Corporate Governance in Challenging Times – Practical Tips for Directors in the Oil & Gas Sector

February 2, 2016

Introduction

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• Directors of oil and gas companies, or those of companies with materialexposure to the Energy sector, face unprecedented challenges as they seek toguide their enterprises through a period of substantial market uncertainty

• While the challenges corporate directors face in the current economicenvironment are significant, the duties that they owe and the standards towhich they are subject have not changed

• Directors in the energy sector should understand what their duties are in thecircumstances and the positive steps they can take to ensure that they meettheir duties and shield themselves from personal liability

• They should also understand the options that may be available for theenterprises they manage to restructure or recapitalize to better positionthemselves to survive current market conditions

DIRECTORS’ DUTIES IN SITUATIONS OF FINANCIAL DISTRESS

Fiduciary Duties

• Directors have fiduciary duties to act honestly and in good faith with a view tothe best interests of the corporation

• Fiduciary duties are owed to the corporation – they do not shift to creditors, even when the corporation is in the vicinity of insolvency

• However, directors may consider the interests of various stakeholders in determining whether they are acting in the corporation’s best interests

Affected stakeholders can include creditors, shareholders, employees,suppliers and the environment

• Directors should not favour the interests of one group of stakeholders overothers. However,

It is recognized, as a practical matter, that creditors may have increasedleverage when a corporation is in financial distressAnd may hold enhanced contractual rights if there has been an event of default under debt instruments

What to Do

• Directors will comply with their fiduciary duties if they undertake an honest andgood faith attempt to address the corporation’s financial problems 3

DIRECTORS’ DUTIES IN SITUATIONS OF FINANCIAL DISTRESS (Cont.)

Duty of Care

• Directors are also subject to a duty of care

• The duty of care imposes an objective standard that requires directors to actcarefully in an informed and considered manner

• In discharging the duty of care, directors must exercise the care, diligence andskill that a reasonably prudent person would exercise in comparablecircumstances

• What to Do

• Meeting the duty of care can be achieved by directors who:devote reasonable time and attention to the affairs of the corporation; andexercise informed business judgement

• Directors should review and take active steps to inform themselves of all material information and should actively question management and advisorswith respect to the corporation’s financial viability and options to raise additional capital or to recapitalize or restructure

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DIRECTORS’ DUTIES IN SITUATIONS OF FINANCIAL DISTRESS (Cont.)

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• Directors should engage independent experts when required

• The board’s decision making process should be documented in order to allowdirectors to demonstrate that they have exercised care, diligence and skill, andhave acted in an informed and considered manner, in reaching their decisions

DIRECTORS’ DUTIES IN SITUATIONS OF FINANCIAL DISTRESS (Cont.)The Business Judgement Rule

• The business judgement rule provides substantial protection for directors’ decisions

• In considering whether directors have complied with their duties, courts generallyapply the “business judgement rule” if the decision-making process meets certainrequirements

• Pursuant to the business judgement rule, courts defer to directors’ business decisions so long as they lie within a range of reasonable alternatives and are taken:

in good faith, andin the absence of a conflict of interest,

provided directors undertook a reasonable investigation, considered the alternatives and acted fairly

• Where directors meet the requirements of the business judgement rule, courts will not substitute their view for that of directors even if subsequent developments showdirectors did not make the best decision

What to Do

• Running a thorough process, engaging the appropriate advisors and documenting thealternatives considered and decisions taken, will be important elements in demonstrating that the applicable duties and standards have been met and that appropriate business judgement was brought to bear

• It will also be important to demonstrate that the board acted in an independent manner and in the absence of any conflicts of interest 6

DIRECTORS’ DUTIES IN SITUATIONS OF FINANCIAL DISTRESS (Cont.)Failure to Meet Duties

• Directors that fail to meet the duties to which they are subject (fiduciary duties and the duty of care) risk exposure to material and negativeconsequences including:

Loss of recourse to indemnificationDerivative actions brought by shareholders for breach of duty

Personal liability for debts or obligations of the corporation

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DIRECTORS’ DUTIES IN SITUATIONS OF FINANCIAL DISTRESS (Cont.)

