Drilling Down on Strategic Alternatives

in the Current Energy Crisis

Part IV: Chapter II in Practice – A Case StudyWednesday, June 3, 2015

12:00-1:00 pm Central

WEBINAR SERIES

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Housekeeping Items

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Speakers

Trent Rosenthal (moderator) | Restructuring & Reorganization Partner – Burleson LLP● Board Certified in Business Bankruptcy Law by the Texas Board of Legal Specialization● Over 3 decades of experience in restructuring and bankruptcy law● Handled numerous oil & gas restructurings and workouts

James (“Jim”) C. Row, CFA | Managing Director & Founder – OFSCap, LLC● Background in energy investment banking (international/domestic)● Securities and valuation expert● Former E&P operator and former CFO

Michael Rosenthal | Co-Head, Restructuring & Reorganization Practice – Gibson Dunn ● Represents debtors/creditors in complex, high profile national & cross-border restructurings and Chapter 11 cases● Provides insolvency-related board advice to large public and privately held companies● Experience with corporate separateness and successor strategies and defenses

Rich Bernardy | Managing Director – M1 Energy Capital● Over 25 years of banking and finance, management and entrepreneurial experience ● Experience includes project and structured finance, private equity, debt securities, sponsorship of equity

investments, financial risk management, accounting, forecasting and capital budgeting

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Agenda

• Key Issues in E&P Cases• Overview of Past Webinars – Background for

Discussion• Case Study Discussion• Q&A Session

Key Issues in E&P Cases

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Oil & Gas Financing: Reserve-Based Loans (RBLs)

• Unlike asset based credit facilities in other industries, a typical RBL has no specified advance rates – the lenders set that based upon facts at the timeo advance rates depend on whether proved producing or non-

producing, developed or undevelopedo discount rate is key – 8-10%o assumption about rate of production – will depend on projected

forward rates for the price of oil/gas - so if the price of oil is low, production may not seem economical, reducing the PV of the reserves

o Each lender has their own price deck• The run up to bankruptcy may be different in an RBL financing

because the lenders tend to lower advance rates if the E&P borrower has financial difficulty.

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Oil & Gas Interests, Generally• An owner of mineral interests, i.e. the rights to gas, oil and other minerals at

or below the surface of a parcel of land (often the landowner) will typically seek an oil and gas exploration and production company to extract the oil and gas from the land. The mineral interest owner grants the exclusive right to explore, drill, and produce oil and gas conveying a “working interest”

• The working interest owner bears the risks, costs, and expenses associated with exploring for, developing, and producing oil and gas

• Net Profits Interests (“NPIs”), Overriding Royalty Interests (“ORRIs”), and Production Payments (“PPs”) (each as described below) are generally created out of the working interest of an existing oil/gas leaseo Investors may purchase these interests in oil and gas production, but it is important to

understand the treatment of such interests in bankruptcyo In re Delta Petroleum Corporation – In both California, Colorado, and perhaps other

states, an ORRI is an interest in real property. The assignment must be recorded to be effective and trump a bankruptcy estate. If recorded, not property of the estate and rides through the bankruptcy case. If not, available for creditors. Best practice is to record because another court may apply the law in its jurisdiction to eliminate your ownership

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Oil & Gas Interests, Generally

• Property of the estate generally does not includeo Volumetric production payments sold to an entity that does not

participate in the operation of the property (Sec. 546 (b)(4)(B)o Any interest in liquid of gaseous hydrocarbons to the extent the

Debtor has transferred or agreed to transfer pursuant to farmout agreement, but does include the consideration the Debtor retains, receives, or is entitled to receive for transferring to a farmout agreement. Sec. 546 (b)(4)(A) and last sentence of Sec. 546 (b)

• Transfer or sale of an interest might be re-characterized as a financing transaction, making the asset property of the estate and payment of the debt would need to be addressed. In re ATP Oil & Gas, Debtor

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Summary of Various Oil & Gas Interests

• Mineral Interest is the ownership of all rights to gas, oil and other minerals at or below the surface of a tract of land. The mineral interest includes the exclusive right to explore, drill and produce the oil, gas and any other mineral at or below the surface of a tract of land.

Mineral Interest

• Working Interest is an interest in an oil and gas lease that gives the owner of the interest the right to drill for and produce oil and gas on the leased tracts of land and requires the owner of the interest to pay a share of the costs of drilling and production operations. • The working interest will always pay a greater percentage of the

production costs than it will receive in percentage of the production. For example, the working interest would bear 100% of the production costs, but receive only 87% of the production, if it agreed to give a 13% landowner royalty.

• NPIs, ORRIs, and PPs (each as described below) are generally created out of the working interest of an existing oil/gas lease.

Working Interest

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Summary of Various Oil & Gas Interests

•Net profit interests (“NPI”) is a share of production of the oil and gas from a property. The owner of an NPI receives a share of the profits earned from production after expenses. •Typically a percentage of a working interest is calculated as a percentage of profits from operation of the property.

•While the NPI is net of expenses, the NPI owner is not directly responsible for any expenses. Additionally, the NPI owner typically does not have rights with respect to operations.

