The recent bankruptcy filing by McDermott International, a Houston-based company that offers construction, engineering and technology services to the energy industry, has raised concerns about the risks of contracting with contractors that are currently part of bankruptcy proceedings or have recently exited these proceedings.
As it relates to McDermott, the company’s financial distress largely stemmed from a 2017 merger with Chicago Bridge & Iron Co. (CB&I), another provider of engineering, procurement and construction services to the energy industry. The deal created positive results but also had negative consequences because McDermott inherited CB&I’s troubled projects and liabilities. Within six months of the merger, McDermott needed more than $400 million in cash to cover project overruns. McDermott’s liabilities continued to increase exponentially, and by Q4/19, it had a liquidity crisis. Those events triggered the company’s Chapter 11 bankruptcy petition on Jan. 22, 2020.
Filing for bankruptcy is one of the most disruptive actions a company will ever undertake. Not surprisingly, parties are often reluctant to engage in new business arrangements with a company that is currently going through a bankruptcy proceeding on the belief it is simply too risky or there is no assurance of performance. Although there may be times when such a belief is justified, there are many other circumstances where engaging in business with an entity currently in bankruptcy proceedings presents no greater performance risk than a typical commercial interaction.
Corporate Bankruptcy Is Not a One-Size-Fits-All
When a company files for bankruptcy and becomes a “debtor,” that does not always mean the company will never return to its pre-petition operating performance. Rather, bankruptcy can mean two completely different things.
A business may file for bankruptcy in the United States under either Chapter 7 or Chapter 11. In Chapter 7, the company generally stops operating as a going concern enterprise. A trustee takes over for the company’s management, liquidates the debtor’s assets and distributes the proceeds to creditors. In other words, the company no longer exists after Chapter 7. However, Chapter 7 filings are only a subset of bankruptcy proceedings, and it is unlikely a company seeking new business engagements will file for Chapter 7.
In Chapter 11, the debtor tries to reorganize either by equitizing debt obligations, selling assets or engaging in other similar transactions designed to maximize recoverable value and continue forward as a going concern enterprise. Unlike a Chapter 7 case, in a Chapter 11 case, the company’s existing management remains in place and is authorized to continue running business in the ordinary course without court approval. This includes entering into new business arrangements with third parties. To encourage other companies to do business with a debtor, expenses arising during a case are entitled to administrative expense status, which means that the debtor must pay them in full to confirm its plan and emerge from bankruptcy. Those claims should be compared to claims that arose prior to the bankruptcy, which are typically unsecured claims (unless secured by collateral or unless they meet certain limited conditions) and may be subject to discharge.
The goal of the Chapter 11 process is rehabilitation and to achieve financial reorganization that will avoid the need for further bankruptcy relief. Consistent with that objective, Chapter 11 allows a company to press pause, negotiate with its creditors and reject or accept contracts. In other words, Chapter 11 allows a contractor debtor to clean up its balance sheet through modifying, exchanging or eliminating debt through a plan of reorganization.
The restructuring plan, once confirmed, is essentially a new contract between the debtor and its stakeholders. By taking those steps, the company that emerges is intended to be a viable and healthy entity with a deleveraged capital structure.
Indicators of a Corporate Debtor’s Financial Health
There are several indicators that current or potential counterparties can look for to determine both a debtor’s financial health and the amount of risk associated with a new commercial relationship with the debtor. Notably, once a Chapter 11 case is commenced, significant amounts of information about the corporate debtor are publicly available and typically available for free on restructuring websites maintained by corporate debtors. Certain key indicators include the availability of cash collateral or debtor-in-possession financing, whether a restructuring support (or a similar) agreement is in place, and the status of the plan confirmation versus plan implementation. Although this list is not exhaustive, these factors can help assess the contractor counterparty’s viability and financial health. Companies thinking about doing business with a bankrupt contractor counterparty should look for these indicators and review the underlying facts closely to help determine the associated risk.
Is cash collateral or debtor-in-possession financing available?
Companies in bankruptcy must pay debts arising during the case in the ordinary course of business and also may seek court permission to pay debts that arose prior to the bankruptcy case. To pay for those expenses, the company needs cash, which is generally available through either debtor-in-possession financing or the company’s existing cash, which may be encumbered by liens and only available with the consent of a secured lender. The availability of either source — and the amount of cash available to the company — can help determine the viability of the company and stability of its Chapter 11 restructuring process. For example, in McDermott’s Chapter 11 cases, the company’s prepetition lenders provided $2.78 billion of debtor-in-possession financing, $1.7 billion of which was new money. That amount indicated that McDermott’s prepetition lenders saw McDermott as a viable enterprise with which they wanted to continue doing business. The financing was also an attempt to ensure a stable Chapter 11 process.
