Energy Future Holdings Chapter 11 Case – The Largest Game Ever of Texas Hold’em?

The chapter 11 case of Energy Future Holdings (“EFH” or “Debtors”) roared back to life this month. Certain key conditions for the plan of reorganization approved last December (the “First Plan”) to become effective were not met by a deadline of April 30, and one of the major parties to the support agreement that underlay the First Plan gave written notice of termination on May 1.  The Debtors followed up immediately by filing a new proposed plan and a motion seeking a confirmation hearing in early August.  (Kelley Drye & Warren LLP represents a creditor of certain Debtors, but has taken no part in the matters discussed here).

EFH entered bankruptcy in April 2014 with over $42 billion in claims, and for well over a year it looked to be among the most intractable cases ever filed. The Debtors’ business operations are divided into two distinct silos: a majority interest in a regulated electrical utility, Oncor, indirectly owned by EFH subsidiary Energy Future Intermediate Holding Company LLC (the so-called “E side” of EFH), and non-regulated electricity generation, mining, and commodity risk management and trading operations, indirectly owned by EFH subsidiary Texas Competitive Holdings Company LLC (the so-called “T side” of EFH).

At the outset, EFH had the support of its E side creditors, who stood to see a substantial recovery from a proposed sale of the Oncor interests, but was facing intense opposition from junior creditors on the T side, who appeared to be out of the money. In the summer of 2015, however, the T side creditors began to coalesce around a bold strategy to backstop a real estate investment trust (“REIT”) structure to take control of the Oncor assets.  A REIT is a hybrid tax entity that is able to reduce or eliminate substantially all of the entity-level federal income taxes otherwise imposed on corporations by distributing its taxable income to shareholders.  The junior T side creditors, who had been prepared to prosecute a campaign of scorched earth litigation against the Debtors, their private equity sponsors and the senior T side creditors, began instead to negotiate the terms under which they would agree to backstop the new REIT vehicle.

The junior T side creditors proposed to pair with Hunt Group, a long time Texas utility operator. When it became clear that a plan of reorganization based on the transfer of the Oncor assets to a REIT structure could (i) garner support from all levels of the T side capital structure, and (ii) generate sufficient value to pay all E side creditors in full, EFH agreed to move forward with it.  Under the First Plan, the Hunt Group committed to provide over $7 billion, and the junior T side creditors agreed to backstop a $5.2 billion rights offering.

The riskiness of the First Plan was acknowledged by all parties. It would require numerous state and federal approvals, including from the IRS and the Texas Public Utility Commission (the “PUC”).  As the quid pro quo for agreeing to pursue the REIT structure, the Debtors insisted that the junior T side creditors agree to a global settlement that would be binding regardless of whether the First Plan ever became effective.  If the REIT proposal failed to garner the necessary approvals, the global settlement was intended to allow the Debtors to focus on an alternative path to exit the chapter 11 cases.  The junior T side creditors agreed to waive any claims against the Debtors, their private equity sponsors and the senior T side creditors, and to accept under an alternative plan a payout of $550 million, a small fraction of their claims.

The PUC approved the deal in March, but with a crucial caveat. Responding to objections raised by municipalities and consumer groups, the PUC issued an approval order that expressly left open the possibility that the Oncor investors (i.e., the junior T side creditors) might not be given the full tax benefits of the REIT structure, but instead might have to share such benefits with ratepayers.  The Oncor investors refused to close the deal on that basis.

Under the First Plan and the related agreements, the Oncor investors were required to close by April 30. However, that date was subject to an extension to June 30 if the PUC approval order had been approved.  The Oncor investors and the Hunt Group evidently believed that they had the additional time, and had already requested a new hearing before the PUC.  The Debtors and the senior T side creditors took the position that the PUC’s order was insufficient, since it did not resolve the treatment of the REIT tax benefits.  The Oncor investors could have effectively bought additional time by agreeing to give up $50 million of the their alternative payout consideration of $550 million, but they declined.  The T side senior creditors sent a notice of termination of the plan support agreement, thus effectively rendering the First Plan “null and void”.

Where the case proceeds from here is anyone’s guess. The machinations of the past several weeks could all be an elaborately choreographed series of steps to place maximum pressure on both the PUC and the Oncor investors to reach a resolution that would lead the Oncor investors to proceed forward.  The Debtors could withdraw the proposed new plan and seek to revive the First Plan.  The Debtors’ new plan also leaves open the possibility of a new REIT structure deal.  It also leaves open virtually any other possible exit strategy, such as a new auction process for Oncor.  At least one earlier bidder for the Oncor assets, NextEra Energy, has already made clear its continued interest.