Oppression

• Persons and entities that believe they have been unfairly dealt with by a corporation may claim for oppression

• Creditors, shareholders or other parties may bring a claim for oppression if directors act in a manner that:

is oppressive;is unfairly prejudicial to the complainant; or

unfairly disregards their interests

• A court may find oppression even in circumstances where directors have compliedwith their fiduciary duties

• As a practical matter, when a corporation is in the “vicinity of insolvency”, thepotential for unfair prejudice or unfair disregard for the interests of creditors is enhanced

• If a court finds oppression, it may make any order it considers appropriate

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DIRECTORS’ DUTIES IN SITUATIONS OF FINANCIAL DISTRESS (Cont.)

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What to Do

• The oppression remedy is very broad and equitable in nature. It allows thecourt to enforce not just what is legal, but also what is “fair”.

• Much of the guidance as to the types of actions that constitute oppressioncomes from caselaw.

• Directors may wish to obtain advice from counsel as to whether an actionthat is being contemplated could be viewed as oppression prior to makingthe decision to take such action

• In considering actions that are in the best interest of the corporation, therights and reasonable expectations of creditors should be averted to and the board’s deliberations in this regard should be documented

DIRECTORS’ DUTIES IN SITUATIONS OF FINANCIAL DISTRESS (Cont.)

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Independent or Special Committees

• Directors owe their duties to the corporation as a whole, and not to any particularstakeholder

• Accordingly, where directors or members of management are substantial shareholdersor creditors of the corporation, the board should give due consideration toestablishing an independent or special committee

• An independent or special committee can help demonstrate that decisions were taken “in the absence of a conflict of interest” which is an integral component of thebusiness judgement rule

• Independence from management may result in greater credibility with creditors where management actions are viewed as having contributed to financial distress

• A subset of the board may be better positioned to act quickly when circumstances require

• A subset of the board also allows those directors with experience and expertise in dealing with financial difficulties to focus on financial issues and restructuring options

• Establishing a restructuring committee facilitates the goals of minimizing disruption to the business and containing costs while identifying the available strategic options

PERSONAL LIABILITY OF DIRECTORSDirectors can be personally liable for damages when duties are breached or for certain corporate liabilities when the corporation does not pay or perform

Statutory Liabilities

• Statutory liabilities for which directors are, or can be, personally responsible include:

Environmental liabilities

Failure to make contributions to pension plans when due

Obligations to pay wages to employees and to withhold and remit source deductions (income tax, CPP, EI)Obligations relating to vacation pay

Obligations to pay GST

• Some of these liabilities (such as wage and vacation pay liability) are strict and others (such as source deductions and GST liability) are subject to a due diligence defence

• Diligence requires directors to take steps that reasonably prudent persons would take in comparable circumstances

• Directors are only liable for amounts accrued during the time that they were actually directors

Other Liabilities

• Directors can also be exposed to personal liability in connection with derivative actions or claims of oppression 11

PERSONAL LIABILITY OF DIRECTORS (CONT’D)

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Environmental Liabilities of Directors

• Directors can become liable for environmental offences and other liabilities of the corporations they supervise

• In People’s Department Store v. Wise, the Supreme Court of Canada held that directors of a corporation owe a duty of care to its stakeholders which includes the environment

• In Alberta, directors can be personally liable for offences committed by the corporation under the Environmental Protection and Enhancement Act and the Water Act

o Personal liability can be imposed where the director (or officer or agent) “directed, authorized, assented to, acquiesced in or participated in the commission of the offence

• To date, we are not aware of any instance where a Canadian court has imposed environmental liability based on the duty of care set out in the Wise decision, however, in Alberta directors have been found liable for environmental offences of the corporations they supervise (generally in circumstances where they are also a principal of the corporation).

