WHITE PAPER Redetermining Borrowing Bases and Falling Prices: Where Discretion Meets Good Faith JOSH IMHOFF, PARTNER OIL AND GAS PRACTICE Carrington, Coleman, Sloman & Blumenthal, L.L.P. • 901 Main Street, Suite 5500 • Dallas, Texas 75202 • www.ccsb.com Redetermining Borrowing Bases and Falling Prices: Where Discretion Meets Good Faith By: Josh Imhoff, Partner OIL & GAS Executive Summary: Credit facilities tied to borrowing bases are common throughout the oil and gas industry. With the steep decline in energy prices, borrowing bases are likely to decline significantly when they come up for redetermination. In addition, many lenders now feel added pressure to pull in capital and be more conservative with their credit as a result of the current financial crisis. Although borrowing base loans typically give the lender wide discretion in revaluing borrowing bases, this discretion is not unfettered. When borrowing base redeterminations are challenged, the cases will often turn on whether the lender acted in "good faith" while setting the valuation. The meaning of the duty of good faith differs among jurisdictions. For example, the UCC and Texas have a standard that is relatively easy to satisfy so long as the parties abide by the express provisions of their loan agreement. On the other hand, in New York an implied duty of good faith and fair dealing underlies commercial contracts, including loan agreements, and this duty can potentially be violated even where the defendant has not violated any express provision of the agreement. In the context of borrowing base redeterminations, it is possible that a lender may violate the duty of good faith under New York law even though the loan agreement gives it wide discretion to set the valuation. A fact question may exist where the lender is alleged to have acted inconsistently in applying its borrowing base analysis, or to have been motivated to use the redetermination as a reason to pull in credit where it previously would have extended it - a fact question that may ultimately be decided by a jury. Lenders and borrowers would be wise to consult the choice of law provisions governing their borrowing base loans, and take account of their potential impact on redeterminations. Lenders should take care to act in accordance with their duty of good faith when making these revaluations, and borrowers should scrutinize their lenders' actions in light of this duty. Page 2 Redetermining Borrowing Bases and Falling Prices: Where Discretion Meets Good Faith Lines of credit tied to the value of mineral interest-based borrowing bases are common forms of financing in the energy industry. With the steep fall in energy prices, the revaluation of these borrowing bases will cause some borrowers to default on their loans. This situation may be further compounded by the current financial crisis, which is putting pressure on lenders to pull in capital and be more conservative with their lending practices. While lenders generally have wide discretion in determining the value of borrowing bases, this discretion is bounded by a duty to act in good faith. The extent of this duty varies among jurisdictions, compelling borrowers and lenders to consider exactly how courts may regard the resetting of the borrowing base. In particular, loan agreements governed by New York law expose lenders to potential liability for acting in "bad faith" - in some instances, even when the terms of the agreement are otherwise followed. Lenders must act cautiously notwithstanding their wide discretion under the loan agreement, while borrowers should be sensitive to redeterminations that run counter to their reasonable expectations. The Cautionary Tale of the Flying J collateral securing credit facilities throughout the energy industry. In particular, revolving credit lines On December 22, 2008, Flying J Inc., one of the 20 in which the availability of credit is tied to the value largest privately held companies in America, with of the borrower's mineral interests - the "borrowing 2007 consolidated sales in excess of $16.2 billion, base" - are coming up for redeterminations, and filed for Chapter 11 bankruptcy protection. In re with the decline in commodity prices, this will result Flying J Inc., No. 08-13384 (Bankr. D. Del., Dec. 22, in revaluations of credit limits that, in many cases, will put the borrower "under water" and result in 2008). This came three days after a series of loan calls to make up the difference which, if not met, will defaults by its subsidiaries began, triggered by the lead to defaults. In many instances, these calls will precipitous fall in oil prices during the last half of require immediate repayment. 