Confirming a new plan for the T side Debtors should be fairly straight forward at this point, given the agreement by the T side junior creditors to settle their litigation claims and accept $550 million. Formulating a confirmable plan for the E side Debtors without the substantial value created by the REIT transaction could be long and difficult.  At a hearing last week, Judge Christopher Sontchi effectively split up the cases.  Confirmation of a new plan for the T side Debtors is scheduled to take place in August.  Judge Sontchi tentatively scheduled a confirmation hearing for the E side Debtors to begin in late September, but he acknowledged that with so many unresolved issues, that timing is unlikely to hold.

Heightening the intrigue, as Judge Sontchi noted last week, is the fact that the 18 month period in which the Debtors had the exclusive right to propose a plan of reorganization has expired.  This means that any party now has the ability to put forward a plan for reorganizing or selling the E side Debtors’ interests in the Oncor assets.  NextEra Energy is strongly believed to be considering such a strategy.

Any exit path for the E side Debtors will likely take a minimum of several months. Several sophisticated parties with billions of dollars at stake are sitting around a table, each waiting to see who will reveal their hole cards first.

Landlords Beware: Lease Terminations May Be Voidable In Bankruptcy

The Seventh Circuit Court of Appeals recently handed down a decision with significant implications for landlords contemplating lease termination agreements with distressed tenants. Ruling on a direct appeal in the chapter 11 case In re Great Lakes Quick Lube LP, the court held that a lease termination agreement between a landlord and a financially distressed tenant can be voided as either a fraudulent conveyance or a preferential transfer in the tenant’s subsequent bankruptcy case.

The debtor-tenant owned and operated a chain of automotive maintenance stores in the Midwest.  Less than two months before its chapter 11 filing, the debtor agreed with one of its landlords to terminate leases at five locations; two were profitable and three were not.  After the bankruptcy filing, an official committee of unsecured creditors was formed and eventually granted standing to pursue an action against the landlord on behalf of the debtor-tenant’s bankruptcy estate to recover the alleged value of the leases for the two profitable locations.

The bankruptcy court ruled that the lease terminations were not “transfers” for purposes of the avoidance statutes and that, even if a transfer had occurred, they could not be avoided and recovered by the estate because Section 365(c)(3) of the Bankruptcy Code prevents the assumption or assignment of a lease that has been validly terminated prior to the bankruptcy filing. The bankruptcy court also found that the debtor’s estate had received a benefit from being relieved of the lease payments at the three unprofitable locations

The Seventh Circuit reversed. The court determined that a “transfer” did occur when the debtor’s rights under the lease were terminated, and disagreed with the bankruptcy court’s finding regarding the non-avoidability of the value of such transfer.  Judge Richard Posner, writing for the court, disregarded the effect of Section 365(c)(3) of the Bankruptcy Code because the creditors’ committee was only trying to recover the value of the leaseholds, and not the leaseholds themselves.  Judge Posner also focused solely on the potential value lost by the debtor’s bankruptcy estate from the leases for the two profitable locations, and remanded the case back to the bankruptcy court to determine such value.  The bankruptcy court’s finding regarding value from the release of lease obligations at the three unprofitable locations did not insulate the transactions from further scrutiny regarding the possible value lost by the debtor’s estate from the termination of the profitable leases.

This is an important decision for landlords, as it stands as an invitation to trustees and creditors’ committees at a minimum to investigate, and possibly commence similar actions, where leases have been validly terminated pre-petition.  Although the opinion is very short and scant in its reasoning, Judge Posner is a highly regarded jurist and for that reason alone the decision is likely to draw the attention of other judges.  Landlords contemplating terminating leases with distressed tenants, particularly in the Seventh Circuit states of Illinois, Wisconsin and Indiana, will need to focus closely on the potential value of any leasehold interests being recovered and any benefits such tenants will be realizing in connection with the release from obligations under such leases.

