Duston K. McFaul is a partner in the Houston office of Sidley Austin LLP’s Corporate Reorganization and Energy practices. He focuses his work on advising clients in the oil and gas industry with complex restructurings, negotiated workouts and contested proceedings.

Mike T. Gustafson is an associate of Sidley Austin LLP’s Corporate Reorganization practice.

A challenging market environment with low commodity prices can spell danger for even the best run companies. While the oil and gas industry has a history of resiliency and laudable entrepreneurism, it is inevitably capital-intensive, even after the most serious of cost-cutting measures. As revenue struggles to keep pace with liabilities and the credit markets seem to tighten, directors and officers should ensure they are making realistic assessments of risks to the enterprise’s long-term future. Avoiding a “Plan B” discussion until it is the only remaining option could eliminate a well-planned restructuring as a viable alternative. Being prepared with a real back-up plan involves foresight, time, and expense. Taking the initiative early is often critical for officers and directors – and the enterprise – in the long run.

Understanding Liabilities

Fiduciary Duties

A director usually has a legal duty to act solely in another party's interest, commonly known as a “fiduciary duty.” State law generally provides that directors owe fiduciary duties to the corporation and its shareholders. Fiduciary duties may include the duties of good faith, care, obedience, and loyalty. These duties require a director to act in the best interests of the corporation, which can involve assessing the need for contingency planning. For example, the duty of care may require a board of directors to act prudently, and recognize and assess situations in which specialized skill is reasonably necessary. Insolvency, or impending insolvency, may be one such situation.

It is also important to recognize the dynamic nature of duties in distressed situations. When a business is insolvent (or in some cases, teetering near insolvency), some courts have concluded that certain duties generally owed to shareholders become owed to the business’ creditors because the company’s insolvency makes the creditors the principal constituency injured by any fiduciary breaches. If a company has filed for Chapter 11, directors’ fiduciary duties typically become owed to the bankruptcy estate as well, meaning these duties are to be exercised primarily for the benefit of creditors.

Fiduciary duties owed by directors in these circumstances also include working to maximize or preserve the value of the enterprise. In developing a strategic plan, the best course may involve forming a special committee of the board to work with advisers to develop alternatives under multiple scenarios. A viable business plan should attempt to indicate some form of sustainability with realistic risk discounting. Without the ability to articulate a path to a more solvent enterprise or workout alternative, it becomes difficult to get stakeholders and lenders on board if Plan B may become a necessity. Moreover, all of the legal gymnastics in the world may not matter if time becomes too short and capital becomes too constrained to develop and achieve a back-up plan.

Statutory Issues

Officers and directors are generally insulated from personal liability for unfulfilled financial obligations of the companies they serve, but there are exceptions. For example, the Internal Revenue Code provides that “responsible persons” may become personally liable to pay certain federal “trust fund” taxes unpaid by a business. Such trust fund taxes include Social Security and Medicare taxes and income tax withholding. As a result, officers and directors could face claims of personal liability should their businesses prioritize payment of other liabilities over payment of these trust fund taxes. Compliance failures by distressed businesses under environmental or labor laws can also give rise to personal liability in some circumstances. Moreover, D&O insurance generally does not cover “penalties” and therefore may not provide protection in certain circumstances. Ignorance of the law is seldom an excuse, and these are but a few of many examples wherein early education can avoid later calamity.

Bankruptcy Is Not Free

If a “free-fall” liquidation is not the plan (and it certainly should not be if preventable), then cash is king in order to accomplish a reorganization. Cash is needed not only to keep the day-to-day business a going concern, but also to bridge a longer-term restructuring solution amidst increasing challenges. Vendors, for example, often put a struggling business on C.O.D. or require cash payments in advance or security deposits. Lenders who had previously been forgiving on covenants often tighten the reins. If a business is at substantial risk of running out of cash when a Plan B may become a necessity, it is often too late, particularly if there is a secured lender with liens on all the assets of the business. There is an old saying among restructuring advisers, “You can be too broke to go bankrupt.” In retrospect, many companies complain that they waited too long to develop a Plan B. There is no record of complaints that a company began assessing its back-up plan too early.

The actual process of filing for Chapter 11 bankruptcy is much more involved than “checking a box” and filing a form with a Bankruptcy Court. The company’s officers and advisors must devote time to preparing for Chapter 11. The filing of cases typically involves the preparation of dozens of pleadings and the drafting of motions with extensive written briefings including exhibits and affidavits, requiring interviews with company insiders and substantial fact collection, negotiations, and strategic development. Specialized professionals may draw on the company’s books and records to prepare budgets, forecasts, and an assortment of schedules and statements regarding the company’s financial affairs.

The debtor must have a mechanism to fund outside professionals. To represent a debtor, counsel must be “disinterested,” and under the Bankruptcy Code, creditors potentially are not “disinterested.” As a result, advance retainers are necessary not only to fund the pre-petition work, but also to avoid potential disqualification because of a firm being a past-due creditor of the client.

Funding after Filing

If a Chapter 11 bankruptcy petition is filed, recovery actions of creditors generally will be stayed, and a “breathing spell” commences. Nonetheless, an assortment of post-petition expenses and indebtedness will need to be paid on an ongoing basis, including for employee wages, utilities, and insurance. Upon filing, the company’s ability to use available cash is usually subject to Bankruptcy Court approval. Though a company will seek the immediate ability to access this cash for expressly articulated needs, cash flow is often restricted and – without an agreement – contests may ensue with secured lenders.

To confirm a plan in bankruptcy and successfully exit Chapter 11, a company is required to fund its administrative expenses under the Bankruptcy Code. Some courts have held that payment of professionals by third parties (not the debtor) creates a conflict of interest to the professional, particularly if the third party is an affiliate or insider of the debtor. There must be a means to finance a Chapter 11 case, and having the capacity or otherwise determining a source of funding is critical well in advance of an actual filing. A smooth reorganization process may have pre-arranged “debtor-in-possession” financing terms, and the company may seek interim approval of this financing within the first few days of a Chapter 11 filing.

Have a Plan

If a Plan B should ultimately become necessary, early discussions and analysis can mean saving the enterprise and jobs in the long run. Once retained, professionals work with company leadership – and if it becomes necessary, major creditor groups – to develop an out-of-court solution or consensual plan to avoid a lengthy or litigious process. Engaging creditors to stay involved in the process rather than selling their claims and exiting the process early can be beneficial on multiple fronts. First, legacy creditors typically have more skin in the game and are incentivized to have a healthy company post-emergence with whom they can have a profitable ongoing business relationship. Second, ensuring that a sufficient number of legacy creditors remain engaged can make a difference in preserving valuable tax attributes in some cases for the enterprise.

Clearly, a full-scale restructuring or Chapter 11 filing is not a company’s ambition. The best result often involves a path to avoid it. There are, however, external factors completely out of the control of even the best run companies. There is nothing wrong with hoping for the best, but dangers lurk when unprepared for the worst. Being realistic about contingency planning may, in the end, protect the enterprise as well as its officers and directors.

This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.