CHAPTER 3 Pre-Bankruptcy Planning

• Jurisdiction: United States

CHAPTER 3 Pre-Bankruptcy Planning

A. Before the Bankruptcy Filing

When a corporation is solvent, the directors owe fiduciary duties to the corporation and the shareholders of the corporation. However, when the company becomes insolvent or, in some states, enters the "zone of insolvency," the scope of directors' and officers' fiduciary duties may expand to include creditors, or at least creditors may have standing to assert derivative claims on behalf of the insolvent or near-insolvent company. The trust fund doctrine in Texas requires the directors and officers of an insolvent corporation to deal fairly with its creditors without preferring one creditor over another or themselves to the injury of other creditors. In Colorado, any fiduciary duty to creditors is limited by common law²¹⁹ and may have been completely eliminated by statute.²²⁰

Determining the "zone of insolvency" is not a cut-and-dry task. In this purgatory of duties, officers and directors often find themselves in the uncomfortable position of responding to derivative claims from multiple constituencies having conflicting interests.²²¹ The business judgment rule is applicable to actions of directors even while the corporation is insolvent, or in the zone thereof. Courts have found the business judgment protection inapplicable where the party challenging the decision can show that the director or officer failed to consider the best interests of the insolvent corporation or its creditors, or breached the duty of loyalty.²²²

Keeping the above in mind, prior to filing a bankruptcy petition, the potential debtor should carefully evaluate the state of its financial affairs and determine its business objectives. Questions to be considered prior to filing include:

• What are the sources of the debtor's financial problems? (e.g., falling commodity prices, operational failures, debt overload, etc.);
• How can bankruptcy assist the debtor in solving its financial problems? (e.g., imposition of the automatic stay, implementation of a process for the orderly processing of claims, ability to reject contracts with onerous terms);
• Can the problems be solved so that the debtor can exit bankruptcy as a going concern? (i.e., Are prices expected to rebound? Are the assets fundamentally valuable? Were operational issues anomalous? Can a less-profitable part of the company be sold off?);
• Should all or part of the company be sold as a going concern?; and
• Should the debtor liquidate its assets?

The company should also consider these immediate issues:

• Are there immediate liquidity or operational problems to be solved? (e.g., inability to pay oilfield service providers, resulting in lien filings; inability to maintain continuous drilling requirements, threatening lease loss; failure to pay royalties, with threat of lease cancellation);
• Is there adequate working capital and other necessary resources? (e.g., new investment opportunities, debt/equity exchange offers); and
• Should some portion of the business be closed immediately or some subset of assets sold immediately? (e.g., "core" properties vs. "non-core" properties, "operated" vs. "non-operated" properties, all assets targeting a particular geological formation).

Options exist outside of bankruptcy, but these require the existence of certain financial and marketplace conditions. However, despite the out-of-court options, a company needs to be preparing two plans of attack: the business-side plan and the bankruptcy case plan. Generally speaking, the options can be summarized as follows:

Restructuring Option	Basic Requirements
out of court, internally fund- ed debt restructuring	adequate operating cash sources and consent of creditors
out of court, externally fund- ed debt restructuring	adequate financing/invest- ment cash sources and con- sent of creditors
out of court, sale transaction and proceeds payments to creditors	willing buyer and either (1) purchase price equal to or in excess of all debts or (2) con- sent of creditors
in court, internally fund- ed debt restructuring and reorganization	adequate operating cash source and court approval of plan of reorganization
in court, externally fund- ed debt restructuring and reorganization	adequate investment cash sources and court approval of plan of reorganization
in court, sale transaction and sale proceeds for payment of creditors	willing buyer and court ap- proval of sale and plan of re- organization or payments per statutory priority scheme

B. Out-of-Court Restructurings

Out-of-court restructurings may offer a "win/win" solution and may be accomplished via exchange offers with bondholders and negotiated debt restructurings with other creditors. When achievable, out-of-court restructurings and exchange offers can be effective in reducing cost and increasing certainty of outcome. They typically follow a process of confidentiality, forbearance, negotiation, restructure, disclosure and solicitation, and successful acceptance.