Net Profits Interest

•An overriding royalty interest (“ORRI”) is an interest in oil and gas free of the expense of production. An ORRI owner is entitled to its interest of oil/gas produced, and will generally not bear any risk of the costs of operations. The owner of an ORRI is entitled to share in a portion of the production but has no rights with respect to operations. •Perpetual ORRIs last for the life of the lease. •Term ORRIs last until a specified volume or stated value of production is achieved.

Overriding Royalty Interests

•A production payment (“PP”) is a share of the oil and gas free of expense of production, terminating when a given volume of production has been paid over, or when a specified sum from the sale of such oil has been realized. Production payments are a type of ORRI, but they are limited in term.

Production Payments

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Statutory Liens• Jurisdiction itself my be a disputed issues and may effect the

outcome• Some states, like Texas, have statutes granting producers automatic

perfection of liens in oil, but those liens may not be perfected under other applicable state law o See In re SemCrude, L.P., 407 B.R. 112 (Bankr. D. Del. 2009) (because

Delaware law governed under choice of law analysis, Texas statute did not create automatic perfection for producers, and liens would be subordinate to bank liens perfected by earlier-filed financing statement)

• The automatic stay does not prevent the filing of notices or affidavits that are a prerequisite to perfecting a statutory oil and gas contractor’s lieno See 11 U.S.C. §§ 326(b)(3), 546(b)(1); In re Houts, 23 B.R. 705 (Bankr.

W.D. Mo. 1982) (holding that filing of mechanic’s lien statement was allowable in spite of the stay, though further enforcement of the lien was stayed)

Overview of Past Webinars:Background for Discussion

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Initial Legal Considerations for Board of Directors

• Hire competent restructuring team• Review organizational and financial documents, including loan

agreements• Review historical operations and expense reduction options• Consider current and near term liquidity requirements• Consider points of leverage with lenders, including leverage

Chapter 11 provides• Obtain debtor in possession financing (if Chapter 11 filing is a

possibility)• Conduct and keep records of board meetings, discussions and

decisions

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Fiduciary Duty - Duty of Care & Duty of Loyalty

• Duty of Careo Directors and Officers must be diligent and informed, and exercise

prudent & unbiased business judgmento Directors are entitled to rely in good faith and with ordinary care

on reports prepared by Officers of the company or outside experts within the area of their expertise

• Duty of Loyalty o Obligates Directors and Officers to act in good faith and in the best

interests of the company, and to deal fairly with the company

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How Do Duties Change When Company is Insolvent?

• Directors owe fiduciary duty to the entire corporate enterprise• Directors should act in manner to preserve and

maximize the value of the corporation• When company is insolvent (or, in some states, in

zone of insolvency), creditors as well as shareholders can derivatively (not directly) enforce breaches

Credit Bidding Limitations

• In re Fisker Automotive Holdings, Inc.o Court in Delaware capped credit bid amount to amount holder paid for

the debt, and not face value, to encourage competitive bids. o See also In re Free Lance-Star Publishing

• In re Momentive (upheld on appeal on 5/4/2015)o The Court held that the lenders were not entitled to a “make whole”

and other prepayment penalties upon acceleration of the debt caused by a bankruptcy filling, unless the agreement expressly provides for same upon acceleration. Moreover, the lenders were crammed down to an interest rate using a formula approach (e.g. T-Bill rate plus small risk premium) and not a market rate interest

• In re R.L. Adkins Corporationo The Fifth Circuit held that a creditor/prospective purchaser failed to

timely exercise its credit bid rights and therefore would lose the right

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Benefits of Purchasing Assets Under a Plan

• Despite stringent confirmation process, purchasing assets through a Plan allows purchaser more flexibility than a purchase of assets through 363 saleo Can purchase assets or acquire equity in reorganized entityo 363 sale purchaser can only offer dollars (or a credit bid) and cannot

dictate which creditors obtain what portion of purchase price nor can it reorganize capital structure

o Greater ability to obtain protection from successor liabilityo Greater ability to avoid competitive biddingo Ability to obtain protection from future asbestos and other tort liability

» Appointment of future claimants’ representative» Section 524(g) statutory trusts

• Competitive bidding not generally required in plan context if creditors vote to confirm the plano Different rule for new value contributions from equity owners

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Case Study Discussion

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Case Study Fact Pattern1. OILCO is a well run family owned E&P Company. Its cash flow has been crushed by

the recent plunge in oil prices, reducing revenue from $100M to $50M per year, and EBITDA to $20 million per year.

2. Its reserve based first lien lender is owed $100M, which bears interest at 6%, and was only willing to waive covenant defaults if OILCO made principal and interest payments that OILCO could not afford. This forced OILCO to file for chapter 11.

3. OILCO obtained authority to use cash collateral and did not need DIP financing.

4. OILCO has also issued $250M of second lien notes, bearing interest at 9% per annum. There is an intercreditor agreement between the first and second lien holders that says that proceeds of the collateral must go first to pay the first lien in full.