PERSONAL LIABILITY OF DIRECTORS (CONT’D)

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• We believe that in the current economic climate and in light of the change in government at the federal and provincial level, the potential that directors could become personally liable for environmental offences and other liabilities of the corporations they supervise has increased.

• Total reclamation and abandonment liabilities related to oil and gas activities of the 811 operators registered under Alberta’s Licensee’s Liability Rating Program (“LLR”) are estimated to be $36.4 billion as of December 2015 (being a present value estimate of future obligations)

• Such obligations represent the industry’s second largest liability (after secured and unsecured debt)

• In the event that a substantial number of provincial oil and gas companies were to become insolvent, the potential for significant unfunded liabilities would exist

LICENSEE LIABILITY RATING (LLR) PROGRAM

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• The operation of the LLR program may limit the options available to boards to sell assets and raise additional capital on a going concern basis

• The LLR program is administered by the Alberta Energy Regulator (“AER”) to reduce the likelihood that costs to suspend, abandon, remediate and reclaim a well, facility or pipeline will be borne by the public of Alberta should an operator become defunct

• For every licensee regulated by the AER, a Liability Management Rating (“LMR”) is calculated every month by comparing the licensee’s eligible deemed assets to its deemed liabilities.

• If deemed liabilities exceed the licensee’s deemed assets, the licensee must provide the AER with a security deposit covering the difference

• An LMR assessment is also conducted on receipt of a license transfer application

• Transfers that result in a licensee’s LLR rating falling below one will not be approved unless additional security is provided

LESSONS FROM REDWATER INSOLVENCY PROCEEDINGS

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• There is an important case working its way through the Alberta courts that will determine the rights of the Province relative to those of secured creditors in connection with the transfer of licenses and reclamation and abandonment costs.

• Redwater Energy Corp. (“Redwater”) is an insolvent oil and gas company with 127 AERlicenced assets that is subject to proceedings under the Bankruptcy and Insolvency Act(Canada) (“BIA”)

• ATB is a secured creditor of Redwater and Grant Thornton Limited (“Receiver”) has been appointed as the court-appointed receiver and trustee in bankruptcy over the assets of Redwater

• Only some of Redwater’s assets are considered to be marketable

o 20 valuable wells out of 127 licensed assets

o Bad assets have abandonment costs approx. ten time their asset value

• Receiver disclaimed the bad assets, and sought to sell goods assets to maximize proceeds to ATB, as secured creditor;

o bad assets would be orphaned with no provisions made by Redwater or the Receiver for reclamation

• AER issued abandonment order for the bad assets, and has claimed that Receiver/Redwater is statutorily liable for end of life obligation on licensed assets and should either package the asset sale to maintain its LLR rating to meet those obligations, or post cash security to AER

LESSONS FROM REDWATER INSOLVENCY PROCEEDINGS (Cont.)

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Competing Legislation

• The BIA empowers a receiver appointed under such statute to conduct a sales process tomaximize proceeds to creditors

• Under the Oil and Gas Conservation Act (Alberta) (“OGCA”) – A licensee has abandonment andreclamation obligations for licensed oil and gas assets at end of life, as a public and statutoryduty inherent in a license to drill

• Receiver and ATB argue:

o BIA is paramount to OGCA because it is federal legislation

o AER’s claims against Redwater are financial in nature (posting security), not regulatory orin furtherance of a public duty

o AER is an unsecured creditor ranking behind ATB in accordance with BIA priority scheme,and the OGCA does not grant AER a priority claim over proceeds from sale of good assets

• AER, the Orphan Well Association and CAPP argue:

o Receiver is included in OGCA definition of “licensee”, and therefore subject to same abandonment obligations as Redwater (may not disclaim bad assets)

o Licensee’s obligations are a public duty inherent in license to drill and must be enforcedto protect the oil and gas industry and Alberta’s public interest

o Receivership should not give a company more favourable abandonment obligations thanit had when it was solvent

o AER’s claim is not a claim to be proved in bankruptcy

LESSONS FROM REDWATER INSOLVENCY PROCEEDINGS (Cont.)

