RBL facilities permit the borrower to take out loans as needed, provided the total principal amount of credit exposure does not exceed the lesser of the total credit limit or the “borrowing base,” which is largely based on the value of a company’s proved oil and gas reserves (i.e., those quantities that, by analysis of engineering data, can be estimated with reasonable certainty to be economically producible). The borrowing base may be smaller than the total credit limit and, it is important to note, is subject to change throughout the term of the credit agreement based on fluctuating market prices for the commodities and the resulting change in value of a company’s proved oil and gas reserves. The credit agreements typically provide for semiannual redeterminations of the borrowing base, as well as a right to one or more unscheduled redeterminations at the request of the lender (or the borrower, in some circumstances).
Problems arise if, after a redetermination, the borrowing base drops below the aggregate principal amount of outstanding loans. Given the severe drop in oil prices over the past year, as well as speculation arising from this year’s shared national credits review after regulators made a strong push for banks to reduce their leverage ratios with respect to RBL facilities, this could become a common occurrence if prices do not increase above current market levels. If such a borrowing base deficiency occurs, the credit agreement may permit the borrower to either pledge additional collateral or pay down the deficiency. Borrowers frequently have difficulty with either option, however, as many borrowers pledge most of their producing assets (typically at least 75 percent of the value of the reserves used to calculate the borrowing base) as collateral, the credit agreement often limits their ability to sell these or other assets, and raising the capital to pay down the deficiency is a challenge given the current state of the energy industry. Further, to the extent companies sell assets in an attempt to increase liquidity, most RBL facilities require that the borrowing base be automatically reduced by the amount of the assets sold that were included in the calculation of the borrowing base.
So how is the borrowing base established, either initially or pursuant to a redetermination? While the answer depends on the particular RBL facility, there are a number of common factors evaluated in setting this limit. For example, the RBL facility will likely provide for an independent engineer to analyze a company’s proved reserves and submit a report, from which the lender will determine a discounted net present value of reserves. Other factors that the lender may consider in setting the borrowing base include the borrower’s assets, equity cushion, liabilities, cash flow, hedged and unhedged exposure to price, foreign exchange rates, interest rates, management, and ownership. Importantly, most RBL facilities state that the borrowing base determination is ultimately subject to the lender’s discretion and that the lenders have no obligation to determine the borrowing base at any particular amount.
A borrower will likely find itself in a difficult position if it receives notice of a material borrowing base deficiency. Understandably, the borrower may disagree with the lender’s determination and may want to find out more information about precisely how the borrowing base was calculated. But the borrower may have difficulty finding support in the RBL facility for any dispute, particularly if the RBL facility gives the lender discretion to establish the borrowing base and does not provide a mechanism for the borrower to obtain additional information. Nevertheless, there are several potential claims a borrower might consider.
Breach of contract. The obvious difficulty with a breach of contract claim is that the RBL facility typically gives the lender discretion to establish the borrowing base, as noted above. Accordingly, even if the RBL facility contains objective criteria that a lender may consider, the contractual right to use its discretion will likely make it difficult for a breach of contract claim to survive summary judgment. But some borrowers have been able to do so. See Farash & Robbins, Inc. v. Fleet Nat’l Bank, 2005 U.S. Dist. LEXIS 33810 (D.N.J. Dec. 19, 2005) (denying summary judgment on plaintiff’s claim that the lender breached the credit agreement by reducing the borrowing base without justification). Cases like Farash are likely the exception, particularly if a court holds that the relevant terms are unambiguous. But see Farash, 2005 U.S. Dist. LEXIS 33810, at *10 (denying summary judgment even though it held that “a review of the contract in question does seem to indicate that the contract is clear and unambiguous in its terms”).
Breach of the duty of good faith and fair dealing. Given the potential difficulty of establishing a breach of contract claim, a borrower may also allege a claim for breach of the duty of good faith and fair dealing. Under New York law, for example, there exists in every contract a covenant of good faith and fair dealing, the purpose of which is to “preclude the parties . . . from engaging in conduct that will destroy or impede the right of the other party to receive the benefits of the contract.” In re Jat Mgmt. of Ohio, Ltd., 2002 Bankr. LEXIS 1546, at *37 (E.D.N.Y. Dec. 13, 2002). Importantly, where the contract contemplates the exercise of discretion, this implied covenant “includes a promise not to act arbitrarily or irrationally in exercising that discretion.” Dalton v. Educ. Testing Serv., 663 N.E.2d 289, 291 (N.Y. App. Div. 1995).
