Sabine Oil & Gas Corporation recently filed for bankruptcy. As is typical, on the first day of the bankruptcy cases, the debtors filed motions allowing them to operate their businesses under court supervision. What is not typical is what they also filed on the first day — a lawsuit against the lenders that provided Sabine’s $700 million second lien loan facility. That lawsuit seeks to avoid liens granted to those lenders, in effect partially unwinding a merger consummated by Sabine only eight months prior to the bankruptcy filing. In many ways, this aggressive litigation strategy should provide the debtors control over the bankruptcy litigation, a prerogative often reserved for creditors’ committees. This article examines the significance of this approach as well as the novel legal issues raised in Sabine’s attack on its own eight-month old merger.
Sabine Oil & Gas LLC and Forest Oil Corporation began exploring a possible merger in December 2013. Over the sub-sequent months, the two entities and their advisors met, conducted reciprocal due diligence and ultimately negotiated a deal. The parties entered into an agreement and plan of merger on May 5, 2014. The original agreement was amended slightly on July 9, 2014, revising the structure of the transaction but not changing its economic terms.
After the amendment, the merger was delayed due to an audit of Forest Oil’s 2013 financial statements by the Public Company Accounting Oversight Board. During this delay, oil and gas prices plummeted, adversely affecting Sabine and Forest Oil as well as the economics of the merger agreement. Given the new economic realities, the companies faced significant challenges in finding a workable capital structure for the combined company. After substantial discussions, the parties agreed upon a revised deal structure.
The merger was ultimately consummated on December 16, 2014. It was effectuated through a series of steps. First, the Sabine entities contributed their equity interests to Forest Oil. In exchange, Forest Oil issued stock to Sabine investors. Following this exchange, the Sabine entities merged into Forest Oil, which then changed its name to Sabine Oil & Gas Corporation. This resulted in Sabine investors holding a 73.5% economic interest in the combined entity, with Forest shareholders owning 26.5%.
As set forth in the charts that follow, the merger also involved a consolidation of the Sabine and Forest Oil capital structures. Forest Oil’s $105 million first lien revolving credit facility was terminated, while Sabine amended and restated its first lien revolver and increased its borrowings to fund the merger. Sabine entered into an amendment to its second lien loan, which provided an incremental $50 million of debt above the $650 million issued in 2012. The combined entity also assumed the unsecured debt issued by Sabine ($350 million) and Forest Oil ($800 million). This left post-merger Sabine with first and second lien secured debt, as well as three unsecured note issuances.
Shortly after the merger, it became evident that the combined company was in financial distress. The drop in oil and natural gas prices and increased debt led to severe liquidity constraints. Given these circumstances, Sabine engaged in discussions with its creditors regarding a potential restructuring. Notably, on May 15, 2015, Sabine also established an investigation committee comprised of independent members of its board of directors to examine potential legal claims arising out of the merger.
On June 11, 2015, the investigation committee concluded that “it would be in the best interest of the Company and its stakeholders” to pursue a fraudulent transfer claim against the second lien lenders. On July 13, 2015, the committee authorized the filing of a complaint along with the filing of the Sabine bankruptcy petition.
The Sabine entities filed their bankruptcy cases on July 15, 2015. On the same day, the debtors also filed their fraudulent transfer lawsuit. A transfer may be avoided as fraudulent if the transfer was made for less than reasonably equivalent value while the transferor was insolvent. Accordingly, the lawsuit alleges that (i) Forest Oil pledged its assets to the second lien lenders, (ii) Forest Oil and its creditors did not receive reasonably equivalent value or fair consideration in exchange for the transfer of its assets to the merged entity, and (iii) at the time of the transfer, Forest Oil was insolvent.
At the heart of the lawsuit is the harm that the holders of Forest Oil’s unsecured notes ($800 million in two separate tranches) suffered because of the merger. Immediately before the merger, these holders would have been entitled to a significant recovery from Forest Oil’s assets. These assets allegedly had value well in excess of the amount of secured debt (which must be paid first) in the Forest Oil capital structure. For illustration, assume that Forest Oil had $500 million in assets. In a liquidation, the secured debt would recover in full ($105 million), leaving $395 million—or close to a 50% recovery—for the $800 million of unsecured debt. This recovery analysis changes dramatically post-merger. In that transaction, the Forest unsecured noteholders became junior to $700 million in Sabine secured second lien debt. If one were to assume that pre-merger Sabine had $800 million in assets, the assets of the combined company would total $1.3 billion ($800 million plus the hypothetical $500 million Forest Oil value). In a bankruptcy under these assumed facts, the first lien lenders of the post-merger entity would collect their $594 million and the second lien lenders would collect their entire $700 million claim. This would leave almost no value ($6 million) for un-secured creditors. As shown by the hypothetical, such a transaction—which is similar to what is alleged—would benefit Sabine’s second lien lenders to the detriment of Forest Oil’s unsecured creditors, who would see their recovery decrease from nearly 50% to almost zero.
On August 17, 2015, the administrative agent under the second lien loan filed a motion to dismiss the lawsuit. Shortly thereafter, Sabine filed a response. The motion to dismiss makes two main arguments: (i) that, as a matter of law, post-merger Sabine received reasonably equivalent value in exchange for the liens; and (ii) that the debtors are barred from avoiding the liens under section 546(e) of the Bankruptcy Code, which prohibits the avoidance of any transfer to a financial institution that was made in connection with a securities contract. These arguments, and Sabine’s subsequent response, are described in turn below.
