CHAPTER 3 AN INTRODUCTION TO LEGAL DOCUMENTATION USED IN BANK FINANCINGS FOR THE OIL AND GAS INDUSTRY

• Jurisdiction: United States

Mineral Financing
(Nov 1982)
CHAPTER 3
AN INTRODUCTION TO LEGAL DOCUMENTATION USED IN BANK FINANCINGS FOR THE OIL AND GAS INDUSTRY
J. Thomas Mullen
James E. Padilla
Catharine A. Haake
Mayer, Brown & Platt
Chicago, Illinois and Denver, Colorado

INTRODUCTION

The purpose of this paper is to provide a brief and basic introduction to the legal concepts involved in bank financings for borrowers in the oil and gas industry. No attempt will be made in this paper to provide a detailed analysis of any particular problem which might be encountered in this area of legal practice. Particular attention will, however, be directed toward analyzing the mechanics of the secured borrowing base revolving credit agreement, one of the most flexible bank financing vehicles for a borrower owning developed oil and gas properties which can be used as collateral security, and also toward describing the documents required for such a loan transaction. A pattern form list of such documents is attached to this paper as Exhibit A.

This paper will also focus on the procedures for obtaining and perfecting liens against and security interests in the types of collateral which often secure repayment of loans made to borrowers in the oil and gas industry. The importance of following the correct procedures for perfecting liens against and security interests in collateral is especially evident today in light of the recent bankruptcies which have occurred within the oil and gas industry.

SECURED BORROWING BASE REVOLVING CREDIT AGREEMENT

The secured borrowing base revolving credit agreement provides for the making of loans by a bank to a borrower with the limit on the dollar amount outstanding at any one time being the lesser of a certain maximum dollar limit (which would be the maximum amount of loans which the bank could ever be comfortable having outstanding to the borrower) and the borrowing base amount (which would fluctuate according to the bank's evaluation of the collateral value

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of the borrower's oil and gas properties). As long as neither of the limits is exceeded (and no event of default has occurred) the borrower may borrow, repay and reborrow funds under this type of credit agreement. Principal payments are not required until final maturity, unless triggered by a reduction in the amount of the borrowing base to an amount less than the amount of the loans outstanding at the time of such reduction. If the borrower has been increasing its oil and gas reserves such reduction should not occur. Obviously, this borrowing base concept provides flexibility to the borrower in terms of financing working capital needs. A pattern form of secured borrowing base revolving credit agreement is attached to this paper as Exhibit B. It has been drafted so that it can be used for a borrower having oil and gas properties situated in any state of the United States of America, including Louisiana. Loans to be made under the pattern form secured borrowing base revolving credit agreement bear interest at a rate based upon the prime interest rate of the lending bank, but the credit agreement could be fairly easily modified (although the changes add substantial length to the document) to provide for the making of loans bearing interest rates based upon Eurodollars (a LIBOR interest rate) or certificates of deposit.

The pattern form secured borrowing base revolving credit agreement provides for the borrower to issue a single promissory note, to be signed at the execution of the credit agreement or on the date of the initial advance, with a grid schedule attached upon which the bank can, if it desires, enter notations relating to borrowings and repayments. Our experience has been that banks are more likely, however, to enter this information in their computer records for the borrower, and this possibility is covered by language included in Section 3 of the attached pattern form credit agreement. It should be emphasized that a new promissory note should not be executed each time an advance is made to the borrower.

Section 2 of the attached pattern form credit agreement illustrates a fairly straight forward method of defining the borrowing base. This section contemplates that proven and producing oil and gas properties will be mortgaged as collateral security. The borrowing base can, however, be defined so that loans can be made on the basis of the value of proven and nonproducing oil and gas properties, undeveloped oil and gas properties, drilling rigs or whatever other collateral the borrower may own and wish to add to or substitute for proven and producing oil and gas properties.

