Insights > Bankruptcy Is Not the End – It’s a Fresh Start

Bankruptcy Is Not the End – It’s a Fresh Start

While many people believe that entering bankruptcy means the end of an organization, the opposite, in fact, can often be true. According to Chapter 11 of the US Bankruptcy Code, “the fundamental purpose of reorganization is to prevent a debtor from going into liquidation, with an attendant loss of jobs and possible misuse of economic resources.”

Under Chapter 11, companies that file for bankruptcy protection typically have the opportunity to reorganize the business and capital structure while continuing “normal operations.” Chapter 11 allows management and the board to continue to control the business while developing a plan of reorganization that provides the operational strategy for the reorganized company and outlines how creditor claims will be adjudicated. For an organization looking for a second chance at business viability, filing for bankruptcy protection under Chapter 11 can be a valuable way to eradicate debt and preserve its enterprise value.

While we have recently experienced the longest economic expansion in history, many analysts predict a near-term economic correction. In fact, many industries, including energy, healthcare, retail, and metals and mining have already seen significant increases in companies seeking Chapter 11 protection in 2019. According to Debtwire’s Restructuring Insights Report, Chapter 11 filings with debts in excess of $10 million were up more than 35% during the second quarter of 2019 (83 filings in total). Of these filings, approximately 20% were in the oil and gas (O&G) and metals and mining sectors.

The Chapter 11 process provides a company with meaningful opportunities to address both operational and financial challenges that it otherwise would be unable to resolve outside of bankruptcy. In addition to optimizing its capital structure, debtors are often able to improve operational performance by restructuring lease obligations, reducing or eliminating legacy liabilities, and renegotiating customer and supply agreements.

Although the Chapter 11 process in the oil and gas industry is governed by the same provisions as other industries, O&G bankruptcies often include a unique set of complexities that require specific consideration for management teams as they navigate an often-chaotic process. Items such as the debtor’s ability to accept or reject leases, the treatment of contractor liens, royalty interests, and the continuation of asset retirement obligations are only a few of the issues that need to be considered in O&G bankruptcies. In addition, given the capital-intensive nature of the industry, access to additional capital and the deployment of that capital is of paramount concern when attempting to reorganize through a Chapter 11 proceeding. A drawn out filing or insufficient liquidity presents real risk to the company of the loss of oil and gas interests and, as a result, a significant erosion of enterprise value.

When executed correctly, however, the Chapter 11 process provides a proven path for O&G companies to meaningfully improve profitability given the “debtor-friendly” design of the bankruptcy laws in the United States.  These performance improvement opportunities are critical for management teams to understand as they consider their strategic options, assess the risks and opportunities of bankruptcy, and determine how best to position their organization for long-term success. The most common and value accretive opportunities include the ability to exit out-of-market and/or unprofitable contractual agreements (e.g., JOAs, gathering agreements, supply/service/equipment leases, take or pay contracts); selling non-strategic assets via a court-supervised auction process; and reducing future cash requirements for legacy liabilities including well plugging and abandonment, depending upon the jurisdiction.

The Chapter 11 process also requires a significant amount of incremental financial reporting and accounting activity. The Bankruptcy Court and US Trustee’s office require frequent and detailed reporting of financial results and the SEC requires unique financial reporting for any externally-audited financial statements. These requirements often create significant strain on an organization’s finance and accounting function.

Finally, upon emergence from Chapter 11, the organization must evaluate whether it qualifies to apply for fresh start accounting under ASC 852, Reorganizations, which requires companies to establish a new basis of accounting, resulting in a “new” entity. Fresh start accounting is required if two conditions are met:

  • The reorganization value of the company immediately before the date of bankruptcy confirmation is less than the total of all post-petition liabilities and allowed claims; and
  • The holders of existing voting equity immediately before bankruptcy confirmation receive less than 50% of the voting equity shares of the emerging entity.

If both criteria are met, the company applies fresh start accounting by remeasuring most of its assets and liabilities at fair value. The approach is similar to a business combination under ASC 805; for example, the fair value of the organization’s assets is generally derived from discounted future cash flows. The opening balance sheet at the emergence date is the starting point for all future accounting and financial reporting.

As with any major corporate transaction or transformational event, communication and education are essential during a Chapter 11 proceeding. Assembling a robust bankruptcy working group—comprised of legal counsel, auditors, and restructuring advisors—is key to success. This group drives the process from beginning to end, serving as the glue that holds the different pieces together throughout the many organizational and management changes that are likely to occur. Engaging the right support team to help navigate the intricacies of a restructuring will ensure that emerging from bankruptcy brings the fresh start needed to get a distressed company back on track.

 

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