Reasonably Equivalent Value
The motion to dismiss argues that pursuant to the merger agreement, the related assumption agreement, and New York law, the combined Sabine entity became the borrower and assumed all obligations under the second lien loan. These obligations are not contested as to either validity or amount. Thus, they constitute “a present or antecedent debt” of post-merger Sabine. The motion to dismiss also asserts that after this assumption, Sabine granted the challenged liens to secure its obligations under the second lien loan. Accordingly, post-merger Sabine, the borrower under the second lien loan, granted the liens to the second lien lenders to secure a present or antecedent debt. The second lien lenders argue that this, by itself, shows that Sabine received reasonably equivalent value for the liens, as “value” is defined in section 548(d)(2) of the Bankruptcy Code to mean “property, or satisfaction or securing of a present or antecedent debt of the debtor.” The motion to dismiss states that “[c]ourts in [the Southern District of New York] uniformly hold that a debtor’s grant of a lien to secure antecedent debt is per se not a constructive fraudulent transfer.”
The motion to dismiss also argues that the second lien loan included an “additional collateral provision” requiring that at all times, the loan be secured by a certain percentage of the borrower’s assets. Thus, once post-merger Sabine became borrower under the loan, that entity was required to grant security sufficient to meet the requirements in the second lien credit agreement, including liens on the newly acquired Forest Oil assets, to avoid an event of default. The second lien lenders assert that avoiding such a default constitutes the receipt of reasonably equivalent value.
The Sabine response states that the invocation of the “antecedent debt rule” is misplaced. This is because the “[d]efendant is viewing the transaction through the wrong lens.” The debtors argue that the claim in the complaint is asserted from the “perspective of Forest Oil creditors on the precipice” of the merger, rather than from the perspective of the post-merger entity. From this perspective, the debtors assert that the merger effectuated a transfer of value from an insolvent Forest Oil to the creditors of pre-merger Sabine, for less than reasonably equivalent value.
Safe Harbor Defense
The motion to dismiss alternatively argues that the transfer is protected by section 546 of the Bankruptcy Code, which limits avoidance actions in connection with certain types of transactions. Specifically, the motion to dismiss relies upon section 546(e), which is intended to promote the stability of the securities markets and facilitate transfers therein by providing a “safe harbor” to transfers involving securities. Section 546(e) generally prohibits the avoidance of a transfer as fraudulent if it was made to (or for the benefit of) a “financial institution” and made “in connection with a securities contract.”
The second lien agent argues that the merger agreement and deed of trust fall within the broad definition of “securities contract.” Further, post-merger Sabine’s grant of liens to the second lien lenders was a direct result of the merger and therefore clears the “low bar” that the Second Circuit Court of Appeals recently articulated for transfers to be deemed “in connection with” a securities contract. Thus, the liens were granted in connection with a securities contract, and are not subject to avoidance under section 546(e). In support of this argument, the motion to dismiss cites several recent cases which liberally interpret section 546(e), some of which have been discussed in previous issues of NewsWire. See Protections of Section 546(e) Clarified, International Restructuring NewsWire (July 2013).
In response, Sabine argues that the safe harbor does not apply because the merger agreement, which provided for a stock-for-stock exchange, did not provide for the pledge of the Forest Oil assets. Instead, the pledges were made pursuant to the second lien loan agreement that Sabine had entered into years earlier, and which was not a “securities contract.” Thus, applying section 546(e) would extend the safe harbor further than any prior case.
As of this writing, Judge Chapman of the Bankruptcy Court for the Southern District of New York has heard oral argument on the motion to dismiss, but has not ruled. Indeed, Judge Chapman indicated that no ruling was imminent, noting that she would not “shift the playing field” at this time. This leaves the legal arguments open for interpretation.
The “antecedent debt rule” argument set forth in the motion to dismiss is thought-provoking. If the case law is interpreted as the second lien agent suggests, the issue may turn on which entity, Forest Oil or post-merger Sabine, is deemed to have granted the challenged liens. Judge Chapman echoed this sentiment at the hearing, and seemed to be intrigued by the argument. If the complaint were dismissed on these grounds, it could have a chilling effect on fraudulent conveyance claims in the merger context going forward.
The second argument regarding reasonably equivalent value presented in the motion to dismiss, that the avoidance of a default constitutes equivalent value, could also create significant precedent. An important consideration for the court will be to reach a conclusion on exactly what avoiding a default is worth.
Finally, and perhaps most significantly, a decision on the motion to dismiss that addresses section 546(e) could add real insight as to the exact parameters of that safe harbor. Recent opinions uniformly conclude that the safe harbor is to be construed broadly. The Second Circuit has stated that there is a “low bar” for a transfer to be deemed “in connection with” a securities contract. The question for courts to consider is how low is that bar? Given the significance of the safe harbor defense in fraudulent transfer litigation, more guidance on this section would be noteworthy.
While the legal arguments raised are important, the most interesting aspect of the Sabine litigation is the debtors’ decision to attack its own merger on the first day of the bankruptcy cases. There are certainly benefits to the strategy. For example, the debtors have been afforded an opportunity to maintain control over both the investigation and the litigation. The debtors have also likely weakened potential arguments for the appointment of an examiner, and have lessened the chances that the unsecured creditors’ committee will unilaterally dictate how the litigation proceeds. Such control would be attractive to any debtor.
Additionally, filing the lawsuit allowed the debtors an opportunity to control the litigation narrative. Specifically, the complaint alludes to the reluctance of the pre-merger Sabine board to consummate the merger, while painting the Forest Oil board as eager to close. The debtors were allowed the first chance to “spin” this issue (among others), possibly to protect the Sabine directors.
Given the benefits derived from Sabine’s proactive investigation and litigation, it is likely that future debtors will consider this aggressive strategy.
Robert Gayda is counsel in Chadbourne & Parke’s New York Office in the firm’s bankruptcy and financial restructuring group.