J. Paul Getty once said, “Formula for success: rise early, work hard, strike oil.” However, with crude oil prices nearly half of what they were a mere six months ago, Getty’s formula may not hold as true as it once did. In the latest EIA STEO Report (April 2015), the DOE projects oil prices for WTI to remain around or below $60 per barrel for the balance of 2015 and grow to $70 per barrel in 2016. In this environment of excess supplies and relatively low prices, many believe in the likelihood of an increase in bankruptcy filings in the energy sector during the second half of 2015 and into 2016. Such insolvencies can have significant effects, not only on the debtor, but also on those counterparties that have been trading physical and financial commodities with the debtor. It therefore is important for counterparties of companies with declining creditworthiness to be prepared for the road ahead and know, in advance, some of the issues that are likely to come up if their counterparty files for bankruptcy.
- Safe-harbor Contracts Upon the filing of a bankruptcy petition by a debtor, an automatic stay arises with respect to the property of the estate. In effect, what this means is actions (judicial and non-judicial) to collect debts from a debtor are stayed automatically. Indeed, almost any action that a creditor may take against the debtor or property of the debtor is stayed. Typically, the automatic stay prevents a creditor from exercising its contractual termination rights, even if bankruptcy is an explicit event of default under the contract. However, for certain types of contracts – forward contracts, master netting agreements and swap agreements – the Bankruptcy Code provides protections for those in the forward contract trade and swaps business to allow parties to such “safe harbor” contracts to exercise their termination and liquidation rights, net and set off, and foreclose on collateral, despite the automatic stay. Prompt action is required for early termination to be effective under current bankruptcy law, and detailed contemporaneous records for the calculation of positions upon early termination are very important (in anticipation of possible disputes with the debtor). For counterparties facing a bankrupt counterparty, therefore, prompt evaluation of whether their contracts qualify for these protections is critical. Of note, in addition to contracts relating to the purchase and sale of commodities such as oil, natural gas, wholesale power, environmental credits such as RINs and other energy products, as well as swaps, qualifying for these protections, a recent bankruptcy court decision has confirmed that retail electric service contracts also can qualify. To date, efforts to exclude so-called “simple supply agreements” that otherwise qualify for the protections have failed, but efforts at such exclusion continue. For certain other types of industry contracts, the terms of the contract would need to be individually analyzed to make an accurate determination of safe harbor status.
- Liquidation Having determined that its contracts with a debtor qualify for the safe-harbor protections, a counterparty will need to understand the intricacies of the various methodologies in its contracts for valuing the early termination amounts associated with the transactions it terminates with the debtor. Industry-standard contracts frequently aim at getting at the same result (what is the market value of the terminated transactions as compared to the contractual value), but use slightly different methodologies to arrive at the early termination calculation. Following the precise contractual method (and documenting such efforts) will be important in subsequent negotiations with a debtor over the termination amounts. Debtors frequently will seize on technical failures in following a contract’s terms either to seek to reduce the amount it may owe or to increase the amount it is alleged to be owed. For example, if a contract requires a non-defaulting party to seek market quotes, it is advisable to have a system in place to document from whom the quotations were sought, when and by whom. Likewise, preparing those who will be seeking the quotes as to what not to say when requesting such quotes can avoid unnecessary, subsequent disputes with the debtor. Finally, as part of the liquidation process, the safe-harbor protections allow a counterparty in many instances to apply collateral and setoff such collateral against amounts owed by the debtor to the counterparty.
- Utility Motions The Bankruptcy Code long has provided protections to debtors with respect to their utility service providers. Essentially, the Bankruptcy Code states that, if the debtor provides an adequate assurance of future payment – e.g., deposit or other security – then the utility may not alter, refuse or discontinue service to the debtor. In an increasingly deregulated environment in which a number of companies now meet their natural gas or electricity needs from other than a traditional utility with a service territory, however, these provisions of the Code can conflict with the safe-harbor protections discussed above. Early in many bankruptcy cases, the debtor may file a “utility motion” in which it seeks to preclude utilities from discontinuing or altering services to the debtor. Frequently it will attach a list of “utilities” that are to be covered by such motion. Often, these lists can be over-inclusive and capture counterparties providing natural gas or electric service to a debtor pursuant to forward contracts. In such instances, it is advisable to attempt to be removed from such list prior to terminating a safe-harbor contract providing such alleged service. Therefore, counterparties should be vigilant in reviewing a debtor’s first-day motions.
- Security Interests The Bankruptcy Code protects a creditor’s rights in collateral over which it has a perfected security interest. Outside of the context of safe-harbored contracts (where a non-defaulting counterparty generally has the right to foreclose on collateral without leave of the Court), in order to take possession of collateral and liquidate it to setoff the debts owed by the bankrupt counterparty, a creditor must first move the Court to lift the automatic stay to permit an action against the collateral to proceed. The debtor then would be afforded an opportunity to challenge the adequacy and priority of the liens, and whether the collateral is property of the estate. A secured creditor should expect delays (of perhaps years) to successfully recover from the collateral securing its debts.
- Asset Acquisitions Although an increase in insolvencies in the energy industry would be very disruptive, it also could provide opportunities for those seeking to acquire assets. Frequently, as a debtor seeks to restructure through a bankruptcy proceeding, it will end up selling certain or, in some cases, virtually all of its assets. Many times, these assets may be acquired at favorable prices. However, the manner in which assets are sold in bankruptcy is more complicated than is traditionally the case for M&A transactions outside of bankruptcies. Such bankruptcy asset sales may take different forms. In some instances, a debtor may sell its assets directly to a purchaser. Increasingly, however, a debtor will seek a “stalking horse bidder” – someone who has negotiated an agreement and price for the purchase of the assets at issue. An auction process is then put in place for the same assets to help ensure that a debtor is maximizing the value of the sale of its assets. The auction process will vary somewhat in any given bankruptcy but often involves a number of steps, including a process by which interested purchasers may become qualified as bidders on the assets – usually by signing a confidentiality agreement and providing financial information. Qualified bidders will then often have a very short period of time to conduct due diligence before they have to submit a bid and mark-up of a debtor-provided purchase and sale agreement, as well as a deposit. To the extent there are bids exceeding the stalking-horse bid by a sufficient amount, an auction to purchase the assets will follow with the bid deemed highest and “best” prevailing. Given the complicated and intertwined nature of such processes, would-be buyers should know and understand the applicable procedures.
While the price of oil looks to improve by the end of 2015 and into 2016, there likely will be difficult times ahead for energy companies. By being proactive with regard to evaluating contracts with counterparties for bankruptcy risk, evaluating rights upon a counterparty bankruptcy and following a counterparty’s bankruptcy from the beginning, companies can avoid some unnecessary pitfalls and reduce their counterparty risk.