Ruling on Pipeline Agreements in Sabine Chapter 11 Case Indicates Battles That Lie Ahead in Energy Company Bankruptcy Cases

U.S. Bankruptcy Judge Shelley Chapman ruled last week in the chapter 11 case of Sabine Oil & Gas that Sabine could utilize the U.S. Bankruptcy Code to “reject” certain agreements with pipeline operators.  This decision will permit Sabine to walk away from its obligations under the agreements and leave the pipeline operators with nothing but a claim in the bankruptcy case for breach of contract damages (a claim that is likely to be virtually worthless).  It upends the generally held view regarding the nature of these types of agreements, which is that they create cognizable real property interests under applicable state law.  Such real property interests have far stronger protections in bankruptcy cases than contractual rights.

Sabine, an exploration and production (E&P) company, filed for bankruptcy under chapter 11 of the Bankruptcy Code back in July 2015 in the Southern District of New York. Similar to most E&P companies, it had arrangements with two midstream gathering and processing (G&P) companies that gathered, treated, transported and processed Sabine’s oil and gas productions.  As is typical with these arrangements (the “midstream agreements”), Sabine agreed to dedicate certain oil and gas production to the G&P companies, and they, in turn, committed at their own expense to construct, operate and maintain for Sabine a system of pipelines and facilities.  Sabine committed under the midstream agreements to deliver certain minimum amounts of oil and gas on an annual basis, or else to make deficiency payments and other fees over a term of ten years.  The midstream agreements specifically provided that they are covenants intended to “run with the land.”

After filing for bankruptcy, Sabine sought to reject the midstream agreements. Section 365 of the Bankruptcy Code permits debtors to walk away from unexpired contracts and leases if they can demonstrate that such agreements are burdensome to their bankruptcy estates and that doing so would be in the best interests of the debtor and all of its creditors.  This is a crucial power under the Bankruptcy Code for troubled companies that are seeking to reorganize.

The G&P companies objected, and asserted strongly that the rejection of the midstream agreements would be of little avail to Sabine, because Sabine had conveyed real property interests to the G&P. They contended that even if Sabine terminated its ongoing contractual obligations under the midstream agreements, the covenants that run with the land could not be affected.

Property rights in bankruptcy are determined by applicable non-bankruptcy (in this case Texas) law. Notwithstanding that the covenants in the midstream agreements purported to run with the land, Judge Chapman, lamenting the “arcane and anachronistic rules” governing real property covenants, observed that the parties’ intentions were not necessarily dispositive, and that a number of conditions were required to be met in order to establish the existence of real property rights in Texas.  Since there were no decisions on point by the Texas Supreme Court that controlled all aspects of the questions at issue, she undertook her own analysis of whether the covenants between Sabine and the G&P companies did in fact “run with the land.”  She concluded that no such real property rights were created under Texas law.  (For technical reasons under the Federal Rules of Bankruptcy Procedure, she did not make a “final” ruling, but instead provided a “non-binding analysis” that can be readily applied when the procedural deficiencies are remedied).

Under Judge Chapman’s reading of Texas law, for a covenant to run with the land and thereby create a real property interest, among other things it must “touch and concern” the land (i.e., affect the fee owner’s ownership rights in some way), and also result from a “horizontal privity” between the parties (i.e., result from some transactional relationship between the parties, such as the reservation of certain rights upon a conveyance of a tract of land). In Judge Chapman’s view, the midstream agreements did not satisfy either of those requirements.  Instead, she found that

[Sabine] simply engaged [the G&P companies] to perform certain services related to the hydrocarbon products produced by Sabine from its property. The covenants at issue are properly viewed as identifying and delineating the contractual rights and obligations with respect to the services to be provided, and not as reserving an interest in the subject real property.

The decision in Sabine clearly has significant potential ramifications for G&P companies which have made substantial investments in facilities and infrastructure for distressed E&P companies. If Judge Chapman’s analysis is followed by other courts, E&P companies in chapter 11 would have the ability effectively to wipe out those investments by rejecting the midstream agreements under Section 365 of the Bankruptcy Code.  Other aspects of the Bankruptcy Code are implicated as well.  For example, a debtor in bankruptcy may sell its assets under Section 363 of the Bankruptcy Code “free and clear” of most contractual rights.  It is far more difficult to strip away real property interests such as covenants that run with the land.  This precise issue has arisen in the chapter 11 proceedings of Quicksilver Resources, which is pending in the District of Delaware, and a decision in that case from U.S. Bankruptcy Judge Laurie Silverstein is expected very shortly.

