Bounty Out Of Bankruptcy

W?hen Grapevine, Texas-based Reichmann Petroleum Corp. filed for bankruptcy-court protection in December 2006, working-interest partners, including Striker Petroleum LLC and Bamco Gas LLC, found themselves in a conundrum. Reichmann had oversold more than 100% in working interests without recording the assignments, leaving the title work in a mess.

To protect their interests, the companies partnered and entered the bidding process to buy Reichmann’s assets out of bankruptcy.

Reichmann held properties in the South Texas Lobo and Wilcox trends and in the Barnett shale in North Texas with a PV-10 value of $29.3 million based on year-end 2007 reserve values. Through MSB Energy Inc., an entity of Frisco, Texas-based Striker; Fort Lauderdale, Florida-based Bamco; and Houston’s Mining Oil Inc.; the three made the winning bid for the assets for $15.2 million.

Says MSB corporate secretary and general counsel Chris Stacy, “We were always anxious about whether we were going to get title to what they said.” And after taking ownership in September, “now we have a lot of clean-up to do. It’s like renovating an old house.”

“All kinds of oil and gas assets come onto the market as a result of financial stress,” says Rhett Campbell, a partner with Thompson & Knight LLP specializing in oil and gas bankruptcies. The law firm recently held a seminar in Houston on buying oil and gas assets out of bankruptcy.

“It’s fairly common in these kinds of times, when prices have dropped dramatically and the credit markets are in a state of commotion with people twisted off on their hedges, that companies in financial distress may need to sell their properties, maybe in a Chapter 11 proceeding.”

Oil and gas assets come onto the market in bankruptcy proceedings in good economic times and bad, Campbell notes. Market and economic conditions, such as those at present, drive companies into Chapter 11 as a strategic move or out of necessity.

“We’ve seen a lot of volatility in commodity prices recently, mostly headed down. Any time that happens, it creates financial stress on companies already stretched too thin.”

Also, companies facing maturation of term loans are having a hard time refinancing. Together, these factors are pushing companies into a position in which they have to consider selling assets and possibly filing for bankruptcy protection.

Yet one company’s woe is another’s windfall. “It is a time of opportunity for buyers to help out those companies in bankruptcy by buying their assets,” Campbell says.

Reorganization unlikely

A company filing Chapter 11 can take either of two paths. A plan of reorganization is the more traditional method for a debtor to emerge from bankruptcy, but a “Section 363” sale, so-called from bankruptcy code, allowing a sale of some or all of the debtor’s assets, is becoming more common.

A plan of reorganization can act as a barrier to entry in the process for competing buyers because the plan process is more complicated. Once a buyer has the lead in a planned process, often that lead can be kept. In contrast, in a Section 363 sale motion—although a faster process—potential buyers have the opportunity to submit competing bids.

Most oil and gas bankruptcy cases involve an outright sale of the company or its assets as opposed to a reorganization, a fact on which astute potential buyers can capitalize. Thompson & Knight partner Randy Williams says that emergence from Chapter 11 into solvency through a reorganization is rare. “More often the assets are sold and the money put into a pot” for creditors to divide.

And in the current financial markets, debtors going into bankruptcy are finding there is less money available to sustain them through a reorganization.

“The only way you can truly reorganize under a Chapter 11 process is if you have access to money. As there’s less money available, you’re going to see that sales are even more important going forward.”

Advantages

Buying assets out of bankruptcy presents distinct advantages. First, not all of the parties involved must consent to the sale, unlike a traditional sale. “The debtor and buyer have to consent, but those with liens do not have to consent to the sale,” Campbell says.

In addition, the assets are “cleansed” of all liens, including restrictions on use. All liens, encumbrances and obligations are eliminated. “The fellow that buys the assets has the assurance that the liens and encumbrances that existed as of the day of the sale are now gone. A lot of buyers think that’s valuable.”

Contractual covenants, such as service contracts or employment or supply agreements, are also wiped clean. “The purchaser is not burdened with the contract,” he says.

Executory contracts, such as a joint-operating agreement, can be terminated as well, but can be retained as part of a purchase negotiation with the buyer. “Executory contracts don’t stay in effect unless the judge orders it so,” says Campbell. “Typically, the purchaser wants certain executory contracts to stay in effect. He picks and chooses and asks the judge to reject the others as a condition of the sale. It’s part of the negotiation.”

Executory contracts can be a tricky part of a bankruptcy purchase. Unlike the data room in a non-court sale, a company undergoing bankruptcy often doesn’t have all its paperwork in order.

“You can’t just simply go into a data room and think that everything you need is always there,” Williams says. “You may have to go beyond that. Look at public records. Talk with the other working-interest owners. It’s not uncommon that you will find a file with what you think is the joint-operating agreement, but when you contact the other working-interest owners you find that the actual joint-operating agreement is a later version.”

Defaults in these agreements must be cured prior to assuming them as well. “You need to make certain the seller understands that if you cure any liabilities to third parties, that amount will come out of the sale proceeds and will not be in addition to what you’re paying. You don’t want to pay any more money than what you’re bidding to fix problems with the cure process.”

In contrast, covenants “running with the land” are not wiped clean by the sale. These are covenants embedded in the title documents, including the lease agreement, such as royalty payments and continuous-development provisions. These must be honored by the purchaser.

The stalking horse

Potential buyers can move to the front of the line and actually control the negotiations for the assets by becoming the “stalking-horse” bidder—the initial best bid that establishes the floor for the properties and what any other bidders must best. Being the first-mover on the field in the battle for the properties has advantages in the bankruptcy process.

