As the saga of the Paragon Offshore plc bankruptcy (Bankr. D. Del., No. 16-10386 (CSS)) continues, it is useful to reflect upon Judge Sontchi’s denial of confirmation of its bankruptcy plan last November. In a 70-page ruling examining the feasibility of the plan in detail, Judge Sontchi concluded that the plan proposed by the debtors was not feasible because their business plan was not reasonable, and Paragon would not be able to refinance its debt in 2021 at maturity. Balance sheet solvency upon exit was not prioritized in the court’s analysis. “At the end of the day,” the court said, “these cases are all about liquidity.”

The Factual Background

Paragon is a global provider of offshore drilling rigs. Currently, the debtors own 40 offshore rigs and equipment and have over 2,000 employees. The rigs operate in the North Sea, the Middle East and India, although until recently the debtors were also active in Brazil, West Africa and Mexico. Before 2015, when oil prices were high, Paragon’s rigs were in strong demand. However, as the price of oil plummeted, the demand for rigs declined, and together with the new builds of rigs, the drop-off in drilling activity created a worldwide glut in rigs available for engagement. Naturally, this led to a steep reduction in pricing, creating a liquidity crunch for Paragon that led to a bankruptcy filing in February 2016.

On Feb. 14, 2016, Paragon filed for bankruptcy with approximately $1.4 billion of secured debt and approximately $1 billion in unsecured debt. The secured debt primarily consisted of amounts owed under a revolving credit agreement, with $708.5 million outstanding, and a senior secured term loan in the outstanding amount of $642 million. The unsecured debt consisted principally of 6.75% senior notes due 2022 and 7.25% senior notes due 2024. Shortly after the bankruptcy filing, Paragon pursued a Chapter 11 plan. Under the plan, the noteholders were to receive $345 million in cash, 35% of the equity in the reorganized company and certain deferred cash payments of up to $50 million in exchange for their senior notes. The revolver would receive a paydown of $165 million in cash and be amended to include a new minimum liquidity covenant, a covenant holiday through 2017 and an extended maturity date. The secured term loan would be reinstated.

Following a hearing on confirmation of the initial plan, the debtors negotiated changes to its original plan with its creditors, which led to the filing of a modified plan on August 15, 2016. Under the modified plan, the revolving lenders agreed to reduce the minimum liquidity covenant and adjust the covenant holidays, so that the revolver would have no EBITDA-based covenants until 2019, among other relief. The debtors also negotiated to reduce the cash payment on the senior notes from $345 million to $285 million and to eliminate the originally contemplated deferred cash payments. As a quid pro quo, the noteholders’ ownership of equity in the reorganized debtors would increase from 35% to 47% and the noteholders would receive $60 million in new unsecured notes. The term lenders, whose debt was still being reinstated, challenged the modified plan as not being feasible.

The Legal Framework

Judge Sontchi first reviewed the jurisprudence relating to plan feasibility under Chapter 11 of the Bankruptcy Code. The plan must be feasible pursuant to Section 1129(a)(11) of the Bankruptcy Code1 by a preponderance of the evidence. Section 1129(a)(11), the court said, does not require a guarantee of success but rather a “reasonable assurance” of success. Various factors that courts use in assessing feasibility of a Chapter 11 plan include:

  • The adequacy of the debtor’s capital structure.
  • The earning power of its business.
  • Economic conditions.
  • The ability of the debtor’s management.
  • The probability of the continuation of the same management.
  • Any other related matters which determine the prospects of a sufficiently successful operation to enable performance of the provisions of the plan.

Contrary to the argument of the term lenders, the court said, balance sheet solvency at emergence was not a requirement of feasibility. Rather, “solvency is merely a factor considered where relevant.” In this case, irrespective of whether the debtors were solvent at plan confirmation, the plan would still not be feasible.

The Court’s Feasibility Analysis

In assessing the feasibility of the plan, the court engaged in an intensive factual analysis. The court first focused on the debtors’ capital expenditure assumptions and, contrary to the claim of the term loan agent, found that they were “well-reasoned and credible.” The court reached a starkly different conclusion, however, when it came to the debtors’ business plan. The court observed that the price of drilling rigs is inversely correlated with the supply of rigs and positively correlated with oil prices. In other words, where there is an oversupply of rigs (as is the case now) and the price of oil is falling, dayrates — that is, the daily rates that customers pay for oil rigs — will fall as well. The court credited the testimony of the expert retained by the term lenders that Paragon would not achieve its projected utilization and dayrates in the current environment.

The court next looked at Paragon’s ability to refinance its debt at maturity. Under the company’s business plan, $1.3 billion of debt, consisting of the term loan debt, the revolver debt and new notes being issued to the noteholders, would come due in 2021. Once again, the court credited the testimony of the term lenders’ expert and found that the debtors were unlikely to be able to successfully refinance their debt at maturity. Among other things, the court noted that the backlog and asset value of Paragon had dropped precipitously since it last was in the debt market, and that the debtors would be in competition with other financially strained oilfield services and drilling companies looking to refinance approximately $110 billion of debt that will mature over the next five years. Finally, the court was convinced that Paragon was likely to run out of cash and fail its financial covenants before its debt matured, mooting the refinancing discussion.

Summing it up, the court found that Paragon’s Chapter 11 plan was likely to be followed by a liquidation or a further financial reorganization, in violation of Section 1129(a)(11), and that therefore the plan was not feasible. The court then denied confirmation of the plan.

Some Observations

On Feb. 7, 2017, Paragon proposed a third plan. How this latest attempt to reorganize and emerge will go has yet to be seen, but it is nonetheless useful to consider the court’s basis for denial of the modified plan. While reciting a litany of factors for consideration, the court’s decision focused largely on whether the reorganized company would have the cash flow to satisfy its financial covenants and whether it could refinance its debt at maturity. This is not to say that other factors could never be of primary concern. However, as far as this court was concerned, liquidity is paramount. In particular, the court paid only lip service to balance sheet solvency, even as it noted that the parties expended an extensive amount of effort to prove or disprove balance sheet solvency in the case. The court was clear that a formal solvency analysis alone will not suffice to satisfy the requirements of Section 1129(a)(11).

There is also the question of how far into the future a court should be looking when analyzing plan feasibility. Here, the court was prepared to go out four to five years, when a substantial portion of Paragon’s debt would be maturing, although the court’s concerns with demand and dayrates for the Paragon rigs — the drivers of its liquidity analysis — appear focused on an even shorter term. The terminus ad quem for a feasibility analysis will necessarily vary according to the facts of the case, including the perceived reliability of available business and market projections. What is self-evident, however, is that the further into the future the analysis is taken, the more imprecise it becomes.