This out-of-court option should be diligently investigated because it could allow a restructuring without the costs normally present in a bankruptcy case.

Strategies include taking on first-, second- or third-lien secured debt; issuing unsecured notes; selling future production; exchanging unsecured notes for new secured debt at a discount; buying back notes at a discount; issuing equity; selling noncore assets; and entering into joint ventures or similar agreements to share the costs of developing mineral interests. However, as financial crises for E&P companies continue, the options available to such companies may become more limited.

Newer out-of-court options include the nonratable debt exchange and the "reverse Dutch auction." In a nonratable debt exchange, a group of unsecured noteholders is given the opportunity to exchange their unsecured notes for secured debt (plus, in some cases, cash and/or equity). The E&P company's overall indebtedness is reduced because a lower principal amount of secured debt is issued in exchange for unsecured notes at a discount to par value (but at a premium to current trading levels). These exchanges offer certain advantages, particularly where the agreement governing the relevant unsecured notes permits new secured debt to be incurred without the consent of the noteholders. In addition, because these exchanges are negotiated with a small number of individual noteholders, they are not typically subject to tender offer rules and can be accomplished quickly and privately. However, because all holders of unsecured notes do not have the opportunity to participate in such exchanges, nonparticipating noteholders may raise issues or consider litigation strategies.

A reverse Dutch auction allows a company to buy back (including by exchange) its debt at the lowest market-clearing price. A reverse Dutch auction process may be more time-consuming and complicated than other strategies (including a private-exchange transaction) because it must comply with the debt tender offer rules. However, it offers the advantage of potentially identifying the lowest market-clearing price and may be structured to give a greater number of noteholders an opportunity to participate in the transaction. If a company has the goal of ensuring that all noteholders have a chance to participate, it may want to consider conducting an SEC-registered exchange offer.

Debt exchanges and debt-issuance transactions generally require the consent of the company's RBL lenders because RBL financing facilities generally provide little leeway for companies to incur material amounts of additional debt or liens. In contrast, indentures governing E&P company bonds typically provide more flexibility for additional debt and lien incurrence. It follows that E&P companies will look to accomplish financial restructuring transactions that comply with existing indentures and then negotiate any requisite consent from their RBL lenders. In some cases, obtaining such consent may necessitate offering additional accommodations to RBL lenders, including a borrowing base reduction.

Not all companies, however, can achieve out-of-court restructurings. This can occur for any number of reasons, such as inability of creditors to agree, large litigation claims, lack of value and cash flow, and the filing of an involuntary petition.²²³ When this occurs, a company may continue seeking to achieve agreement with its key creditors in an effort to achieve either a prepackaged plan of reorganization (voting solicitation occurs prior to the filing of the bankruptcy case) or a pre-negotiated plan of reorganization (key creditor constituencies reach agreement in principle before the bankruptcy filing, and the case is filed with the plan of reorganization and disclosure statement to achieve the reorganization as promptly as possible). If none of these options is available, the company should have its bankruptcy strategy ready for implementation.

In an E&P scenario where there is little bank debt but large trade debt, a vendor financing arrangement should be explored. This arrangement is one in which the vendor provides the goods and services needed to drill and/or complete wells, and in exchange they are repaid over time. These arrangements, especially after a bankruptcy filing, are typically on a nonrecourse basis (although they can be on a recourse basis) and are paid for usually from the net profits of the wells that are drilled and/or completed. Due to the risk involved, a risk premium is usually also paid to the vendors, and the vendor financing agreement also sets a high default rate in the event invoices are not paid as due. Such an arrangement benefits the lienholders as well, because if the leases are lost, so is their valuable collateral. A vendor financing agreement must meet several requirements, the most important of which is that the debtor must demonstrate that it is in the best interest of the estate. In...