A number of factors make clear, however, that Judge Chapman’s decision will not, in and of itself, lead to a cascade of E&P companies seeking to reject midstream agreements with G&P companies. First and foremost, as the opinion itself demonstrates, the resolution of these questions is highly dependent on the facts of each individual case.  For example, Judge Chapman noted that Sabine only granted rights to the G&P companies in hydrocarbons after they were extracted from the ground and were thus personal property under Texas law.  Had the G&P companies in Sabine been granted rights to minerals in the ground, they would have constituted an interest in real property, and the outcome could very well have been different under Judge Chapman’s analysis.

Next, while Judge Chapman’s opinion will undoubtedly be persuasive, it will not be binding on any other court, even in the Southern District of New York. Judge Silverstein will shortly be rendering her decision in Quicksilver, and bankruptcy courts in Texas will almost certainly soon be weighing in on this topic.  Some of these decisions are certain to be appealed, setting up a process that will take two or three years, at a minimum, to play out in full.  Ultimately, it is not unreasonable to expect that a federal court of appeals will certify this question to the Texas Supreme Court for resolution.  The laws of different states are certain to be implicated in other cases as well.

Many industry observers are justifiably concerned over the prospects of G&P companies in the wake of the severe economic distress facing E&P companies, and whether other troubled E&P enterprises will similarly seek to jettison pipeline arrangements and other types of midstream agreements in bankruptcy.  However, Judge Chapman’s opinion will not in and of itself be a game-changer regarding the rights of G&P companies.  It is, rather, the first salvo in what could be a protracted battle among E&P companies and G&P transporters, and ultimately probably downstream refiners as well (and their accompanying lenders, creditors and investors) regarding the allocation of the ongoing economic pain stemming from historically low prices for oil and gas.  Many similar encounters lie ahead.

Delaware Bankruptcy Judge Rejects Effort to Circumvent Supreme Court’s Asarco Decision

The Supreme Court’s decision last term in Baker Botts v. Asarco, in which the Court ruled that professionals that are paid from a debtor’s bankruptcy estate cannot be compensated for time spent defending their fee applications, continues to rankle bankruptcy practitioners.  Moreover, a recent decision in a Delaware bankruptcy case shows that the impact of Asarco will not be easily circumvented.

Attorneys and other advisors retained by a debtor, a trustee or an official creditors’ committee are known as “estate professionals,” because their retention in each case must be approved by the bankruptcy court, and their fees and expenses are paid out of the debtor’s bankruptcy estate and are subject to review and approval pursuant to Section 330 of the Bankruptcy Code.  Section 330(a)(1) of the Bankruptcy Code states, “After notice to the parties in interest and . . . a hearing . . . the court may award to . . . a professional person . . . reasonable compensation for actual, necessary services . . . .”

In Asarco, the law firm of Baker Botts was retained to represent the debtor in its chapter 11 bankruptcy case. During the case, Baker Botts sued Asarco’s parent company to recover improperly transferred assets, and won a huge recovery for the benefit of Asarco’s creditors. At the end of the chapter 11 case Baker Botts applied to the bankruptcy court for final approval of $120 million in fees and expenses, plus a performance bonus of $4.1 million.  Asarco, which wound up back under the control of its parent company after all of its creditors were paid in full, objected to Baker Botts’ fee application.  Following a multi-day trial, the bankruptcy court approved Baker Botts’ requested fees and also awarded it over $5 million to cover the costs incurred in defense of those fees. The Fifth Circuit reversed the award of fees for defending fees, and the Supreme Court upheld that reversal.

The Court’s analysis was straight-forward: under American jurisprudence, each side in a litigated dispute bears its own attorneys’ fees, unless there is an applicable statute or agreement that provides otherwise.  In the Court’s view, the plain text of Section 330(a) does not support a deviation from the “American Rule” regarding attorneys’ fees.  Citing to Webster’s New International Dictionary, the Court’s majority stated, “The word ‘services’ ordinarily refers to ‘labor performed for another.’”  Since Baker Botts was litigating to defend its own fees, the Court reasoned, it was not providing an “actual, necessary service” to the bankruptcy estate and therefore was not entitle to compensation for such time.

As many commentators have noted, the implications of Asarco in chapter 11 cases going forward could be substantial.  The requirement of bankruptcy court approval for all fees paid to estate professionals helps to maintain the fairness and integrity of the bankruptcy process, and is accepted as an inconvenient but necessary requirement by law firms and other professional firms that undertake such work.  That fees may only be allowed after a “hearing” necessarily implicates a contested process, and challenges from other parties have always been a recognized hazard for such firms.  A prohibition on compensation for costs incurred in fee disputes places estate professionals at a clear disadvantage.

