April 14, 2020
By Paul D. Bradford and Merrill E. Jones
Because Borrowing Base deficiencies or other distress are likely in the current oil and gas price environment, we wanted to highlight some key concepts related to cash and production proceeds.
Cash is King:
Typically, the Bank’s term sheet and credit approval and our Loan Agreement will require Borrower and other loan parties to maintain their primary depository accounts and principal banking relationship with Bank. This provision is typically found in the covenants in Section 7 of our form Loan Agreement.
Having visibility and the ability to verify the revenues and expenses moving through the deposit accounts with Bank is a crucial tool in distressed times.
If Borrower’s deposit accounts are not currently maintained with Bank, whether because the primary depository clause was intentionally omitted, was negotiated out, or has been breached, then now is a good time to endeavor to get those deposits moved to Bank as a condition for any forbearance or waivers, to collateralize those deposit accounts at Bank, and to require a deposit account control agreement on deposit accounts maintained at other banks. We will discuss collateralizing deposits and deposit account control agreements below.
Assignment of Production:
An important part of the Bank’s collateral security is the Assignment of Production in the deeds of trust and mortgages securing payment of the loan. The Assignment of Production is found in Article 3 of our form Deed of Trust.
The Assignment of Production provides that Bank is entitled to receive all oil and gas production from or attributable to the Mortgaged Properties and all proceeds from the sale of such oil and gas production. In the mortgage, Borrower further authorizes and directs all parties producing, purchasing, and receiving oil and gas production or the proceeds therefrom to treat Bank as entitled to receive the same. The Loan Agreement typically conditions Bank’s direct receipt of the production proceeds on an outstanding Event of Default, and the mortgages provide that all production purchasers should continue to pay Borrower until Bank exercises its rights granted under the Assignment of Production by providing written notice to pay Bank.
The Loan Agreement also typically allows Bank to elect after an Event of Default or if there is an Borrowing Base deficiency to require all production proceeds to be paid into a lockbox account at Bank. The lockbox, when combined with providing notice of direct payment to production purchasers under the Assignment of Production, allows the Bank to exercise control over the production proceeds. Amounts received in the lockbox account may be applied to the loan or released to Borrower to pay approved expenses. Bank would probably need to allow bona fide operating expenses to be paid from the lockbox account to prevent lien filings against a well, lease, or unit, or an operator asserting its operator’s lien against production proceeds.
Cash as Collateral Security:
The Loan Agreement typically provides for a security interest and common law setoff rights with respect to all deposit accounts of Borrower maintained at Bank, excluding, however, accounts maintained for the purpose of revenue distribution to third parties entitled to those revenues, payroll accounts, 401k, IRA, Keogh, or other retirement accounts, trust accounts, and any other accounts for which security or setoff would be prohibited by law. After an Event of Default, Bank may exercise UCC remedies and setoff rights with respect to the pledged deposit accounts.
Deposit accounts maintained at Bank may also be expressly assigned as security for the loan in a separate collateral document. Many Banks would feel more secure with a collateral assignment naming specific account numbers.
Deposit accounts maintained at other banking institutions may be pledged to Bank and perfected by execution of a deposit account control agreement by Borrower and the other bank. The deposit account control agreement could be a condition for installment cure of a Borrowing Base deficiency or for a waiver or forbearance. Having all of the Borrower’s cash pledged as security could deny Borrower funding needed for a bankruptcy filing.
Please remember that collateral assignments and deposit account control agreements executed within 90 days prior to a bankruptcy filing may be voided as a preference, so the earlier they are executed, the better for Bank. There are also circumstances under state and federal bankruptcy and insolvency law where collateral assignments and deposit account control agreements granted while insolvent within the prior one or two years could be voided as fraudulent transfers.
The Defensive Draw:
During a downturn or price shock, many Borrowers have utilized a strategy of requesting an advance of the full availability on a revolving credit facility, then holding the cash as leverage for negotiations on an expected forthcoming Borrowing Base deficiency or for funding a bankruptcy to be filed (the so-called “Defensive Draw”).
In response to a request for a Defensive Draw, Bank might consider a few bases for denying the draw.
First, Bank might consider sending an immediate notice of a special Borrowing Base redetermination that results in a reduction or elimination of the availability. The Loan Agreement will typically permit Bank to redetermine at any time (subject to limitations in the Loan Agreement). The redetermination provisions are typically found in our Loan Agreement in Subsection (a) of Section 3.
Second, Bank might examine whether the intended use is consistent with permitted purposes under the credit facility. Most purpose clauses will include working capital or general corporate purposes, so the permitted purposes are very broad. However, intending to be held as a cash balance for future operating costs might arguably exceed current working capital needs.
Third, Bank may consider whether a Material Adverse Change has occurred that would be a basis for denying the Defensive Draw. The typical “Material Adverse Change” provision in our Loan Agreement would create a condition for future advances that there shall not have occurred any result, occurrence, condition, change, fact, event, circumstance, or effect that, individually or in the aggregate, has caused or would reasonably be expected to cause a material adverse change in (i) the financial condition, business, assets, properties, liabilities (actual and contingent), operations or results of operations of Borrower (or any guarantors or subsidiaries), . . . or (iii) the ability of Borrower (or any guarantors or subsidiaries) to perform their obligations under or consummate the transactions contemplated by the Loan Documents. The Request for Borrowing form will usually include a representation that no Material Adverse Change has occurred. The specific Material Adverse Change provision in your deal should be reviewed.
Fourth, a Defensive Draw which Borrower intends to deposit into an account at another banking institution could breach the primary deposit accounts covenant and form the basis for denying the Defensive Draw. To the extent the Defensive Draw is held in a deposit account in which Bank has a security interest or deposit account control agreement, the risk to Bank with respect to a Defensive Draw is mitigated.
Finally, in some instances there may be a solvency representation in the security documents that might be breached and form the basis for denying the Defensive Draw.
A refusal to fund a Defensive Draw under an existing Borrowing Base should be carefully considered, since it might result in a lender-liability lawsuit.
Cash Hoarding:
A credit agreement response to the Defensive Draw emerged a few years ago during a prior price downturn in the form of Cash Hoarding provisions.
Under the Cash Hoarding provisions added to many credit agreements in 2014 and 2015, Borrower would covenant to provide prompt notice if consolidated cash balances exceeded a threshold number, and then to use those excess cash amounts as prepayments on the revolving line of credit or as cash collateral for letter of credit exposure. Over the ensuing years, Cash Hoarding provisions were often negotiated out of loan documentation, so those provisions may not be in the Bank’s current loan documents.