The Response of Canadian Banks to the Supreme Court of Canada’s Redwater Decision
By: Danielle Maksimow, Norton Rose Fulbright Canada LLP
On January 31, 2019, Canada’s highest Court, the Supreme Court of Canada, shocked the Canadian banking and insolvency worlds when it issued the highly anticipated and ground-breaking decision of Orphan Well Association v. Grant Thorton Ltd. (commonly referred to in Canada and herein as the “Redwater Decision”). The Redwater Decision overturned the 2017 Alberta Court of Appeal decision and held that trustees in bankruptcy must satisfy the end-of-life abandonment and reclamation liabilities of insolvent oil and gas obligors before satisfying the claims of other creditors, including secured creditors (prior to the Redwater Decision, trustees would typically disclaim uneconomic assets). Depending on the extent of obligors’ end-of-life abandonment and reclamation liabilities compared to their assets, this has the potential to leave secured creditors with significantly less access to the proceeds from the oil and gas obligors’ assets in an insolvency situation.
Capital Market Response to Redwater in Canada
In response to the Redwater Decision, over the last few months, Canadian banks have started adding various provisions into their credit agreements with Canadian sub-investment grade obligors in the exploration and production (“E&P”) industry. The purposes of these new provisions (collectively referred to herein as the “ARO Provisions”) is to help alert lenders to early warning signs and to get them a seat at the table earlier in the process if there is a significant issue with their obligors’ abandonment and reclamation obligations, as well as to incentivize their obligors to promptly deal with abandonment and reclamation obligations. The ARO Provisions have been included both in new financings as well as in existing financings in connection with waivers or with amendments accompanying semi-annual scheduled borrowing base re-determinations or annual extension requests. Each deal looks a bit different depending on who the administrative agent and lead banks are (most major banks in Canada have their own preferred language), the credit rating of the borrower, the current liability management rating (“LMR”) of the obligors and whether the deal has a borrowing base or is covenant-based, but some common themes have started to emerge. The following is a high-level summary of the most common documentation changes that Norton Rose Fulbright Canada LLP has seen in the Alberta market to date, and is not intended to be an exhaustive list of all variations in language used, as these provisions can be highly negotiated and case-specific. Furthermore, most deals will not have all of the below documentation changes, but rather, varying combinations depending on the factors previously referred to herein.
Common Documentation Changes
1. Reporting Requirements
Additional reporting requirements is the most universal of the ARO Provisions, with virtually all Canadian sub-investment grade obligors being subject to increased reporting obligations. These obligors are now required to provide their lenders with (a) detailed annual decommissioning budgets and forecasts for all oil and gas wells, pipelines and facilities, (b) in the case of borrowing base lenders, a semi-annual reconciliation report relating to such annual budgets with management commentary of any material deviations, (c) copies of any material abandonment and reclamation orders issued to obligors by energy regulators in material jurisdictions and relating to material non-compliance of obligors with environmental laws and (d) notice of any letters of credit or other security deposits that are given or issued by an obligor to energy regulators in material jurisdictions. In addition, it is typical for the quarterly compliance certificate to require a statement of the LMR of each obligor in each material jurisdiction. With respect to LMR, while Alberta publishes a monthly list of the LMR of E&P companies, the current market trend is for lenders to require their obligors to back out of that number any security deposits they have posted that were valued in calculating the LMR (the first deals in the market did not require this and specifically allowed for the inclusion of security deposits). One rationale behind this market shift is that some lenders think that the obligors could borrow money to provide such security deposits and “inflate” their LMR and make it look better than it actually is.
2. Representations and Warranties
Some bank credit agreements have added a new representation and warranty that the obligors are not in default under any abandonment and reclamation orders that they have received from a Canadian energy regulator in a jurisdiction where the obligors oil and gas assets exceed a threshold amount. This is typically qualified as to a material default or default that would result in a material adverse effect, but in one recent deal, a much lower threshold was inserted, with the intent of this acting as a draw stop if the dollar amount of such an order exceeded a certain level (since representations and warranties are repeated by the borrower each time that a draw-down is made under a bank credit agreement).