Is a restructuring support agreement in place?
Restructuring support agreements (RSAs) are now a common component of large Chapter 11 bankruptcies. An RSA is a pre- or postpetition contract entered into by the debtor and significant lenders or bondholders, most commonly right before the bankruptcy filing, under which the debtor and such funded-debt creditors agree to support a proposed Chapter 11 plan. Some terms typically found in an RSA include what the intended treatment of trade vendors and unsecured claims are and how or when the debtor will pay those claims. These agreements bind the parties to vote in favor of the plan or support a going concern sale process.
The existence of an RSA may provide two benefits. First, an RSA can give significant guidance on the stability of a Chapter 11 bankruptcy case and a higher degree of assurance as to the most likely outcome of the case. Second, an RSA may mean a plan is consensual or has a high degree of being confirmed over dissenting objectors if it has “locked up” the requisite number of supporting creditors. For example, in McDermott’s bankruptcy, the company’s plan of reorganization was supported by an RSA to which a near overwhelming majority of McDermott’s funded debt holders agreed. That level of support indicated that McDermott would enter bankruptcy with a stable backdrop on which the company could rely to try and ensure a consensual and efficient process.
What is the status of the plan?
At a high level, the steps to consummate Chapter 11 plan are filing a Chapter 11 plan and related disclosure statement, obtaining bankruptcy court approval of the disclosure statement and vote solicitation procedures, soliciting votes from requisite classes of creditors, obtaining bankruptcy court approval of the plan following receipt of the requisite support from the voting classes of creditors and the plan and any related transactions being consummated or “going effective.” In a prepackaged bankruptcy case, votes are solicited before the case is filed and, after the case is filed, the debtor seeks simultaneous court approval of both the disclosure statement and the Chapter 11 plan. In some prepackaged cases, approval has been sought the same week — or even within a day — of the bankruptcy case filing.
A party looking to engage in business with a debtor should assess where the debtor currently is in this plan process, as it can provide important indicators of the likely path and timing of the Chapter 11 case. Note that although confirming a plan is crucial for any Chapter 11 debtor, a confirmed plan is similar to an executed merger or asset purchase agreement which has not yet been consummated.
There may be a degree of lag time between the date the plan is confirmed and the effective date. The reason is oftentimes the debtor needs to satisfy certain conditions precedent before the company can implement its plan. A party evaluating entering into transactions with a debtor before the plan is consummated should evaluate these conditions precedent and inquire about the progress toward satisfying them. However, despite this typical delay, following confirmation of a Chapter 11 plan, there is even higher degree of certainty about the outcome of the Chapter 11 case.
For example, in McDermott’s case, while the company confirmed its plan in mid-March 2020, public reporting indicates McDermott plans to exit Chapter 11 in June 2020. The gap period is due to the extensive conditions precedent McDermott needs to satisfy before its plan goes effective. When the company does exit, though, McDermott anticipates exiting with only $500 million of funded debt, a stark contrast to the $4.6 billion of funded debt with which it entered bankruptcy. The company also will have access to a letter of credit capacity of about $2.44 billion under the company’s proposed exit facilities and long-term liquidity from the sale of certain technology assets.
Conclusion
Regardless of whether a third party acquires a company as a going concern enterprise from its Chapter 11 case or if the company reorganizes through a debt-to-equity conversion, the company that emerges from Chapter 11 should be lower leveraged and a more credit-worthy entity than before. In many cases, the business that emerges may be better structured than its competitors in the industry. Although there is no assurance of success for any business plan, assuming a contractor counterparty emerging or recently emerged from bankruptcy is in a weak credit position is generally more perception than reality. McDermott’s Chapter 11 case is an example of that.
Doing business with any contract counterparty always contains some degree of risk, and those risks may be higher if that counterparty is currently in Chapter 11. But by reviewing the path the company proposes, along with the underlying support for that path, other businesses should not automatically refuse to do business with a debtor. Indeed, because the purpose of Chapter 11 is to keep the debtor’s business viable as a going concern, the level of risk may be the same, if not less, than doing business with a party outside of Chapter 11 bankruptcy. And, if the company will be exiting bankruptcy in the near term, companies may be interested in contracting with it because it may will emerge much stronger.
Scott Greer, a partner in the Houston office of King & Spalding, focuses exclusively on construction law and leads the firm’s worldwide energy and construction transactional practices. He can be reached at sgreer@kslaw.com.
Matthew Warren is a finance partner in King & Spalding’s Chicago office. He can be reached at mwarren@kslaw.com.
Jacob Jumbeck is an associate in the corporate, finance and investments practice in King & Spalding’s Chicago office. He can be reached at jjumbeck@kslaw.com.
