With cratering oil prices wreaking havoc on energy companies' financial health, increased scrutiny from both the U.S. Securities and Exchange Commission and potentially litigious investors is turning up the heat on firms to ensure they're adequately disclosing how much danger they're actually in, attorneys say.
The oil slump has drained cash reserves, hammered stock prices, chilled development and financing and forced many companies to pursue asset sales and restructurings in order to survive. With the due date for many companies' SEC 10-K annual reports rapidly approaching, the price plunge has also increased the risk of regulators or shareholders flagging potential misstatements or omissions in those reports, or any other securities filing.
"Companies need to adjust their mindset to think of this as as disclosure document, as opposed to a marketing document, and not look to put a marketing spin on things," Kirkland & Ellis LLP partner Matt Pacey said. "This isn't the right point in the commodity cycle to be doing that."
As oil prices plunged in 2015, drillers fielded more questions from the SEC about their liquidity and the oil and gas reserves they held, as well as risk trends if oil prices don't recover anytime soon, attorneys say. That scrutiny will only intensify this year — the head of the SEC's Fort Worth, Texas-based regional office recently told Law360 that the agency is keeping a close eye on oil and gas company disclosures and looking out for any potential conflicts of interest.
"The SEC is heavily focused on E&P companies' disclosures right now," Vinson & Elkins LLP partner Sarah Morgan said. "As people have lower cash flows, the SEC is very focused on how they're booking proved undeveloped reserves in the face of either significant limitations on available funding, or uncertainty over whether that funding is available at all."
That means companies really need to think about whether those proved undeveloped reserves can be developed within the SEC's five-year window for booking them, she said.
The regulator is also eyeballing how companies are writing down the value of their assets due to the oil price slump, according to Pacey.
"I think they are focused on whether people are writing down assets when they need to and appropriately applying their write-down tests, which can tie back to them booking reserves they shouldn't be booking," Pacey said.
Basically, a securities filing that describes generic risks that can be applied to any other oil and gas firm affected by the slump isn't going to cut it with the SEC, attorneys say.
It certainly isn't going to cut it with shareholders dismayed over the plunging value of their investment. A depressed and volatile oil price environment is a breeding ground for shareholder securities fraud suits claiming they were kept in the dark.
The more distressed a company is, the more important its disclosures of potentially material information for investors are, Morgan said.
"The litigation risk is especially heightened when you have the likelihood of a major event affecting the company's capital structure, like an out-of-court restructuring or a bankruptcy filing," Morgan said.
Shareholder suits would likely involve claims of material misstatements or omissions. But determining the materiality of information can be a fuzzy proposition for companies, according to Baker Botts LLP partner Mollie Duckworth.
"There's not a one-size-fits-all protection from a claim that you have a material misstatement, it's very fact-specific for each issuer," Duckworth said. "Every issuer has to think about, 'What would my investors want to know and what's important to them as they decide whether to hold on to their securities or buy more securities in the future?'"
It's safe to assume that the company's liquidity will be a shareholder priority, meaning companies need to get really specific in their disclosures about any events in the near future that could affect their liquidity, attorneys say.
Topping the list of potential events is a reduction in how much money companies can borrow. Starting in April, lenders will revise the borrowing bases for so-called reserve-based loans, a staple of energy industry lending especially in the upstream sector, that are based on a company's total reserves and the price of oil. The borrowing bases are revised twice a year.
With U.S. oil prices dipping below $30 a barrel this week, borrowing base cuts for companies could be especially deep this time around, attorneys say.
“If there's the expectation that there's going to be a borrowing base redetermination in the near future where their borrowing base is going to be reduced, they need to disclose that,” Morgan said.
With cash reserves and borrowing bases squeezed, another potential event for companies is not being able to comply with covenants in their debt agreements. That's not something companies generally think about when oil prices are high and their balance sheets are healthy.
"We've been advising all of our clients to focus on their ability to comply with their debt covenants over the next year and disclose any potential covenant problems," Pacey said. "The litigation risk is heightened if you were to subsequently violate your covenant and not disclose that potential."
Liquidity and covenant risks are all part of the Management's Discussion and Analysis of Financial Condition and Results of Operations, or MD&A, disclosure required under federal securities laws. In the current low oil price environment, companies must try to paint accurate pictures of their circumstances and identify any risks if prices don't recover, or go even lower, attorneys say.
"It's really about companies having a conversation about how the current state of affairs is impacting not just historical results, but how they expect things to look for the next year or so and making sure that's captured in the filings," Duckworth said.
Making such disclosures can be tricky during such a volatile time in the oil and gas industry, Paul Hastings LLP partner Doug Getten said.
"If you're too bullish, for example, then someone might have cause to complain," Getten said. "The SEC is looking to companies to provide more fulsome disclosure in this area, but you have to be prudent about what you can disclose."
Still, in this environment, disclosing too much information is not as risky as not disclosing enough information. Oil and gas companies should review previous disclosures to see if they accurately reflect current financial conditions and identify future risks, attorneys say. If they don't, a complete rewrite may be in order.
"During a normal reporting cycle, companies frequently use their existing framework from the prior year and may update a few numbers and sentences," Pacey said. "This is a situation where companies need to step back and review their disclosures as a whole."
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