On December 31, 2014, when the price of West Texas Intermediate crude oil dropped 50% from summer prices that year to just under $55.00 per barrel, experts predicted there would be a flurry of industry restructurings; but no one could predict how hard the industry would be hit and what the downturn would entail. When prices dropped another 40% in 2015 we were reminded that the oil and gas exploration and production business operates in an unpredictable cycle making planning difficult. While experts cannot agree when this cycle will hit bottom and at what price, they appear to have agreed that relief will likely not occur in 2016.
For those that survived the bust in the early 1980s and again in late 2008, by comparison 2016 looks grotesque. What is so grotesque about this downturn is not just the number of companies that will be hurt but that efforts to recapitalize or restructure are being hindered by the obstacles created by two events. The first obstacle is caused by the regulatory restrictions on reserve-based lending that will make the source of financing unavailable to many exploration and production companies. The second obstacle was put in place by two recent decisions of the Federal District Court for the Southern District of New York that make it more difficult for issuers to structure nonconsensual out-of-court restructurings of public debt.
Constraints on Reserve-Based Lending
Exploration and production companies that traditionally relied upon reserve-based revolving credit for their working capital needs and to fund exploration and drilling no longer have those facilities available to them. Regulators have begun to rate these loans based upon the financial strength of the borrower rather than the creditworthiness of the loan itself. In turn, lenders have been forced to reevaluate the borrowing base on many energy loans based on current prices, even though the borrower may have sufficient cash flow to timely service the debt over the life of the loan without any regard to the fluctuation of crude oil prices. The lenders are trying to account for the billions of dollars of credit extended to the exploration and production companies while fending off the regulators who claim to be taking steps to avoid an undetermined financial crisis in the banking industry or Wall Street. Because crude oil prices have fallen so dramatically, borrowing base deficiencies under these credit facilities have risen to obscene levels, leaving borrowers with only one option: to pay down the debt because all their collateral has already been pledged to the lenders. These borrowers don’t have a cash war chest so they are negotiating deals with their lenders to pay these deficiencies in installments over a relatively short period of time. These borrowers have been trying to raise capital by selling properties or securing additional credit through junior lien or subordinated debt to circumvent events of default under these facilities.
Publicly-Held Debt Has Historically Been a Good Source of Liquidity for Energy Companies
To raise capital or liquidity, exploration and production companies have frequently issued long-term senior unsecured debt instruments in public offerings. While this unsecured debt was easily serviced by cash flows when crude prices were above $50 per barrel, the reduction in revenue caused by falling crude prices this calendar year has made it difficult to service the debt, precipitating a large number of bond payment defaults as well as nonpayment defaults and covenant breaches. The number of both economic and noneconomic breaches will likely increase with reevaluations of SEC reserves. Capital markets have, for the most part, been closed to the energy sector. Indenture Trustees have strictly enforced the rights of the bondholders post default in part to mitigate risks, limit liability, and avoid litigation in an otherwise turbulent environment.
In response, a number of energy companies have chosen bankruptcy to obtain a court-supervised debt restructuring. Others, in an effort to avoid bankruptcy or to restructure existing debt to permit a new issuance of securities, have tried a variety of balance sheet restructurings involving consent solicitations and exchange offers or intercompany sales transactions. When these have involved publically offered bonds, Section 316(b) of the Trust Indenture Act of 1939 has imposed requirements designed to protect minority bondholders in out-of-court restructurings that impair certain of their core rights. Prior to 2015, established precedent generally interpreted the concept of core rights narrowly. However, two cases recently adopted a much broader interpretation of the scope of noteholders’ legal rights that are entitled to be protected under Section 316 of the Trust Indenture Act. These two decisions have upset settled interpretations of Section 316 of the Trust Indenture Act and will materially impact the ability of issuers to restructure their debt and their balance sheets.
In 2015, Two New York Cases Have Turned Out-of-Court Publicly-Held Debt Restructuring Transactions Upside Down
A. The Marblegate Decision
The first decision came in the Marblegate Asset Management, LLC[1] case. In this case, a for-profit education company and its affiliated entities sought to restructure approximately $1.5 billion of debt out of court because the company effectively could not file bankruptcy without rendering it ineligible for federal funding which accounted for 80 percent of its revenues. The company’s debt consisted of approximately $1.3 billion of secured debt in the form of a revolver and term loan debt. The balance of approximately $200 million was in the form of unsecured notes issued by the subsidiary and guaranteed by the parent. This transaction qualified under the Trust Indenture Act. The parent issued guarantees on both the secured and unsecured debt. The parent’s guarantee of the unsecured debt could be released by either one of two events: (i) by majority of a vote taken by the unsecured noteholders, or (ii) by a corresponding release of a separate guarantee given by the parent to the secured lenders. There was no value assigned to the parent guarantee when the original indenture was issued.
