On January 31, 2017, Seadrill Limited (NYSE:SDRL) announced the status of discussions between the Company, secured lenders, unsecured bondholders and Hemen Holdings ("Hemen"; SDRL Chairman John Fredriksen's holding company). I discussed the proposals and likely outcome for shareholders in the article ("Seadrill Restructuring To Leave Shareholders With Penny Stock"). I don't think the lead was buried! As part of the spirited discussion that followed my (and other) article, a number of readers wondered what would happen if no deal was reached. Frighteningly, some readers seemed to think equity holders would receive "their share" in a deal. In this article, I would like to discuss what a likely scenario might be if no restructuring agreement is reached (from a US company perspective).
SDRL has over $10 billion in debt and $14 billion in total obligations. There is no way the Company can meet is near-term cash needs from operations. A combination of new liquidity and debt restructuring is required.
Discussions have been held between 1) secured debtholders, 2) Bondholders, 3) Hemen Holdings ("Hemen") and SDRL. The competing proposals from both the Bondholders and the Company are attached if you would like to get into the weeds. Hemen is an entity SDRL Chairman John Fredriksen uses for his SDRL investment. Mr. Fredriksen, as of a 2016 filing ( Form SC13G/A), was deemed to own 24.2% of SDRL stock. Mr. Fredriksen also has a substantial interest in the Company's debt.
While it appears the conversations are serious and material, the "bid and ask" between the Company and the Bondholders, at this point, appears to be large. There has been no public discussion regarding talks between the Company and secured debtors. Another creditor, Ship Finance (NYSE:SFL), which chartered three rigs to SDRL under "fully guaranteed subsidies" and is owed $875 million took the unusual step on January 31 of issuing a press release stating, " Ship Finance has not agreed to the terms proposed by Seadrill in October 2016 and summarized in today's filing by Seadrill. In November, the Company proposed a more balanced long-term structure through which Seadrill could meet its commitments."
A target date of April 30 has been set to reach a restructuring agreement with all relevant parties.
A Word About Capital Structure
Unfortunately, some SDRL investors do not understand how the corporate capital structure works. Below is a simplified schedule of repayment priority.
Simply put, if you loan money and the money is secured by collateral, you have a claim on that asset until your debt is repaid. To the extent the collateral is not sufficient to satisfy the repayment of your loan, you also have a claim on unsecured assets and excess cash flow. The claim priority is typically defined in your agreement and may be higher (senior) or lower (junior) than other creditors.
If you loan money and it is not secured, you have a claim in default on unsecured assets and excess cash flow.
Equity is last to get paid. Any money and/or assets of the Company that remain after debt is satisfied belongs to equity. In a typical "going concern" situation, equity is valued on the Company's future prospects (or as the finance texts teach, the net discounted value of future cash flows). In a restructuring, equity often does not get a "seat at the table" as it has no claim.
When a Company appears unable to meet its debt obligations, it enters what is known as "the zone of insolvency". In this case, management has a fiduciary obligation to work in the best interest of the creditors, not equity holders (as is the case in a normal going concern environment).
To be clear, in SDRL's case, debts far outweigh equity and equity will receive almost nothing, except perhaps a "warrant" on the post-restructuring success of the company. I have previously estimated the value of equity to existing equity holders post-restructuring at about 5%-10% of "new" equity (and could be closer to zero).
Secured debt gets paid first, then unsecured debt (Bondholders); equity gets what is left over. In a restructuring/bankruptcy situation, equity gets, best case, a sliver of equity in a post-restructuring company because there is nothing left over.
What If No Agreement Is Reached?
All parties are motivated to reach an agreement for the simple reason a well-functioning SDRL offers the greatest potential for maximum realization of debt obligations. A well-functioning SDRL is needed because virtually all obligations, whether secured or unsecured, has a liquidation value below operating value. In other words, simply seizing collateral and selling it provides a return below the outstanding value of the obligation.
Though all parties are motivated to reach agreement, stakeholders have different positions of security and different places on the capital structure and hence different perspectives and motivations. For example, a debtor with collateral that equals 90% of its debt may be more likely to "foreclose" on the security than a creditor with an unsecured claim. The unsecured debtor will be more likely to agree to delay payments and accept equity in the restructured company as partial payment (or to reduce the debt balance) for outstanding debt. Equity (stockholders) often are not part of the discussion and/or are forced to accept dilution (see the DRYS one-year chart for a peak at what dilution could look like).
