March 13, 2020
The oil price plunge starting on March 6 seems like a sucker-punch to the oil and gas industry after the price decreases and market unrest as a result of COVID-19. Oil and gas companies and companies that contract with them should analyze their current liquidity situation and plan for future challenges before options are limited. Below, we highlight five things to consider in connection with such analysis. Our energy team is experienced in these issues and invites the opportunity to discuss them with you and answer specific questions you may have.
Oil and gas companies must analyze their positions with respect to both solvency (the ability to sustain operations long-term) and liquidity (the ability to meet short-term and current obligations). A mistake many companies make is waiting until there are serious liquidity issues to analyze options and take action. The time to act is now and there are real advantages to being proactive when faced with an economic downturn. A company has significantly more options if it has at least six months of cash liquidity. Where an existing debt obligation will mature during that six-month period—such as a material payment coming due, a borrowing base redetermination, or the termination of hedges--the company should have cash liquidity that will extend for at least an additional six-months from such maturity event. Companies with that level of liquidity have an ability to negotiate with lenders and counterparties and possibly restructure liabilities as needed to preserve going-concern value through the economic downturn. If that level of liquidity does not exist, a company has no leverage and few options other than to pursue a prompt liquidation or other bankruptcy on terms dictated by those willing to fund such process.
In connection with liquidity and solvency analysis, oil and gas companies should holistically review liabilities and actively manage them to mitigate risk and improve liquidity to the extent prudent and reasonable. This could include finding creative ways to renegotiate or exit contracts with off-market or burdensome terms. A counterparty should prefer a market contract with a stable company to a more lucrative contract with a company in a liquidity crisis. Liability management should also include a review of general and administrative expenses. Finally, it may also include the development of other legal strategies and contingency plans to maximize the company’s ability to stretch liquidity and negotiate with creditors.
Liability management also entails measures to minimize the exposure of officers and directors to personal liability. For example, officers and directors can face personal liability if liquidity is not managed and a company runs out of cash without having remitted payroll taxes or paid all accrued employee wages. In addition to liquidity planning, it is prudent to review the company’s organizational documents to ensure that fiduciary duties of managers and directors have been fully exculpated and waived to the maximum extent permitted by law. Doing so sufficiently in advance of any eventual bankruptcy filing or other litigation can minimize the ability of a trustee or creditors to recover from managers and directors based on their prior actions. A review of all applicable indemnification provisions and any existing director and officer insurance policies is also prudent.
If a company determines that a reduction in headcount is warranted, it is important to get legal advice so that certain state and federal laws, including the Worker Adjustment and Retraining Notification Act (WARN), are complied with. These are not difficult to comply with, but they do contain technical requirements such as providing specific information to employees or allowing a certain number of days to elapse between certain events.
If you invest in a company that goes through a restructuring or bankruptcy process that leaves little or no proceeds for the equity holders, it seems obvious that the equity holders should have no tax consequences. However, if debt is forgiven and the entity is a partnership flow-through entity for tax purposes, the equity holders could be required to pay tax on “cancellation of debt income” (also referred to as CODI). The structure of the entity and its affiliates should be reviewed to determine if there are any actions that can be taken to reduce, offset or eliminate CODI, including a potential incorporation of the entity. Interested parties should also consider taking steps to protect existing claims to any future tax refunds, which can be valuable assets in distress situations.
In addition to the above, there are a number of issues that oil and gas companies and companies that contract with them should begin to think about. Given the current commodity price environment, companies should analyze P&A liabilities and the management of them (which varies by state), other surface restoration requirements, financial assurances triggers, and any termination or damage triggers that may be in their oil and gas leases. The key is to be proactive and to give consideration to these issues well in advance of a liquidity crisis. Our energy team is experienced in these issues and invites the opportunity to discuss them with you and answer specific questions you may have.