Introduction As a reaction to the dramatic oil price volatility, many energy companies plan to streamline operations by reducing work force and shedding assets. Those who do so face tightening credit and decline in asset value that may impact the solvency of the business enterprise. Energy companies must maintain operations where possible to preserve value and position themselves for a turnaround in prices. Those without staying power because of a lack of capital may be forced to position themselves for sale of all or substantially all of their assets at the highest value. Buyers will want to acquire assets expeditiously and free of liability. Under these circumstances, various parties doing business in the energy industry must be aware of their duties and risks of liability. These parties must also be up-to-date on the means by which to expeditiously transfer assets free of certain claims and interests to maximize recovery. This Client Alert will briefly highlight only a few points to be aware of.
Attorney-Client Privileges: Who May Assert Them (Former Officers and Directors)? What Is the Effect of Dissolution? Given the unpredictability of the current energy market, a precautionary note is in order: efforts should be made to preserve attorney-client privilege in event of later litigation. The attorney-client privilege protects from disclosure to third parties confidential communications between an attorney and a client made for the purpose of obtaining (or rendering) legal advice. Therefore, non-legal advice is not protected. Generally, a corporation's equity interest owners, officers and directors cannot compel disclosure of the corporation's privileged information, since the privilege belongs to the corporation. However, in limited situations, the attorney-client privileges may be lost either thorough waiver or based on “exception.” Examples include: privilege passes to chapter 7 trustee of company; based on a “fiduciary exception” to the corporate attorney-client privilege, disclosure may be compelled for “good cause” in situations where shareholders seek to enforce the rights of the corporation against the corporation’s officers and directors; and disclosure of the protected communication to third party. Courts often consider the question of whether the attorney-client privilege survives the dissolution of a limited liability company, limited partnership, corporation, or other legal entity, and if so, who is entitled to assert the attorney-client privilege. Because the protections and waivers vary from jurisdiction to jurisdiction, understanding the parameters of the protections afforded when communicating with your counsel – whether in-house or outside counsel - is very important.
Representations and Warranties Insurance In instances where parties are seeking to buy and sell assets under financially stable circumstances, Representations and Warranties Insurance is becoming more common in mergers/acquisitions. It protects against breaches of representations and warranties included in a final Purchase Agreement. Both buyers and sellers can purchase this type of insurance. As examples, the buyer can be protected against diminution of value if it relied upon inaccurate factual warranties in determining the value of the target company. A seller can distribute funds from a transaction more quickly, as this insurance can reduce/eliminate reserves or escrows.
Fiduciary Duties in Zone of Insolvency – Applicable State Law Varies For any company nearing insolvency – the “Zone of Insolvency” – the officers and directors must determine if applicable law in its jurisdiction recognizes a creditor’s right to bring direct fiduciary-duty claims against the officers and directors of a corporation operating in the zone of insolvency. Normally, a corporation is operated for the benefit of its owners. However, some states have shifted the duties, such that once in the zone of insolvency, a company has a fiduciary obligation to make business decisions in the best interest of the company’s creditors.
Currently, Delaware law does not recognize such a right, but Pennsylvania does – referred to as the “tort of deepening insolvency.” Furthermore, there are duties of care and loyalty, among others, that receive heightened scrutiny when a company ultimately fails to pay its creditors in full. Therefore, if a company is nearing insolvency, consideration must be given to the then-current applicable law, to advise the officers and directors on the potential effect of their business decisions.
Any Downsizing Requires a Lengthy Look at the Federal and State WARN Act The Worker Adjustment and Retraining Notification (WARN) Act is a federal statute requiring covered employers to provide employees 60 days’ advance notice before closing a plant or conducting a mass layoff. Covered employers that do not satisfy the WARN Act’s requirements or qualify for an exception may be liable to affected employees for back pay and benefits. Some states have enacted their own versions of the federal WARN Act, often referred to as “mini-WARN Acts.” If a union represents any portion of an employer’s workforce, a collective bargaining agreement may provide for additional notice or additional rights and remedies.
Generally, if a plant closing or mass layoff triggers the WARN Act, all other employment losses within 30 days of the event are aggregated with it. Therefore, a WARN notice can be required even for non-plant closing/non-mass layoff employment losses. While the length of the notice period can be reduced in limited circumstances (e.g., where there is a faltering company, unforeseeable business circumstances exist, or a natural disaster occurs) the ramifications for non-compliance are significant.