5. Royalty owners are owed $5M, and unsecured creditors are owed $30M.

6. The equity consists of 1M common shares trading at .05 cents per share.

7. A hedge fund recently purchased all of the second lien notes for $.30 on the dollar, or a total net outlay of $75M.

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Case Study Fact Pattern7. OILCO is in the 120 day exclusive period in which only it can file a plan of

reorganization.

8. The unsecured creditors committee is aggressively represented.

9. OILCO believes that the enterprise value of OILCO is between $225M to $250M, leaving value for the second lien notes, but nothing for the unsecureds. OILCO has teamed up with the second lien holder and proposed a plan to issue a new note to the first lien holder at an interest rate of T-Bill plus .5%. The $250M in second lien notes will convert to 80% equity in OILCO. The remaining balance of the equity, 20%, will be distributed 10% as a management incentive plan, 5% to unsecureds and 5% to current equity.

10. OILCO intends to pay all royalty and working interest owners in full.

11. The Bank (first lienholder) does not like its treatment and has teamed up with an investment banking firm to sell OILCO for $175M in cash, paying them off in full and leaving $75M for the second lien holders.

12. The Committee disputes all of the liens and argues the plan is unconfirmable because of the distribution to old equity.

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Case Study Fact Pattern

• Players:

o Debtor/Management, CRO: OILCO (Michael Rosenthal)

o Bank: First Lien Note Holder (Trent Rosenthal)

o Second Lien Note Holders held by Hedge Fund (Rich Bernardy)

o Unsecured Creditor (Jim Row)

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Debtor/Management Perspective

• As the Well Turns – Continuing Operations o Goal – uninterrupted operations and preservation of going concern valueo Protecting key vendors, mineral interest owners, employeeso Funding for operations

• Exiting the Merry-Go-Roundo Basic confirmation requirements – voting requirements, absolute priority rule

and feasibilityo Developing the outline of a plano Garnering support for the plan – must have one accepting classo Forcing dissenting classes or creditors to accept – cramdown and class consent

issues

• Protecting Waldo – The Non-Creditor Playerso Management and the Board

• Role of management ongoing• Releases and exculpation

o The tip to equity

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First Lien Lender’s Perspective

• Pay me now – Pay me in full• Sell assets• Make whole provisions• Cram-down concerns

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Second Lien Lenders Concerns

• Expectations of equity owners – unexpected issues to address• Market Value of assets once out of bankruptcy• Do the unsecured creditors have any merits to their

filings• Are there issues that must be addressed before we

can take control of the company• Do we need to make changes to management for

the exit of the bankcruptcy.

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Unsecured Creditor Committee

• Recovery based on unencumbered assets• Priority last after Administration, Secured, and

Unsecured Special Priority• First Day – CRITICAL

o Impact all future rightso Are you a priority for the company?o Are you a critical supplier or service provider?o Court may grant special priority if going concern

• DIP financing and timing

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Unsecured Creditor Committee

• Monitor – unsecured’s benefit the most from monitoringo Filing objectionso PROTECT YOUR RIGHTS

• If not, the game is ½ over just after it starts• File under Rule 2002 – added to Service List

o Interface with US Trustee (UST) – good source of infoo 341 Meeting

• Committee Fees are paid for by the Estate• Reclamation – days

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Possible Outcomes

1. First Lien Solution – Plan unconfirmable; assets should be sold, first lien paid with balance to second lien and others.

2. Second Lien Solution – Plan confirmable; first lien crammed down with new note given at low interest rate. Second converts to equity, with small equity distribution to unsecureds and old equity.

3. Unsecured Solution – Plan unconfirmable because of old equity distribution and lien avoidance issues; unsecured creditors should be bought out at face with lien creditors taking debt and equity in reorganized entity.

The CFO's Dilemma - Proactive Next Steps 28

Negotiated Resolution

• First lien holder, under threat of cramdown, agrees to deferred payment note at 90% of face with reasonable terms and market interest rate; 5% new equity kicker.• Second lien holder full conversion of debt to 80% of

new equity• Unsecureds $10 million cash payment and interest in

litigation trust funded with avoidance actions• Management gets 5% Management Incentive Plan• Old equity invests $15 million to retain 10% of new

equity

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Q&A Session

• Please Submit Questions via Questions Pane on Your Screen• Please Be Patient As We Try to Answer All

Questions

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Thank You For Joining Us!

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Contact Information

Trent Rosenthal [Online Bio]Restructuring & Bankruptcy Partner – Burleson LLP Phone: 713.358.1724Email: trosenthal@burlesonllp.com

James (“Jim”) C. Row, CFA [Online Bio]Managing Director & Founder – OFSCap, LLCPhone: 713.823.2900Email: jrow@ofscap.com

Michael Rosenthal [Online Bio]Restructuring & Reorganization Partner – Gibson, Dunn & CrutcherPhone: 212.351.3969Email: mrosenthal@gibsondunn.com

Rich Bernardy [Online Bio]Managing Partner – M1 Energy CapitalPhone: 713.300.1420Email: rbernardy@mecapital.com