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• The case was heard on December 16-17 before Justice Wittman of the Alberta Court of Queen’s Bench but as of December 20, 2015, no decision has been issued

• The decision in Redwater will have significant implications for directors of oil and gas companies that are in the vicinity of insolvency

• If the court finds in favour of the AEU, boards will need to ensure that abandonment obligations in respect of all of a corporation’s licensed assets are provided for when structuring an asset sale transaction

• Moreover, in the event that the court concludes that a licensee has a “public duty” to meet abandonment and reclamation obligations, we believe that directors could be exposed to liability in circumstances where the corporation did not meet that duty and directors acquiesced or participated in decisions that resulted in such outcome

PROTECTING THE BOARD• Directors should take certain steps to mitigate personal liability when the corporation

is experiencing financial distress

• The best defence is the implementation of procedures and the retention of independent advisors to ensure that directors’ duties are met and their decisions areprotected by the business judgement rule

• However, there are a number of practical steps that can be undertaken to mitigatedirectors’ personal liability

Existing D&O insurance should be reviewed to ensure that there are no gaps in coverage and that coverage is in place for a reasonable period of time

Existing indemnification arrangements between the corporation and its directorsshould be reviewed to ensure they are “state of the art”

If such arrangements do not meet this standard, new indemnification agreements should be put in place

• Consideration should be given to segregating corporate funds to pay forrenewals/extensions of D&O insurance or run-off as well as to satisfy other liabilities for which directors can be personally liable

• Obtaining director protections and court-ordered charges in any court supervised restructuring process also provides substantial protection

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RECAPITALIZATION AND RESTRUCTURING

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• The current low price environment for hydrocarbon products will cause manycompanies in the Canadian Oil and Gas sector to experience significant financial pressure

• Some companies in the sector will likely have to undertake some form of recapitalization or restructuring to continue as a going concern

• Options exist under different statutes to effect a recapitalization or restructuring

Recapitalization

• A recapitalization involves restructuring the enterprise’s mix of equity and debt to create a capital structure that is more viable for the long term. It can involvedifferent components such as issuance of additional equity, swapping debt forequity, issuance of additional debt, reducing interest rates or extending maturities. It typically involves a negotiated process with creditors by which an enterpriseseeks to reduce its aggregate obligations in respect of outstanding indebtedness

• A recapitalization can be undertaken on a going concern basis or where theenterprise is insolvent. Recapitalizations of solvent enterprises can be undertaken as a plan of arrangement under applicable corporate statutes or as part of a CCAAprocess where there are questions as to the enterprise’s solvency. In certain circumstances a recapitalization can takes place under the corporate statute even when the entity is insolvent.

RECAPITALIZATION AND RESTRUCTURING (Cont.)

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• Usually limited to a balance sheet restructuring and not to minimize oreliminate obligations relating to unfavourable contracts

Restructuring

• Restructuring in the context of financially distressed enterprises can be undertaken through a variety of techniques that are similar to arecapitalization

• A restructuring is often pursued as an alternative to bankruptcy and can be undertaken with or without court protection although in our experience, it isoften pursued within the context of the Companies’ Creditors Arrangement Act (“CCAA”)

• A CCAA restructuring provides the enterprise with the ability to stay actionsby creditors while it pursues a restructuring and provides flexibility to dealwith unfavourable contracts or other obligations such as employee or leasematters

RECAPITALIZATION AND RESTRUCTURING (Cont.)