Two weeks ago, Judge Mary Walrath, a well-regarded jurist in the influential Delaware bankruptcy court, denied an effort in the Boomerang Tube chapter 11 case to work around Asarco contractually.  Judge Walrath, in a carefully considered decision, makes her view clear that Asarco imposes a broad prohibition on fee-shifting into the Bankruptcy Code, one that estate professionals may not sidestep by contract.

Boomerang Tube filed for bankruptcy under chapter 11 last June. A short time thereafter, and right after the Asarco decision was handed down, the U.S. Trustee for the District of Delaware (a representative of the U.S. Department of Justice) appointed an official committee of unsecured creditors (the “Committee”), and the Committee selected Brown Rudnick LLP to represent it.

Brown Rudnick’s effort to render Asarco inapplicable to its applications for payment in Boomerang Tube was straight-forward.  In its motion to Judge Walrath to be approved as Committee counsel, the firm asked for the approval order to include a provision that would entitle it to be compensated from Boomerang Tube’s bankruptcy estate for any fees, costs or expenses incurred in defending its fees against any challenges.  In support of this provision, Brown Rudnick contended that Section 328 of the Bankruptcy Code allows for the retention of estate professionals “on any reasonable terms and conditions.” It further argued that Asarco had ruled only that Section 330 did not create an exception to the American Rule against fee shifting, and that the Supreme Court had noted that parties could and regularly did contract around the American Rule.  The U.S. Trustee objected, and Judge Walrath approved Brown Rudnick’s retention while reserving judgment on the fee defense provision.

The U.S. Trustee took issue with Brown Rudnick’s narrow interpretation of Asarco, and argued that estate professionals could not use Section 328’s retention provisions to avoid Section 330’s prohibition on fee shifting.  He further argued that fee defense provisions are not “reasonable” and cannot be approved under Section 328.

After requesting further briefing, Judge Walrath carefully weighed the arguments before coming down unequivocally on the side of the U.S Trustee on each one.

Judge Walrath first determined that Section 328 did not by itself create an exception to the American Rule, as it makes no mention of awarding fees or costs in the context of an adversarial proceeding. She noted by contrast that several discrete Bankruptcy Code provisions do contain express language providing for payment of fees to a prevailing party, and concluded that the absence of such express language was evidence of Congressional intent not to create an exception to the American Rule in Section 328.

She next considered Brown Rudnick’s argument that nothing in Section 328 prevented the Committee and Brown Rudnick from agreeing contractually in Brown Rudnick’s retention agreement for the payment of defense fees. She agreed that Section 328 contained no such prohibition, but rejected the argument that the retention agreement could, by itself, effect an exception to the American Rule, because in the end it would be Boomerang Tube’s bankruptcy estate, a non-party to the retention agreement, that would bear the costs.

Finally, Judge Walrath agreed with the U.S. Trustee’s argument that fee shifting provisions are not “reasonable” within the meaning of Section 328. Brown Rudnick contended that such provisions should be viewed as similar to the type of exculpation and indemnification provisions that are typically approved under Section 328 in retention agreements for investment bankers and financial advisors.  Judge Walrath found the analogy unpersuasive.  She noted that indemnification provisions are routine for investment bankers outside of bankruptcy, whereas lawyers are not commonly entitled to reimbursement for the costs of defending their fees.

Judge Walrath concluded her opinion by expressly warning other professionals not to parse her decision to find other possible ways to avoid Asarco: “Such provisions are not statutory or contractual exceptions to the American Rule and are not reasonable terms of employment of professionals.”

Judge Walrath’s decision in Boomerang Tube will undoubtedly be cited and followed by many other judges, but it will not resolve the issue.  Threats to contest estate professionals’ fees are an ingrained part of the hard-nosed negotiating process that is the hallmark of chapter 11 practice.  It is therefore inevitable that law firms will be making similar attempts to protect themselves in other districts.  As her opinion shows, these are not easy questions, and the strong likelihood is that there will be some courts that come out the other way.  This issue will probably come before the Supreme Court again.

Were the Energy Future Holdings and Caesars Chapter 11 Cases Just Saved by K Street Lobbyists?