In other jurisdictions, however, the duty of good faith and fair dealing may not apply to every contract. In Texas, for example, the duty arises only when a contract creates or governs a “special relationship” (such as a relationship between insurer and insured) between the parties. See Subaru of Am., Inc. v. David McDavid Nissan, Inc., 84 S.W.3d 212 (Tex. 2002). It is unlikely that a typical lender-borrower relationship would qualify as a “special relationship.” NationsBank v. Perry Bros., 1995 U.S. App. LEXIS 42416 (5th Cir. Aug. 24, 1995).
While there is a dearth of case law, some borrowers have attempted to assert a claim for breach of the duty of good faith and fair dealing after a borrowing base adjustment. In Mallon Resources Corp. v. Midland Bank, 1997 U.S. Dist. LEXIS 10346 (S.D.N.Y. July 17, 1997), Mallon Resources had an RBL facility with Midland Bank that was governed by New York law. The borrowing base was initially set at $10 million, and the term sheet between the parties stated that “Midland shall use [an engineer’s reserve report] as one factor in determining the Borrowing Base, but will determine the Borrowing Base in its sole discretion based on such other factors as it deems appropriate.” Mallon borrowed the entire $10 million, but the bank thereafter reduced the borrowing base to $9.2 million after the first redetermination, and Mallon was required to pay the $800,000 difference. Mallon sued and brought a number of claims, but all of Mallon’s claims were dismissed except the breach of the duty of good faith and fair dealing claim. The court held that although it is generally true that a party cannot violate a duty of good faith and fair dealing by exercising its rights under the contract, “Mallon’s allegations that its business was successful and that its reserves had substantially increased are sufficient allegations . . . that Midland may have assigned values to Mallon’s assets not in its discretion but in bad faith.”
Although Mallon’s claim for breach of the duty of good faith and fair dealing survived Midland Bank’s motion to dismiss, the borrower did not prevail at trial. See Mallon Res. Corp. v. Midland Bank, 1997 U.S. Dist. LEXIS 14954 (S.D.N.Y. Sept. 24, 1997). Mallon argued at the bench trial that a Midland Bank executive and the bank’s independent engineer who evaluated Mallon’s reserve data conspired to knowingly set the initial borrowing base too high after the bank learned that Mallon had received an offer to obtain financing from another bank. Mallon also argued that Midland Bank did this in order to obtain the fees generated by the credit agreement, knowing that it would then have to reduce the borrowing base due to the poor results of a new well. The court disagreed that the evidence supported such a theory and held that there was no evidence that the bank or the engineer knew about the competing loan opportunity or that the bank knew about the poor results from the new well at the time the initial borrowing base was established.
Other cases shed additional light on what a borrower may need to show in order to prevail on a good faith and fair dealing claim when the contract permits the lender to exercise discretion. In K.M.C. Co. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985), the Sixth Circuit (interpreting New York law) held that when evaluating whether a creditor accelerated a loan in good faith, “to a certain extent the conduct . . . must be measured by objective standards” in addition to the creditor’s “subjective state of mind.” Accordingly, the court held that there “must at least be some objective basis upon which a reasonable [creditor] in the exercise of his discretion would have acted in that manner.”
These cases suggest that some examples of bad-faith conduct by lenders in adjusting a borrowing base might be (1) the lender’s motive to obtain additional fees before the borrower went to a competing lender; (2) the lender’s awareness of adverse financial results at the time the initial loan was made, suggesting its later reduction in the borrowing base was made in bad faith; or (3) the lack of any objective basis for adjusting the borrowing base. As demonstrated by the Malloncase, however, even if a borrower survives dismissal as a matter of law, it may be difficult to present sufficient evidence to satisfy the trier of fact.