If no agreement between all creditors and the Company is reached, a debtor or more likely a group of debtors can force SDRL into bankruptcy. This would almost certainly occur in conjunction with two items, 1) a plan of reorganization and 2) debtor-in-possession ("DIP") funding. If certain circumstances, if all parties agree going in to the bankruptcy on a plan of action, but need the process to shed certain obligations or for other reasons, the plan is called a "pre-packaged" bankruptcy. The absence of conflict among the stakeholders is immensely helpful in increasing the speed and reducing the cost and disruption of a bankruptcy (which, in the best of circumstances is hugely disruptive and very expensive).
Plan of Reorganization
A plan of reorganization can be put forward jointly by the debtors and Company management, by Company management, or by the debtors (either collectively, individually or by class if there are conflicts). If there is a lack of agreement, the second, a plan put forward by Company management (possibly in cooperation with a subset of the creditors) is likely to prevail. The plan(s) would need to be ratified by a judge. A trustee to administer the plan would also be appointed. Like the plan of reorganization, the trustee can be one recommended all interested parties, the company, by the debtors or in this case, even by the judge. The plan of reorganization would guide SDRL's activities until a restructuring agreement is reached and the Company emerges from bankruptcy.
DIP funding, which would have a repayment position higher than any non-secured debt, would be provided by a third party. The funder could be an existing stakeholder or new lender. DIP funding is used to pay operating expenses in excess of inflows (salaries, third party vendors, required maintenance, special surveys, etc.).
Under a plan of reorganization, the Company can eliminate certain (such as leases), but not all, obligations and restructure other obligations (debt). In no case can a legally secured asset by "reclaimed". In SDRL's case all rigs are collateral for debt and therefore are not available for other creditors or new creditors.
A creditor's committee ("CC") is put together with the various forms of debt serving on the committee (e.g. secured has representatives, unsecured as representatives, etc.). Again, if there can be internal agreement it is "easy", if not, a judge can impose the makeup recognizing the conflicting interests (too many claims, too few assets).
Restructuring Plan and Approval
Typically, the CC, working with management monitors operating progress and gets involved in strategic (board level) decisions. In certain cases, the CC can request, to the trustee and judge, management or certain members of management) be replaced. The CC also negotiates among itself for the "proper" restructuring that is acceptable to all creditors. Again, speed and ease depending on the amount of agreement, within the group. The goal is to put forward a plan of reorganization that all parties support. A reorganization plan is ultimately approved, or rejected, by the bankruptcy judge.
Sometimes management proposes a plan without the support of all creditors. As in the case of Paragon Offshore (OTCPK:PGNPQ), a judge may refuse to confirm a restructuring plan that he/she feels is either unfair, unrealistic or does not fairly represent all parties. The need for a judge to deem a plan fair and realistic is why SDRL's current plan cannot be imposed on bondholders.
In the absence of agreement on a plan of reorganization, the trustee can put forward an alternate plan of reorganization. Ultimately, the judge either validates a plan, requests a new plan or, rarely, imposes a plan.
Depending on the degree of cooperation, the time spent in bankruptcy can be several months or several years. Bankruptcy is expensive, disruptive and bad "PR". It is the goal of all stakeholders to exit bankruptcy as quickly as possible.
In all the scenarios I can imagine, a SDRL bankruptcy would be an operating bankruptcy. In other words, the company would continue to perform contractual services, seek new contracts and continue to work just as pre-bankruptcy. It is simply a question of time, money and distraction.
Ultimately SDRL, or a NewCo, that holds assets and debt will emerge. Again, in all the scenarios I can imagine, SDRL stock will be worth pennies on the dollar. In the Paragon Offshore bankruptcy mentioned earlier, the stock continues to trade for pennies on the dollar, even though any recovery for equity holders would round to zero. So there will be an opportunity, as irrational as it appears, for SDRL stock to be traded, even in a bankruptcy situation.
In the absence of an agreement between the collective group of creditors and SDRL management, bankruptcy could occur. The process is long, expensive and distracting. A Creditor's Committee would work to reach agreement within the debtor group, with management and with the bankruptcy trustee on a restructuring plan. The judge has the power to approve the restructuring plan, request a new plan and/or alternations to aspects of the plan. Ultimately, a restructured company emerges with debt, either in amount and/or timing, adjusted to reflect a sustainable go-forward entity. Depending on the security associated with the claim (or lack thereof), a creditor could receive most of what is owed, part of what is owed and/or equity in the new company. Current equity holders will end up with a sliver of equity (or warrants) in the restructured company likely worth mere pennies (or less). Due to the current capital structure and company prospects, equity holders do not have a current claim to SDRL's assets or cash flows.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.