We wanted to build on our previous article E&P Debt vs. Equity Trades, which suggested there was a mispricing in the market which allowed an investor to profit by going long unsecured bonds vs. short the equity in many E&P structures in early February.

However, there was another reason this trade (specifically buying the unsecured bonds) was very attractive. Many companies had drawn on their revolving credit facilities before filing and therefore had cash on the balance sheet that was (arguably) not secured by first lien debt and therefore a potential source of value for unsecured creditors. Forbes and Reorg Research actually collaborated on a piece discussing these RBL drawn downs in February. Chaparral Energy, Midstates Petroleum, LINN Energy, and SandRidge Energy all drew on RBL facilities in late January/Early February 2016.

Lenders are able to have security interest over a bank account, but cash drawn from a revolver pre-bankruptcy is only subject to security interests if stated the revolver docs (for example, an “account control agreement”). Standard revolvers are typically subject to these account control agreements, however many of the covenant-lite facilities issued in the last few years have not included these covenants and language. In particular, many reserve based lending (RBL) facilities, which are usually secured by undeveloped oil and gas reserves, did not include account control agreements as lenders competed for new issue business during the fracking boom from 2011-2014. Many debtors were incentivized to draw on these facilities early as semi-annual and potentially early redeterminations would shrink the borrowing base, and other sources of funding were increasingly unavailable. These secured lenders then became involved in the restructuring negotiations of the debtor as the lenders were now not covered through the reserves, and these reserves are expensive and complicated to extract.

This added complexity is actually a positive for unsecured creditors, especially when unsecured bonds were trading at such low levels (cents on the dollar), in February 2016 in many of these E&P structures. Secured lenders were incentivized to push for a quick bankruptcy process as to not have value escape through restructuring fees, etc and therefore were incentivized to negotiate with unsecured creditors and give them a potentially larger than expected piece of value or either cash or post-reorg equity. Unsecured creditors would then sign a RSA and therefore own a piece of post-reorg equity with close to zero cost basis, and retain enormous upside if oil prices rally.

Some of the smarter distressed funds (Solus, etc) recognized this and bought some unsecured E&P bonds at the lows in February/March for cents on the dollar. In the link above, Pucillo of Solus also mentions U.S. Bankruptcy Code Section 547: The 90-Day “Preferential Payment” period. A preferential transfer (not to be confused with fraudulent conveyance) focuses on whether one creditor has received a payment that results in that creditor getting better treatment than others creditors 90 days before a filing. In this specific example, these E&P companies issued secured bonds and had to wait 90 days to file for bankruptcy (most likely at the request of the lending banks) for those secured bonds to maintain their secured collateral. This allowed an investor to reduce their already extremely low basis in unsecured bonds by receiving one coupon payment before a default.

U.S. Bankruptcy Code Section 547 is not just applicable to E&P companies. Distressed drugmaker Concordia International (CXRX) issued $350mm first lien senior secured bonds on October 13th, 2016 and if CXRX were to file, the company would have to wait until roughly January 13th, 2017 otherwise these bonds would be stripped of their liens.

Another, potentially less liquid way to express a Bankruptcy Code Section 547 related view is through a front end CDS Roll trade. An investor would sell protection on the earlier date and buy protection on the next date 3-months out. For example, say the 0M / 3M roll costs 10pts, which is relatively steep, the risk profile would look as follows (assuming a 20% CDS recovery):

1) The credit files before the 0M roll occurs - you lose the 10 pts you paid.

2) The credit files after the 0M roll but before the 3M protection expires - You make 70pts (100 - 10pts - 20 recovery).

3) The credit files after 3M expires or doesn’t file at all - you lose 10 pts.

Obviously confidence about the filing date is paramount to the trade mentioned above, but oftentimes front end curves in extremely distressed names trade flat and understanding when Bankruptcy Code Section 547 is applicable can make an astute investor a lot of money.