2008. At the time of the filing, oil prices had fallen over 75% from their high of $147 per barrel reached in July 2008. When the value of this "linefill" declined with oil prices, the Flying J Inc. presides over a vertically integrated group of companies that includes the exploration, pipeline group was required to refining and transportation of petroleum products, as make mandatory prepayments well as a large retail distribution system that of its outstanding indebtedness. includes over 200 travel plazas. The credit facilities that went into default were secured by various These prepayments contributed assets. In particular, Flying J's pipeline group had a to a constriction of liquidity $120 million revolving credit line with Merrill Lynch that rippled throughout Capital Corporation and other lenders that was the organization. secured in part by the value of the petroleum products in its roughly 700-mile long pipeline between El Paso and the Texas Gulf Coast. When the value of this "linefill" declined with oil prices, the Typically, the borrowing base is a function of the pipeline group was required to make mandatory value of proved reserves. The base may be limited prepayments of its outstanding indebtedness. to proved, developed and producing reserves These prepayments contributed to a constriction of (PDP), or it may include some portion of proved, liquidity that rippled throughout the organization. developed and non-producing reserves (PDNP) and This triggered a series of defaults that began on proved undeveloped reserves (PUD). Friday, December 19, 2008. Flying J filed Chapter 11 the following Monday. While definitions differ from loan to loan, the borrowing base can generally be reduced to some Borrowing Base Credit Facilities formula equal to the product of the amount of reserves multiplied by their per unit value. The Unfortunately, variations of Flying J's story will be commodity prices that determine unit value are, in repeated in the weeks and months to come, as the particular, outside the control of the borrower and, steep decline in oil and gas prices affects the as the market has made all too obvious, subject to Page 3 Redetermining Borrowing Bases and Falling Prices volatility. An extreme drop in commodity prices can liabilities, cash flow, business, result in a sudden diminution of the value of the properties, prospects, management and borrowing base and corresponding decrease in the ownership of Borrower) as Lender amount of available credit. Obviously, if much of customarily considers in evaluating the credit line is outstanding, this can quickly turn similar credits. It is expressly the loan upside down and require the borrower to understood that Lender has no rapidly pay shortfalls or risk default. obligation to designate the Borrowing Base at any particular amount, except in Borrowing base loans typically require a the exercise of its discretion. redetermination of the borrowing base every six months, and they may also include provisions In this common example, subjective and objective allowing the lender to call for additional elements are combined - the Lender has discretion redeterminations at will or under certain to determine the base, but agrees to use an circumstances, such as a perceived change in the analysis that is internally consistent with the value of the collateral minerals. While the timing, analysis it applies to other borrowers. criteria and procedure for the determination of the borrowing base are generally described in the loan The loan agreement, together with the notes, agreement with great specificity, these factors often security instruments and other documents that reduce down to the production of reserve reports by make up the loan transaction, constitutes a contract. an independent engineer, which are evaluated by As with any other commercial contract, the parties the lender, who then determines the borrowing to a borrowing base loan are generally free to agree base. on its terms, and courts will interpret the contract consistent with those terms. An agreement that gives the lender discretion to determine the value of An agreement that gives the the borrowing base therefore gives the lender wide lender discretion to determine latitude in actually making the evaluation. the value of the borrowing base Nevertheless, there are limits to the amount of discretion that may be exercised, not only in the gives the lender wide latitude in express terms of the agreement, but existing actually making the evaluation. statutorily and at common law as well. As Nevertheless, there are limits discussed below, the bounds of these limits may be to the amount of discretion greatly impacted by the choice of law governing the loan. that may be exercised. The Credit Crisis Among these loan agreements, perhaps the most Borrowing base credit facilities have been impacted important variable is the amount of discretion given not only by the fall in energy prices, but by the to the lender to determine the borrowing base from financial crisis that has affected credit markets the reserve report. While the lender always has across all industries. Even in a favorable credit control over the determination, the agreement may environment, borrowing bases would tend to be give the lender "sole discretion" to come up with a downwardly adjusted as a result of the drop in value, or it may require the lender to apply a more prices.