Other claims. In addition to claims of breach of contract and breach of the duty of good faith and fair dealing, plaintiffs have made other claims—mostly without success—in borrowing base or similar disputes. A general roadblock to alleging tort claims in this context is the economic loss doctrine. In New York, for example, courts have described this doctrine as “reflecting the principle that damages arising from the failure of the bargained-for consideration to meet the expectations of the parties are recoverable in contract, not tort.” Bristol-Myers Squibb, Indus. Div. v. Delta Star, Inc., 206 A.D.2d 177, 181 (N.Y. App. Div. 1994). The following are other claims made to challenge borrowing base determinations:
- Fraud: While plaintiffs have argued that purported misrepresentations made during the course of negotiations relating to closing the original loan or borrowing base determinations constitute fraud, there are numerous hurdles to clear when making such a claim, including the economic loss doctrine and the difficulty of proving intentional or reckless misrepresentations.
- Economic Duress: In Interpharm, Inc. v. Wells Fargo Bank, N.A., 2010 U.S. Dist. LEXIS 32318, *23–24 (S.D.N.Y. Mar. 31, 2010), the plaintiff claimed that a forbearance agreement entered into with Wells Fargo was the product of economic duress due, in part, to Wells Fargo’s improper calculation of the borrowing base on a revolving credit facility that caused the plaintiff to default on the loan. The court held that the plaintiff failed to allege facts that would support a finding of economic duress and granted Wells Fargo’s motion to dismiss.
- Unjust Enrichment: Plaintiffs have attempted to argue that as a result of an improper decrease in the borrowing base, the lender was unjustly enriched by fees, interest, or other funds derived from the borrower.See, e.g., Mallon Res. Corp. v. Midland Bank, 1997 U.S. Dist. LEXIS 10346, at *9 (S.D.N.Y. July 17, 1997) (granting Midland Bank’s motion to dismiss Mallon’s claim that the bank was unjustly enriched by the shares of Mallon stock obtained by the bank in connection with an improper reduction in the borrowing base for a RBL facility).
- Breach of Fiduciary Duty: Plaintiffs in borrowing base or similar disputes have attempted to assert breach of fiduciary duty claims. However, credit agreements often include a disclaimer of fiduciary duties. In some jurisdictions, such as Texas, post-contract conduct may trump an explicit disclaimer of fiduciary duties, but New York courts typically recognize the enforceability of such waivers. See Centro Empresarial Cempresa S.A. v. Am. Movil, S.A.B. de C.V., 952 N.E.2d 995 (N.Y. App. Div. 2011).
The case law demonstrates that discretion is a difficult hurdle for borrowers to overcome when asserting claims against a lender after a borrowing base redetermination. Unless a court finds some ambiguity in the relevant contractual provisions, a borrower’s strongest claim is likely to be a breach of the duty of good faith and fair dealing (assuming this claim is available under the applicable law). However, unless the borrower can procure sufficient evidence of bad-faith conduct on the part of the lender, the borrower’s claims may ultimately fail.
In light of the potential viability of a claim for breach of the duty of good faith and fair dealing, both lenders and borrowers may consider reassessing their preferred choice-of-law provisions. Texas law, for example, will usually foreclose such a claim. By contrast, New York law, which often governs RBL facilities, will give a borrower a greater chance to make a colorable claim for breach of the duty of good faith and fair dealing. There are, of course, many reasons for borrowers or lenders to prefer a certain state’s laws, but in the current economic environment, the potential viability of breach of the duty of good faith and fair dealing claims is worthy of additional consideration.
Finally, to evaluate evidence prior to bringing a claim, borrowers may consider negotiating for greater access to information regarding how a lender calculates the borrowing base. Lenders are likely to resist such efforts, however, and even if the borrower did obtain greater access to information, a lender’s contractual right to discretion may still result in the early dismissal of the borrower’s claims. Nonetheless, increasing the transparency of the borrowing base calculations may serve to ward off disputes in the first place and, in this regard, may ultimately be beneficial to both the borrower and lender.
Regardless of the futility of certain claims available to borrowers, the potentially devastating impact of a borrowing base deficiency, coupled with the continued depression of oil and gas prices, will likely cause more borrowers to exhaust their options, including filing litigation against lenders.
Keywords: energy litigation, borrowing base, redetermination, reserve-based revolving credit facilities, RBL facilities, oil slump, good faith and fair dealing
Scott Fletcher, Stephen Olson, Omar Samji, and Tom Howley are partners, and Will Taylor is an associate at Jones Day in Houston, Texas.