Bankruptcy and restructuring professionals usually do not need to be political junkies. Amendments to the Bankruptcy Code, and the accompanying machinations of the Congressional legislative process, typically occur at a glacial pace, and such changes nearly always affect future rather than current chapter 11 cases.  However, the federal tax and spending bill approved by Congress earlier this month, passed in the usual whirlwind of year-end activity and horse trading, nearly derailed the pending reorganizations of two of the largest chapter 11 cases ever filed, Energy Future Holdings Corp. (“EFH”) and Caesars Entertainment Operating Company (“Caesars”).  (Kelley Drye & Warren LLP represents creditors of both EFH and Caesars, but has had no involvement in the matters discussed here.)

The bill initially contained language intended to eliminate certain tax advantages of real estate investment trusts (“REITs”).  Such structures are central components of the chapter 11 plans for both enterprises.  Had the bill passed with the language unmodified, it could have been devastating for both companies.  The blow would have been particularly keen for EFH, which only a few days earlier had succeeded in getting its plan of reorganization confirmed, following months of work by an army of bankruptcy professionals and a multi-day hearing.  The proposed REIT limitation language could have prevented the plan from ever becoming effective.

REITs are entities designed to hold real estate assets and provide investors with numerous tax breaks.  The EFH plan is centered around an unusual strategy of permitting certain creditors to invest in a new REIT structure to take control of EFH’s public utility assets, an approach projected to attract enough new capital to pay most of EFH’s remaining creditors in full immediately upon the effectiveness of the Plan.  Although the Caesars case remains mired in contentiousness and is at best several months away from having a plan confirmed, all plans proposed to date in Caesars have similarly been centered on transferring various hotel and casino properties to a REIT structure.

In recent years, a number of companies with substantial real estate assets, such as Sears and Darden Restaurants (owner of the Olive Garden chain), have transferred those assets into REITs and then leased them back, moves that have resulted in aggregate tax savings of over $21 billion. Certain members of Congress view these types of transactions as an abuse of the REIT structure, and inserted provisions in the tax and spending bill designed to curb them.

The REIT limitation language was contained in the initial version of the tax and spending bill that was released on December 7. It is unlikely that more than a handful, if any, of the bankruptcy professionals in the EFH and Caesars cases were aware of the threat posed by the tax and spending bill (and a review of bankruptcy-related news services turns up no mention of the REIT limitation proposal), but business persons at both EFH and Caesars spotted the danger.  Lobbyists for both companies immediately began pressing the case that any changes to the tax benefits of REITs should be prospective only, as it would have a huge negative impact on several companies to disrupt deals that had already been announced.  A crucial ally was found in Sen. Harry Reid of Nevada, a state heavily reliant on the strength of the gaming industry and therefore the continued viability of Caesars.

Sen. Reid also sought unsuccessfully to help Caesars by adding language to the tax and spending bill which would have amended another federal statute, the Trust Indenture Act (“TIA”).  The proposed TIA change was intended to defuse a litigation threat to Caesars, but it drew significant opposition from numerous financial institutions, hedge funds and academics, and was removed.  Withdrawing the proposed TIA amendment language may have given Sen. Reid a bargaining chip to push through the necessary protective fix with respect to the REIT proposal.  In any event, by the time the bill made it to President Obama’s desk for signature on December 18, an additional fifty-four words that insulated EFH and Caesars had been inserted to the language governing the REIT changes:

The amendments made by this section shall apply to distributions on or after December 7, 2015, but shall not apply to any distribution pursuant to a transaction described in a ruling request initially submitted to the Internal Revenue Service on or before such date, which request has not been withdrawn and with respect to which a ruling has not been issued or denied in its entirety as of such date.

The threat to the REIT transactions for EFH and Caesars was averted and, for EFH creditors especially, it remained a merry Christmas.

GM Judge Nuances His Earlier Rulings and Sets Out Permissible Ignition Switch Lawsuits

At a hearing in late August, Judge Robert Gerber expressed his annoyance with both sides in the ongoing battle to determine whether General Motors LLC (“New GM”), the entity formed in 2009 to acquire the assets of General Motors Corporation (“Old GM”), is shielded from lawsuits based on ignition switch defects in cars manufactured prior to New GM’s acquisition of the assets of Old GM in 2009. He chastised the parties for being “insufficiently nuanced” in their interpretations of his decisions earlier this year on the extent to which New GM could face liability for economic damages stemming from the defects, which allegedly caused numerous deaths and injuries, and which were known by employees of Old GM but were not properly reported (or may have been deliberately covered up).