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Strategic Considerations

• Electing to pursue a restructuring or recapitalization gives rise to a host of strategicconsiderations and professional advisors should be engaged early in the process

• Companies considering a recapitalization or restructuring will need to be proactivein identifying available options, and engaging with their stakeholders if they wish toretain control over their assets and be the sponsor of the solution

• In addition, any recapitalization or restructuring requires capital to fund theprocess and different options exist to secure the required funds

• The appropriate strategy will be highly dependent on the corporation’s particularcircumstances

• A successful recapitalization or restructuring is dependent on obtaining therequisite level of affected stakeholder support

RECAPITALIZATION AND RESTRUCTURING (Cont.)• Accordingly, a pro active and well timed engagement strategy should form part of

any plan

• Corporations seeking stakeholder support for a plan should be able to demonstrate that it will yield a better result than the alternatives

Secured creditors may wish to avoid receivership and/or bankruptcy if they believe such a process could erode their security position

Stakeholders who are confident in the management team, business plan and long term value of a corporation’s assets are much more likely to support a recapitalization or restructuring as opposed to seeking liquidation and winding-up

• Corporations that have a well developed plan, sufficient capital to fund a recapitalization or restructuring and who proactively engage their stakeholders atthe appropriate time have a much better chance of achieving the desired result

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OSLER’S MARKET LEADING EXPERTISE

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Osler, Hoskin & Harcourt LLP (“Osler”) is one of Canada’s leading business law firms and we have a large team of highly experienced legal professionals that are able to assist on corporate governance matters or restructuring and insolvency mandates. We also have senior practitioners in the areas of Energy, Commercial Lending, Litigation and Taxation that work with our other experts to provide our clients with integrated and multidisciplinary solutions.

Osler succeeds for several reasons:

• Diverse Clientele and Wide-Ranging Scope – We act for all types of clients dealing with challenging business circumstances and deliver expertand innovative advice in complex matters. We are relied upon as trustedadvisors to directors, senior executives, in-house counsel, credit andinvestment officers and fund managers, as well as other professional advisors, court-appointed officers and regulators.

• Multi-Disciplinary Approach – Solving complex challenges requires an integrated approach across many different disciplines. We deliver a multi-disciplinary approach that draws upon market leading resources throughout the Firm to deliver integrated solutions seamlessly and effectively.

• Cross-Border Strength – We have extensive relationships with U.S. based advisors and have earned a leadership position in crafting comprehensive cross-border solutions in North America. We were among the first counsel globally to structure cross border protocols governing administrative process, substantive treatment and court-to-court communications in international restructurings.

• Rapid Response – We engage quickly, efficiently and effectively to meet the needs of any business-critical situation, regardless of the level of complexity.

RECOGNITIONBoth IFLR 1000: The Guide to the World’s Leading Financial Law Firms and Chambers Global: The World’s Leading Lawyers for Business rank Osler among the leading law firms in Canada for Insolvency & Restructuring.

IFLR notes that ”Osler’s restructuring and insolvency team has a reputation for its depth of experience and integrated approach across offices,” while Chambers Global says that sources declare Osler ”is one of the best Canadian firms we work with.”

OUR PEOPLEOsler has a large team of highly experienced legal professionals that are able to assist on corporate governance issues or restructuring and insolvency matters, augmented by our market leading Energy and Litigation teams. Please feel free to contact any of our legal professionals should you wish to discuss your legal needs orhear more about how we can help you achieve your objectives.

Lorne Carson Partner, Commercial Lending and Restructuring Calgary lcarson@osler.com403.260.7083

Robert Anderson, Q.C. Partner, Insolvency & Restructuring, Litigation Calgaryranderson@osler.com403.260.7004

Janice Buckingham Partner, Energy Calgaryjbuckingham@osler.com403.260.7006

Frank Turner Partner, Corporate -Corporate Governance Calgaryfturner@osler.com403.260.7017

Robert Desbarats, Q.C. Partner, Energy Calgaryrdesbarats@osler.com403.260.7015

Marc Wasserman Partner, National Chair,Insolvency & Restructuring Torontomwasserman@osler.com416.862.4908 24

OUR PEOPLE

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Maureen Killoran, Q.C. LitigationCalgarymkilloran@osler.com403.260.7003

Andrea Whyte Partner,Corporate, CorporateGovernance Calgary awhyte@osler.com403.260.7035

Thomas Gelbman Partner, Litigation Calgarytgelbman@osler.com403.260.7073