3. Negative Covenants
A new negative covenant to maintain a minimum LMR (the value of which will vary, but if the obligors have a LMR greater or equal to 2.0 at the outset, the typical value is 2.0) (the “Minimum LMRCovenant”) has been added to many bank credit agreements. Some bank credit agreements require this test to be met at all times, including on a pro forma basis after each disposition and acquisition, with a cure period of 30 days if there is a breach, while other bank agreements have greater flexibility and only require the Minimum LMR Covenant to be met monthly or even quarterly (which permits the obligors to do what they want during the applicable reporting period as long as they are in compliance on the test date) and have cure periods of up to 90 days.
Some bank credit agreements also have added a new negative covenant prohibiting their obligors from making any dispositions or acquisitions if the result would be for the obligor making the disposition or acquisition to have its LMR fall beyond a certain level on a pro forma basis. Again the typical threshold here is 2.0, but in situations where the obligor group is less than 2.0 starting out, lower thresholds are sometime seen (and in a recent deal, dispositions and acquisitions were allowed even if they were below the threshold as long as such dispositions and acquisitions improved the LMR of the obligor making the acquisition or disposition).
4. Borrowing Base Re-determination Triggers
Two new borrowing base re-determination triggers have been added to several borrowing base deals which allow any lender to request a re-determination of the borrowing base (a) if the LMR falls below a certain level which is typically 2.0 unless the LMR is below 2.0 to start with (note that when this is included, it is typically in lieu of the Minimum LMR Covenant) or (b) if an order or orders are issued and the cost of complying with same would exceed a threshold amount and the time period for complying with the order and appeal period have expired.. Canadian banks are taking differing approaches to how they are determining borrowing bases after the Redwater Decision, and our current understanding is that there will typically be some reduction in value attributed to borrowing base properties to reflect abandonment and reclamation liabilities, although no market approach has yet developed on the exact amount of the discount.
5. Events of Default
Initially following the Redwater Decision, a new event of default was added to many bank credit agreements that was triggered if an obligor’s LMR fell below a certain level. In the experience of Norton Rose Fulbright Canada LLP, the market has shifted and it is becoming more common for LMR to be dealt with in the negative covenants instead (perhaps because of optics as is perceived less harsh and gives the obligors an opportunity to cure the default), even though a negative essentially gets the banks to the same place as an event of default once the cure period for the negative covenant breach has expired.
Further, a new event of default has been added to several bank credit agreements that is triggered if an obligor becomes subject to abandonment and reclamation orders from an energy regulator in a material jurisdiction, the cost to comply with all such orders exceeds a threshold amount, such order(s) are not withdrawn or satisfied within the prescribed time period, and all appeals have expired.
6. Transitional Provisions
Since the current Canadian LMR regime may be amended or replaced with an improved system, as a part of the ARO Provisions, Canadian banks are including transitional provisions in their credit agreements to provide a road map for what will happen if and when this occurs.
The wording for these provisions is fairly consistent across the market (with an exception noted below), and says that if any energy regulator in a material jurisdictions ceases to use the LMR system as a means of determining compliance with abandonment and reclamation rules and policies, or if the method of calculating LMR materially changes, or if a material change is made to the minimum statutory LMR threshold for which licence transfers are permitted or security deposits are required, then any of the administrative agent, the majority lenders (i.e., lenders holding at least two-thirds of commitments) or the borrower can by written request compel the borrower and the administrative agent to enter into good faith discussions to determine a comparable rating system, calculation or threshold, as applicable, and to amend or replace the concept or usage of LMR. Until such an agreement is reached (which must be signed off on by the majority lenders), LMR will continue to be calculated under the old methodology. Some bank credit agreements go a step further than this and include additional triggers for commencing these discussions, such as the occurrence of any “force majeure” event or similar circumstance which materially reduces the cash flow derived from oil and gas production of the obligors for an extended period of time that materially reduces the “deemed assets” component of the LMR of an obligor in a material jurisdiction. This is more typically seen in bank credit agreements that do not have a borrowing base.
In conclusion, Canadian banks have acted quickly to develop an arsenal of tools to protect themselves from the potential fall-out from the Redwater Decision, ranging from new reporting requirements and representations and warranties to new borrowing base triggers and determination methods, negative covenants and events of default. These new requirements make it much harder for obligors to ignore their abandonment and reclamation liabilities during the life of their loans and to deal with them in a timely and intentional manner. To date, the ARO Provisions are mostly seen in sub-investment grade deals and the language is continually evolving and improving. Norton Rose Fulbright Canada will keep the ACIC updated as the approaches used to protect lenders against the fall-out from the Redwater Decision continue to evolve in Canada.