding.
Despite having successfully consummated the two debt exchanges in 2015, Warren Resources recently announced that it would defer an interest payment due on February 1, 2016, and warned that it would need to seek bankruptcy protection if it is unable to reach an out-of-court agreement with its creditors.
While debt exchanges can be win-win situations for companies and creditors alike, debt exchanges also may delay market rationalization, as companies are kept afloat while creditors wait for oil and gas prices to rise. Thus, even after effectuating a debt exchange, a company’s runway may be insufficient to wait out the current downturn in oil prices or other economic events that have caused financial distress. Given its recent announcement, Warren Resources may be a future example of a company effectuating a debt exchange that ultimately provided insufficient financial relief to avoid a more formal restructuring at a later time.
In this regard, holders of funded debt obligations must be cognizant of the potential risks when deciding whether to participate in a debt exchange outside the context of a chapter 11 case. For example, the entities that participated in the Warren Resources exchanges accepted a reduction in the principal amount of their debt, but now hold security interests in Warren Resources' assets. As secured creditors, these participating entities now possess additional rights that may provide them with a greater recovery in any future Warren Resources restructuring. By contrast, creditors participating in debt exchanges involving an exchange of debt for common stock or some other form of equity may end up with limited or no recoveries in a subsequent restructuring, as the holders of equity interests generally receive distributions only after all creditors are paid in full.
Unlike out-of-court restructurings that may provide certain holders of funded debt with opportunities to improve (or diminish) their position within a capital structure, the structure and laws that govern chapter 11 cases generally result in similarly situated holders of funded debt receiving pro rata distributions.
Absent a dramatic increase in oil prices, it appears that upstream oil and gas companies will continue to be restructured (perhaps at an even accelerated pace) and creditors will have numerous decisions to make with respect to participating in debt exchanges. In most instances, creditors should consider the impact a subsequent restructuring would have on them when making a decision to participate in such an exchange.
About the authors
Timothy Hoffmann is a partner in the Business Restructuring & Reorganization practice at Jones Day and is based in the firm's Chicago office. His practice focuses primarily on bankruptcy and insolvency-related matters. Hoffmann has represented debtors, secured lenders, strategic investors, and various other parties in financially distressed situations, including both in-court and out-of-court restructurings. He Hoffman earned his JD cum laude from University of Dayton where he was the Articles Editor of the University of Dayton Law Review. He clerked for the Honorable Burton Perlman in the United States Bankruptcy Court for the Southern District of Ohio.
Mary Shepro is an associate in Jones Day's Chicago office and her practice includes restructuring and insolvency representations. She earned her JD cum laude from the University of Notre Dame where she was Managing Senior Editor of the Notre Dame Law Review; her MSc from the London School of Economics; and her BA from Columbia University.
The views and opinions set forth herein are the personal views or opinions of the authors; they do not necessarily reflect views or opinions of the law firm with which they are associated.