Energy Insolvencies

Distressed M&A deals are rising in the Canadian oil patch. That’s not entirely a bad thing

In April, many oil and gas exploration and production companies in Canada went through the painful equivalent of a visit to a proctologist. They’re going to get their assets examined.

It’s a bi-annual process, usually happening in November and April, where institutional lenders take a close look at companies that owe them money, checking out the state of their collateral. Oil and gas companies typically borrow large amounts of capital to fund operations. Lenders frequently use a company’s proven reserves as collateral for their loans, explains Kelly Bourassa, head of the Restructuring and Insolvency Group at Blake, Cassels & Graydon LLP’s Calgary office.

The values of those reserves are just as volatile as the oil and gas prices they are tied to. Thus bankers and other lenders – using short-term futures contracts on commodity prices a year or two down the road – like to reset the value of such collateral twice a year.

In bank-speak, it’s known as a borrowing base redetermination. In simple terms, an oil company that had, say, $100 million in collateral and owed $50 million to lenders when West Texas Intermediate oil was trading in June 2014 in the $100 US range is in good shape. But with oil down 70 per cent since those 2014 highs, a borrowing base redetermination would show fretting bankers their collateral in that company is worth just $30 million now — not enough to cover their $50 million in loans. When a borrowing base is set lower by creditors, “Borrowers,” explains Bourassa, “are effectively required to pay down their credit to below that (new) base in order to stay onside their credit facility.”

Such check-ups on the shrinking value of the assets held by many oil & gas companies – especially weaker juniors and midcaps – could well conclude with a diagnosis of insolvency and a prescription for bankruptcy in the coming months.

In Distress

Corporate lawyers in Canada specializing in oil and gas are seeing increasingly strong signals so far in 2016 that lenders – finally convinced $30-range oil is likely the new norm the next few years – are now pressuring companies having increasing difficulty covering their debts to seek protection under the federal Companies’ Creditors Arrangement Act (CCAA).

That gives them time to restructure their financial affairs under the watch and guidance of an independent court-appointed monitor and try to pay off creditors as best they can. (Companies must owe more than $5 million to use the CCAA, which automatically grants them 30 days to restructure, though the court can give more time.)

When lenders did redeterminations in the fall of 2015, recalls Bourassa, they “were fairly generous.” Few expected oil prices to go and stay as low as they did. Rather than nudge companies with a credit shortfall to consider the drastic option of filing under the CCAA, they amended credit covenants and eased their loan agreements. But now, says Bourassa, companies are more offside their credit facilities than ever. Lenders are under increasing internal and regulatory pressure to recover their loans.

The most likely way for a failing company to pay off creditors is through so-called “distressed” M&A deals — a last-ditch sales process for a whole company or a portion of its assets arranged through a plan of arrangement and court procedures under the CCAA.

“We are definitely starting to see signs of increased distressed M&A,” says Jane Dietrich, a Toronto partner in Cassels Brock & Blackwell LLP’s Restructuring Insolvency Group. “It’s on both the sell side, and on what options are out there to buy.”

“Distressed M&A” has a bad ring to it. No doubt, it can be risky for a buyer to merge with a financially shaky target weighed down by debt, or even just to acquire some of its assets, which may be tainted with unseen third-party liens and liabilities. For sellers, of course, it’s imperative to get the best possible price for their company or assets (and thus placate shareholders) — and not wind up the bumbling board that prematurely launches a desperate fire sale just as oil prices start climbing.

In normal M&A transactions, explains Dietrich, sellers provide representations, warranties and indemnities about the state of their business and assets. If someone misrepresents the numbers, a buyer has recourse to sue someone (usually directors).

“In a distressed M&A transaction,” continues Dietrich, “often the seller isn’t going to give you reps and warranties. If they do, there is very often not a solvent company behind it that you can sue if those reps and warranties are wrong.”

Yet with good legal representation and stringent due diligence, distressed M&A deals conducted through the CCAA can actually produce a deal purged of many legal risks for both sides. “When you are buying assets out of an insolvency process,” says Dietrich, “you go to court and get an order blessing the sale.” That court order insulates board members from legal claims by shareholders or creditors that fair value wasn’t paid for assets or other complaints.