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Under the terms of Section 2 of the attached pattern form credit agreement the "Borrowing Base" is an amount, determined by the bank semi-annually, which is the lesser of the bank's determination of the loan value of the oil and gas properties and the amount requested by the borrower to be the Borrowing Base. Some banks are more specific than others in setting forth in the credit agreement how the borrowing base or the loan value of the oil and gas collateral is calculated.¹ It is more favorable to the bank to define the borrowing base as generally as possible (to provide flexibility in the future should the bank change its economic parameters used in calculating the borrowing base). Few borrowers (or their counsel) in our experience have complained about the vague definition of "Borrowing Base" contained in Section 2 of the attached pattern form credit agreement. A bank is usually willing upon request by the borrower to disclose more specifically in an informal manner the way such bank calculates the loan value of oil and gas properties. Borrowers and their counsel also generally realize that banks are constrained from arbitrary and capricious determinations and redeterminations of the borrowing base by the possibility that competing banks might be delighted to gain a borrower as a customer by offering to calculate a more rational and therefore more favorable (to the borrower) borrowing base.

An integral part of the secured borrowing base revolving credit agreement is that section dealing with the problem of the decreasing borrowing base. During the past few years the continuing increase in oil prices had made it unlikely that borrowers that added oil and gas reserves on a yearly basis would ever face a situation where, at the time of the semi-annual redetermination of their borrowing base, the borrowing base would be less than the then outstanding unpaid principal amount of loans made under the credit agreement. The recent depression within the oil and gas industry has changed this pattern. Section 6.1 of the attached pattern form credit agreement provides to the borrower (it is important to note that the Bank cannot choose which option the borrower must exercise) a choice of three ways in which to bring outstanding loans in compliance with the borrowing base. The borrower can provide to the bank additional collateral with sufficient loan value, or make a single payment in the amount of the excess loans or pay down such excess on a monthly basis with the amount of each payment being approximately equal to the amount of the proceeds of production received from the mortgaged oil and gas properties. The ninety percent figure appearing in clause (iii) of Section 6.1 has been selected in order to allow the borrower to retain ten percent of the gross

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proceeds of production to pay operating expenses and production taxes. This ninety percent figure can be and often is further refined and revised to allow the borrower to retain an amount of proceeds which is likely to be more equal to the amount necessary to pay operating expenses and production taxes.²

With the exception of Section 3 and Section 6.1, the attached pattern form credit agreement is a fairly standard form of revolving credit agreement that may be used for a loan transaction not involving a borrowing base. Section 10 contains a fairly broad range of covenants. Borrowers have occasionally argued that if the bank is looking to specific oil and gas properties mortgaged to it (rather than the general assets and credit of the borrower) to service and ultimately to repay the loans, then financial and other covenants are somewhat irrelevant. Our experience has shown, however, that bankers are concerned about the overall financial condition of their oil and gas industry borrowers and therefore desire some degree of control over the business of the borrower so that some or all of the covenants set forth in Section 10 of the attached pattern form credit agreement may be appropriate.

While the secured borrowing base revolving credit agreement provides flexibility to the borrower (by allowing borrowings, repayments and reborrowings within certain limits), and flexibility to the bank (by allowing the bank to extend credit and record a mortgage, without having to have executed a new mortgage or new promissory note until such time as the original borrowing base has increased to the point that it exceeds the original principal amount of the promissory note), it should be kept in mind that increases in the original borrowing base and subsequent loans should be made by the bank with some care. State statutes with respect to the priority of liens securing payment of future advances sometimes may be interpreted such that while the priority of the mortgage securing payment of advances made within the parameters of the aggregate dollar amount of the original borrowing base cannot be primed by other liens, except perhaps mechanics' and materialmens' liens³ , this will not necessarily be true with respect to advances made as a result of an increase in the original borrowing base, since such increase may, depending upon the wording of the bank's loan commitment, be at the bank's discretion.⁴ The bank client should be cautioned that each time it raises a borrower's borrowing base, even if the...