“The significance to the buyer is you’re the one who sits down with the debtor and negotiates the purchase-and-sale agreement, or the stalking-horse contract,” Williams says. “That’s going to set the mark at which everyone else has to shoot, not only in price, but the terms in which you’re going to accept title to the assets.”

One of those terms is the breakup fee. In the event the first-mover bidder is not the winning bidder, the breakup fee—which must be reasonable, court approved and usually 1% to 4% of the purchase price—will pay for the effort of the initial due diligence and negotiations. It is designed to cover legal fees and expenses, and to encourage others to enter the transaction. Other bidders typically have to best that bid plus the breakup fee to win the deal.

“You are negotiating the contract and doing the due diligence to make that first offer and to set the bar for everyone else. You’ve set the stage for the debtor to get more money than you’re willing to spend for the assets. In the event you don’t end up with the assets, you’re going to get some of your investment back.”

When the court approves the stalking-horse contract, this is significant because the deal is set. “Everyone else has to play by the rules you’ve set,” says Williams.

Strategic maneuvers

Buying assets out of bankruptcy has become big business in the past few years, and interested buyers often try to gain an advantage by looking for financial distress before a company files for Chapter 11.

Thompson & Knight partner David Bennett says one strategy for gaining an upper hand is to become a debtor-in-possession (DIP) lender. These are loans typically obtained by a Chapter 11 debtor early in a case to help finance the bankruptcy process. In many cases, it is a relatively secure loan with a relatively high coupon. At present, these DIP loans are in short supply.

“It’s a method to obtain information early and to align with management,” Bennett says. “It is an opportunity for interested buyers to obtain an entrée into the case by providing capital to the case, which then becomes currency in the process.”

In the appropriate circumstances, a DIP lender may even come in ahead of all of the existing secured debt, and a DIP loan can become a part of the purchase price.

A related strategy is to purchase a claim, either secured or unsecured, from an existing creditor. Without a claim, an interested buyer doesn’t have standing in the bankruptcy case to come into the process early. Any attempt to influence the sales process, such as how the bidding procedure is set up, establishing the breakup fee, or even whether assets will be sold, will be decided early.

“In the absence of holding a claim, interested buyers don’t have standing to come in and take a position on those issues. Those factors can determine the outcome.”

Creditors holding a claim are often motivated to sell their position as bankruptcies often result in claim recovery of about 10 cents on the dollar. The larger the claim purchased, the more weight that creditor carries in the case, Campbell says. “That strategy works very well. People do that a lot.”

Another strategy is the lock-up agreement, which prevents the auction process and is an exception to the rule in which the courts favor competition to achieve the highest value for the assets.

The lock-up agreement is designed by the interested buyer and debtor to cut to the quick to a final sale, avoiding market forces that might drive up the price. Still, the judge has to believe the offer is fair and all claim-holders, both major and minor, must agree to be bound to it. Otherwise, it’s worthless, says Bennett.

“A lock-up agreement is a swim upstream, but it could be successful if all of the constituencies can be bound. It’s certainly a method to speed the process along and to get to an end-game in the case sooner.”

One purchase strategy that is not as effective as often believed is membership on the creditors’ committee. This committee plays an advisory role with access to insider information, and has influence with the judge. But interested buyers “will have so many conflicts of interest you will be disqualified from many discussions and will subject the sale to a higher level of scrutiny,” Bennett says.

Campbell adds, “It’s difficult to be on a creditors’ committee and be a buyer of assets. We discourage people from that. Whether you’re on the committee or not, as a buyer you’re always going to be granted access to information relative to your asset. It’s unnecessary to be on the creditors’ committee.”

Cash trumps all

Winning bids in a bankruptcy-induced sale are not always the highest in dollar value, but the “best” bid in the eyes of the court when taking into consideration the buyer’s ability to close. In almost every case, the “highest and best price” is the highest cash price over the highest dollar price.

“Cash is king in a bankruptcy. An interested buyer may be rejected because of a perceived inability to close on the assets,” says Bennett. The sales process frequently requires a deposit or proof of financing, “but there are certainly cases where a lower bid will be determined to be the best bid. If one of the buyers has the ability to close and the other is a questionable prospect, the court goes with the lower bidder.” Finding portfolio-building opportunities in bankruptcy courts is a process of separating the wheat from the chaff.

“What makes Chapter 11 so attractive is that it is a relatively inefficient process,” says Campbell. “There is no clearinghouse for Chapter 11 assets that go on the market, and there are buyers that just won’t deal in the bankruptcy space.”

When New York-based Lothian Oil Inc. became overextended and ran out of money, it filed for bankruptcy-court protection in June 2007, putting into play nonproducing tracts of 3,500 acres and 6,600 acres in the West Texas Wolfberry formation adjacent to producing properties. Midland oilman Ted Collins entered the process as the stalking-horse bidder, offering $2.5 million and $9 million respectively for the properties, and established the terms of sale. A bidding frenzy ensued at the auction in February 2008, and Collins won both sales for $11 million and $22 million.

Buyers must be careful and understand what they intend to buy, Campbell says: Know the reserves and be aware that bankruptcy transactions are often not clean—the purchase often involves additional legal work after the sale.

Yet opportunities abound in bankruptcy courts. “A lot of people make a lot of money buying assets out of bankruptcy,” Campbell says. “It’s often overlooked by buyers as an opportunity.”