The oil plunge starting on March 6 seems like a sucker-punch to the oil and gas industry after the price decreases and market unrest as a result of COVID-19. However, for those with capital to spend, it will lead to opportunities to acquire assets and distressed companies (including acquisitions of asset packages, acquisitions of companies, and take-private transactions). Below, we highlight five things to think about in connection with acquisitions of assets from distressed companies. Our energy team is experienced in these issues and invites the opportunity to discuss them with you and answer specific questions you may have.
A sale process pursuant to Section 363 of the Bankruptcy Code typically includes two stages of auctions. The initial selected bidder on the assets of a bankrupt company, known as a stalking-horse bidder, agrees to set a floor price, ensuring a minimal recovery to creditors. Thereafter, interested parties bid against the stalking horse. In exchange, the stalking horse typically obtains court-approved bid protections, including a break-up fee and expense reimbursement that compensate the stalking horse for its opportunity cost and the value provided to the bankruptcy estate should the stalking-horse bid induce any higher or better bids. Therefore, a stalking-horse bidder should consider the risk of being outbid at an auction when negotiating the terms and conditions of the purchase agreement, maximize the scope of its bid protections and ensure that any court-approved bidding procedures are as favorable to its bid as possible.
Creditor Influence on Negotiations
The bankruptcy court must approve the purchase agreement in connection with any purchase of assets from the debtor. In connection therewith, the bankruptcy court has broad discretion to consider the objections of the seller’s creditors, including those with liens on the assets at issue, those holding blocking debt positions on the terms of any Chapter 11 plan and any post-petition DIP lenders that otherwise have material consent rights. As a result, a buyer must consider how the seller’s creditors may react when negotiating the terms and conditions of the purchase agreement. In some instances, negotiating directly with such creditors on the terms of a Chapter 11 plan can minimize public competition and otherwise improve the position of a potential buyer. In any case, a buyer should structure its bid to maximize the extent to which it may acquire assets free and clear of liens, claims and other liabilities of the seller under Section 363(f) of the Bankruptcy Code.
Executory Contracts, “Cure” Costs and Consent to Assignment Provisions
An “executory contract” is a contract under which unperformed obligations remain on both sides, such that either party would be excused from performance if the other party were to breach its remaining obligations. Section 365 of the Bankruptcy Code provides the debtor the option to reject, assume or assume and assign its executory contracts in bankruptcy. Many contracts commonly entered into in the oil and gas industry, including joint operating agreements, vendor contracts, farmout agreements and midstream agreements, may qualify as executory contracts under the Bankruptcy Code. Therefore, it is important for a buyer to identify material contracts that may qualify as executory contracts and timely direct the debtor as to those executory contracts that will be assumed by the debtor and assigned to the buyer pursuant to the bankruptcy process. This process is typically addressed in any purchase agreement as well as in the sale motion and related orders proposed to the bankruptcy court.
In order for a seller to assume and assign any executory contract, it must cure any defaults with respect to such executory contract. The amount and allocation of responsibility for payment of such “cure costs” is a key consideration when buying assets pursuant to the bankruptcy process. Although cure costs are technically the seller’s responsibility, a buyer can increase the value of its bid by assuming all or some portion of them.
While consent to assignment provisions in oil and gas contracts are typically enforceable outside of bankruptcy, it is possible for them to be rendered unenforceable under Section 365(f)(1) of the Bankruptcy Code. Section 365(f)(1) provides that a trustee may assign an executory contract or unexpired lease “notwithstanding a provision in an executory contract or unexpired lease of the debtor…that prohibits, restricts or conditions the assignment of such contract or lease.” Note that this safe harbor provision is only applicable to contracts and unexpired leases that qualify as executory contracts and not available with respect to consent to assignment provisions in oil and gas leases in Texas and other jurisdictions where oil and gas leases are not considered executory contracts.
Post-Closing Indemnification and P&A Liabilities
Following a sale of assets pursuant to the bankruptcy process, a seller is likely to distribute the sale proceeds soon thereafter and remain insolvent or, if possible, wind down. As a result, the seller’s representations and warranties in the purchase agreement typically do not survive closing and the seller’s post-closing indemnification obligations are often very limited.
The Bankruptcy Code requires that all administrative claims must be paid in full. Accordingly, the question as to whether plugging and abandonment claims are entitled to administrative priority and the party responsible for plugging and abandonment obligations is a key consideration when buying assets pursuant to the bankruptcy process. The answer largely requires a state-by-state analysis and, therefore, it is important that the parties address the allocation of plugging and abandonment and other environmental obligations in the purchase agreement. Understanding a debtor’s ability or inability to abandon assets with P&A liabilities in excess of market value may also provide a buyer with additional leverage.
Out of Court Transactions
Buying assets from a distressed seller outside of bankruptcy presents other opportunities and risks. On the one hand, out of court transactions are generally subject to less competition and public disclosure. However, where a seller is potentially insolvent and yet willing to transact, a buyer must consider the risk of subsequent challenges by creditors (or a bankruptcy trustee) to unwind the sale transaction and otherwise claw back value from the buyer. In the current climate of volatility and distress, this risk should not be overlooked. In some instances, pursuing the transaction through a structured Chapter 11 case is the best way to mitigate claw-back risks, execute with greater certainty and maximize the extent to which the sale is free and clear of the seller’s liabilities. In other instances, particularly where there are few creditors and they are tactfully engaged in the sale process, an out of court approach can be an effective strategy to minimize competition and transaction costs.
The above includes certain key issues that may arise in connection with the acquisition of assets from distressed companies, but the list is by no means exhaustive. The key is for a buyer to be proactive and make the most of distressed opportunities. Our energy team is experienced in these issues and invite the opportunity to discuss them with you and answer specific questions you may have.