Ross Bentley, a Calgary-based securities lawyer practising with Blake, Cassels & Graydon LLP, says lower oil prices have affected the financial health of public companies in the energy space in different ways. “If you are talking energy services and juniors to even intermediate oil and gas companies, these are very difficult times. They are tending to run into severe liquidity and capital resource constraints.”

But a subset of mostly Calgary-based senior exploration and production companies, he says, along with senior infrastructure firms such as pipeline companies, while “clearly feeling the effect” of low oil, “tend not to be quite as constrained.”

Those healthier companies, along with private-equity firms, pension funds and foreign buyers, are the ones now shopping for value among distressed companies. But, notes Ross Bentley, he’s also now seeing ratings agencies downgrading the credit ratings of senior oil and gas companies.

In February, for instance, Moody’s Investor Service cut both Cenovus Energy Inc. and Encana Corp. debt ratings to junk. “Once people fall below investment grade they lose access, for instance, to the commercial paper market.”

That makes it far more difficult for them to raise money through the issuance of commercial paper — short-term unsecured debt with terms rarely longer than 270 days, and typically used for meeting short-term liabilities.

                                   

Think Differently

The dramatic economic downturn has been a mind-
bender for boards in the energy sector. Directors, usually appointed to boards because they have a track-record of successfully running companies, can get caught in a knowledge black hole when things go dramatically wrong — especially when the cause is an uncontrollable outside force like plummeting prices.

“There’s an inherent personal trait to not think that your company is so distressed that it’s insolvent,” says Dietrich. It’s critical at times like these, she says, for directors to be able to “readjust their thinking.”

When a company is distressed, directors may need to shift their view on which stakeholders are most impacted by circumstances. If a borrowing base redetermination, for instance, shows a distressed company’s cash flow is insufficient to cover its debt, creditors may take dominance over shareholders. That’s when directors may decide to sell assets.

Richard Orzy, Co-Head of Restructuring and Insolvency at the Toronto office of Bennett Jones LLP, has been a leading restructuring lawyer for 35 years. He agrees with Dietrich that distressed M&A deals under the court guidance mandatory in a CCAA transaction (or under the lesser-used Canada Business Corporations Act) can often lead to a better purchase than a regular transaction would.

Though there can be increased costs to transactions done under the CCAA or CBCA, “You get better title. You get a cleaner result,” says Orzy. “In a regular M&A or purchase transaction, you get the company with all the warts. And even good companies have warts.”

CCAA transactions can provide sellers with vesting orders — an important legal tool when transferring title on assets from one party to another. Such orders provide comfort to purchasers and make it difficult for anyone – including creditors who hold collateral – to challenge a transfer of property or assets. Vesting orders, when given, says Orzy, “give you pristine, perfect title to the assets.”

The court process, adds Orzy, often means directors get full release from being sued by shareholders, creditors or other parties after a distressed deal closes.

“Contrary to what your first reaction might be,” says Orzy, declaring you’re in distress doesn’t necessarily make it harder to sell a company or assets and get a fair price on the sale.

And, because deals under the CCAA or CBCA act as a kind of legal wart remover, buyers may be willing to pay a premium for a target or its assets. When Nortel Networks Corp. filed for CCAA protection in 2009, it eventually sold its assets off for $7.3 billion. “The result was much more than anyone ever expected,” says Orzy.

For a distressed company, running the best possible sales process once it is under the CCAA is critical to lenders, shareholders and other stakeholders. Along with the need for thorough legal representation on all sides, there are firms that specialize in setting up the sales process, and scouring the globe for potential buyers. At Blakes, Bourassa has gotten much busier working with lenders as well as buyers.

“When we speak to potential acquirers, we coach them on the CCAA process, and how it would work in a [distressed] situation...to allow them to acquire assets for what they view as a fair value, but free and clear of the claims of subordinate creditors and avoid any abilities of the shareholders to block any transaction.”

She’s seeing the value gap close between distressed sellers and potential buyers. And, though oil prices are low, they seem to be stabilizing, giving companies with stronger balance sheets more comfortable sniffing-out strategic acquisitions. That, Bourassa predicts, means more distressed deals are likely to be closed this year compared to 2015.