Potential for Private Equity Being a “Trade or Business” for Control Group Liability for Underfunded Pension Plans The Court of Appeals for the First Circuit ruled that a private equity fund may be considered a “trade or business” under the rules of the Employment Retirement Income Security Act of 1974 (ERISA). Sun Capital Partners III, LP v. New England Teamsters and Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. 2013) cert. denied, 134 S. Ct. 1492 (U.S. 2014). This decision was the first in which a court treated a private equity fund as a “trade or business” under ERISA. Private equity funds now, along with other control group parties, risk exposure to the unfunded benefit obligations of portfolio companies.
Successor Liability Both common law and statutory law provide for certain liabilities to follow assets when they are sold, even if the acquirer expressly states that the acquisition does not include certain assets or certain liabilities. As a result, parties often seek to accomplish the sale through a chapter 11 bankruptcy proceeding. The express language of section 363(f) of the Bankruptcy Code authorizes the sale of assets by a debtor free and clear of claims and interests, including certain “successor” liabilities. Therefore, a bankruptcy sale is intended to allow debtors to maximize the value of their assets and create more certainty for purchasers by minimizing the risks associated with buying distressed assets.
Chapter 11’s with Quick Bankruptcy 363 Sales Followed by a Dismissal Without Conversion or Plan Confirmation Section 363 bankruptcy sales of substantially all a debtor’s assets shortly after the filing of a bankruptcy petition has been gaining favor. Similarly, bankruptcy courts are authorizing the dismissal of the chapter 11 case once the sale is completed, without the need for a conversion to a chapter 7 or confirmation of a chapter 11 plan. Furthermore, a recent Delaware Supreme Court ruling held that a board of directors does not need to shop a company before or after signing a merger agreement. The court held that the board may negotiate with only one prospective purchaser as long as there is a “viable passive market check” of the process. Recently, several Bankruptcy Courts have ruled that sections 105(a) and 1112(b) of the Bankruptcy Code provide authority for a “structured dismissal” of the bankruptcy case, dismissing the case without the need for a conversion to a chapter 7 or confirmation of a chapter 11 plan, noting that the remedy “is clearly within the sphere of authority Congress intended to grant to bankruptcy courts in the context of dismissing Chapter 11 cases.” A “structured dismissal” of a chapter 11 case following an early sale of substantially all of the debtor’s assets has become increasingly common as a way to minimize cost and maximize creditor recoveries.
Preferential and Fraudulent Transfers – Creditors Beware When a company starts to falter, creditors demand protections and may apply pressure for payment. These “payments and protections” may be deemed to be either “preferential,” or even “fraudulent transfers.” Preference and fraudulent transfer actions allow entities that have filed for bankruptcy protection (debtors) and bankruptcy trustees to avoid certain pre-bankruptcy transfers so that those transfers (or their value) can be recovered and redistributed to creditors. Avoiding pre-petition transactions prevents aggressive creditors from obtaining favorable treatment as a debtor slides into bankruptcy.
There are various exceptions and defenses to preference liability, including: contemporaneous exchange for new value, ordinary course of business, purchase money security interests perfected within 30 days, subsequent extension of new value, floating or statutory liens, protections for securities transactions. Similarly, there are defenses to a “fraudulent transfer” claim.
Strategies for unsecured creditors to avoid receiving a preferential transfer include: invoicing strategies (e.g., require payment by cash, cashier's check, certified check or wire transfer); managing accounts (e.g., to reflect the “new value” if goods are shipped or other unsecured credit extended after payments are received from the debtor); cash checks promptly; avoid post-dated checks; obtain a third-party guaranty; obtain an irrevocable letter of credit or credit insurance; consider obtaining credit insurance, but confirm that it provides coverage for preference claims; and other avoidance actions.
Fraudulent transfers consist of certain transfers of an interest in property (or the fraudulent incurring of an obligation) without adequate value. Actual fraud is not required. Fraudulent transfers can be set aside – avoided – so the transferred property can be recovered. When the transferor is insolvent, or in the zone of insolvency, transactions especially suspect to involving a fraudulent transfer include: conveyance for no consideration given by an insolvent person to a friend or relative; inter-corporate guaranties; joint and several loans; leveraged buyouts; dividend recapitalizations; insider employment contracts and benefits; and dividends and stock redemption. Multiple transactions over several years may be collapsed to support a claim of a fraudulent transfer. The look-back period varies from one year to 10 years, depending on the law applicable to the particular transfer and creditor. The primary defense to such claims is based on valuation at the time of transactions, as well as the solvency of the transferor.
Conclusion The above discussion addresses only a few of the many issues that should be considered by those doing business in the energy industry during this period of price volatility. For example, the enforcement of contracts and leases and their treatment in a bankruptcy case can be the subject of much discussion. These topics, as well as many others, will be the focus of future updates and seminars from your friends at Reed Smith LLP.
Client Alert 2015-019