A committee consisting of holders of approximately 80 percent of the secured debt and holders of approximately 80 percent of the unsecured notes negotiated an out-of-court restructuring whereby the secured lenders received debt and equity providing for an approximately 55 percent recovery and the unsecured noteholders received equity equal to an approximately 33 percent recovery. However, if 100 percent of the creditors did not consent to the negotiated agreement, the parent would proceed with an intercompany sale transaction that would release the parent guarantees; the secured lenders would foreclose on their collateral, which was virtually all the assets, and the dissenting unsecured noteholders would receive no distribution while the consenting unsecured noteholders would receive the negotiated deal.
While the court denied an injunction proceeding brought by the dissenting noteholders, in lengthy dicta, the court analyzed Section 316(b) of the Trust Indenture Act and concluded following a review of the text and drafting history that Section 316(b) should be read expansively to protect nonconsenting minority bondholders from being forced to release claims outside of a court-supervised debt restructuring.
B. The Caesars Decision
One month later in the Caesars Entertainment Corp.[2] case, the same court further reasoned its position. In Caesars, in the initial indentures, the parent issued $1.5 billion in unsecured notes. One- half was due in 2016; the remaining half was due in 2017. The parent issued unconditional guarantees and was prohibited from divesting its assets. In 2014, additional indentures were issued that arguably released the parent guarantees but were supported by a majority of the noteholders.
In January 2015, Caesars’ wholly owned operating company filed chapter 11 in Chicago. The indenture trustee for the notes asserted that the bankruptcy triggered the parent guarantees and demanded payment. The parent argued that the additional indentures issued in 2014, which were supported by a majority of the noteholders, released the parent of the guarantee obligation. When voting on the additional indentures in 2014, the noteholders knew that releasing the guarantees did not create any impairment to them.
The indenture trustee filed suit in the Southern District of New York seeking a summary judgment that the release of the parent guarantees violated Section 316(b) of the Trust Indenture Act. The parent argued that the noteholders, when voting in favor of the additional indentures, knew that the guarantees were never intended to provide value but were a device created to comply with SEC regulations. Looking at the indentures’ language, the court disagreed and concluded the parent guarantees were a meaningful provision of the original indentures.
The indenture trustee then argued that any impairment affects a noteholder’s right to payment, reasoning that all impairments are violations of the Trust Indenture Act. The court disagreed, stating that if the indenture trustee were correct then courts would have to interfere with ordinary business practices and would then have to determine when impairment levels were impermissible. The court held that Section 316(b) bars an action that would impair a noteholder’s right to sue for payment and a noteholder’s substantive right to receive such payment. The court also concluded that there has to be a balance between corporate flexibility and protecting minority bondholders from being forced to release their claims outside of a formal court debt restructuring.
The Takeaway
Many lenders have large energy portfolios, and until now, they have been able to kick the can down the road hoping the market environment may correct itself. The landscape is clearer now but, hopeful relief in the way of crude oil price improvement likely will not come in 2016. Regulators have substantially inhibited new loans from these institutions. Coupled with that, the capital markets are not as open to the energy sector as they were before the crude prices dropped. The only viable option remaining is to restructure. The dilemma is whether to do it in or out of court. Certainly bankruptcy is a viable restructuring option supervised by a federal court with the power to bind any creditor or party in interest.
For out-of-court restructurings, the district court in the Southern District of New York has thrown a wrench in the pipeline. Despite the court’s reasoning in the Caesars case that it did not want to interfere with a company’s ordinary business practices, the effect of the court’s rulings did just that. The court interpreted the Trust Indenture Act so broadly in these two cases that minority bondholders can use the Trust Indenture Act not just for its intended purpose, which is to shield them from harm, but as an offensive tool in a restructuring. Marblegate and Caesars give minority bondholders a saber to impose a right to unanimous consent of rights to matters that historically–and in the terms of the indentures–required only a majority vote. These two cases color what was relatively established authority that the Trust Indenture Act only protects noteholders’ legal rights. Now their practical right to payment of payment with interest under the original issuance is arguably protected.
What does this mean for out-of-court restructurings? It means the advisors need to be more creative when confronted with indentures qualifying under Section 316(b) of the Trust Indenture Act and be reminded that there is more than one method of restructuring out of court including those governed by state law that do not have the constraints imposed by Section 316(b) of the Trust Indenture Act.
Notes:
[1] Marblegate Asset Mgmt. v. Education Mgmt. Corp., 111 F. Supp. 3d 542 (S.D.N.Y. June 23, 2015).
[2] MeehanCombs Global Credit Opportunities Funds, LP v. Caesars Entertainment Corp., 2015 WL 9478240 (S.D.N.Y. December 29, 2015).