Not surprisingly, a lengthy opinion issued by Judge Gerber last week on two crucial ancillary issues – could knowledge of Old GM regarding the scope of the ignition switch defects be attributed to New GM, and, relatedly, whether New GM is liable for punitive as well as compensatory damages – was an exemplar of nuance.  Judge Gerber finely parsed those questions and made subtle but meaningful distinctions between Old GM actions, which cannot be a basis for New GM liability, and knowledge of Old GM that became knowledge of New GM under principles of imputation and for which New GM could be liable.  (Kelley Drye & Warren LLP represents certain major creditors of Old GM but has had no role in these proceedings.)

As widely reported, Judge Gerber previously ruled that most of the lawsuits against New GM are barred by the provisions of the Sale Order he entered at that time, which transferred the assets to New GM “free and clear” of claims against Old GM (other than a narrow range of expressly assumed liabilities) and protected New GM from any claims based on theories of successor liability.  However, he also held that New GM could not claim protection under the Sale Order against liabilities based solely on its own post-sale conduct, and said that he would permit lawsuits in other courts based on such allegations against New GM to move forward.  The August hearing was held to determine which of the pending actions satisfied Judge Gerber’s requirement of being independent claims against New GM.

At the end of that hearing, Judge Gerber directed counsel for New GM to submit to him marked copies of the complaints in the pending lawsuits, showing specifically which causes of action New GM believes are grounded in the behavior of Old GM and should be barred by the Sale Order. He also requested briefs with regard to the issues of imputation of knowledge and punitive damages.  Judge Gerber was determined, as he put it at a subsequent hearing in October, to fulfill the role of “gatekeeper” in terms of construing the Sale Order and his opinions from earlier this year, and to decide once and for all (albeit subject to appeals) the types of claims which could get past the “bankruptcy gate” and proceed in other courts.

Judge Gerber made clear during the October hearing just how narrow a needle’s eye he intended to thread.  He stated that he would have no tolerance for causes of action based on theories of successor liability, no matter how they might be “dressed up” to resemble something different.  On the other hand, he also said that independent claims against New GM could be based on “inherited” knowledge.  The distinction would depend on the specificity of the allegations of knowledge and the rules governing imputation under the state law governing each specific action.

Thus, for example, Judge Gerber ruled in last week’s opinion that any causes of actions referring to New GM as a “mere continuation” of Old GM, or that elided the distinctions between Old GM and New GM, would be barred as grounded in successor liability.  Claims stating that “New GM knew,” however, would be permitted to go forward and satisfy a high but by no means impossible standard:

[P]laintiffs will have to prove the New GM knowledge they allege, on the part of identified human beings, and by identified documents to the satisfaction of . . . any . . . court hearing those claims – and by competent proof, not on theories that New GM was a “successor” to Old GM.

Judge Gerber applied a similar analysis to the issue of punitive damages. While making clear that punitive damages could not be based on the knowledge or conduct of Old GM, “or anything else that took place at Old GM[,]” and had to be based on “New GM knowledge and conduct alone[,]” he nevertheless also ruled that “New GM might have acquired relevant knowledge when former Old GM employees came over to New GM or New GM took custody of what previously were Old GM records.”  But the plaintiffs would need to show that such knowledge was “acquired in fact, and not by operation of law (such as any kind of successorship theory).”

Judge Gerber emphasized that imputation and punitive damages were ultimately matters to be determined under applicable nonbankruptcy law, and that he was not making any substantive rulings on these issues:

[The Court] has ruled simply that allegations of imputation to New GM premised on the knowledge of New GM employees, or documents in New GM’s files, get through the bankruptcy gate. After that, issues as to the propriety of imputation in particular contexts in particular cases are up to the judges hearing those cases.

It was clear from Judge Gerber’s earlier rulings that New GM would be required to defend itself in lawsuits that seek damages based solely on New GM’s post-sale actions and conduct, and the fact that such claims would possibly involve automobiles or parts manufactured by Old GM would not provide New GM with a shield under the Sale Order. Last week’s decision splits innumerable hairs, but delineates the extent to which the Sale Order protects New GM and the hurdles that the plaintiffs will need to clear to the satisfaction of other judges in order to get their claims past the bankruptcy “gate.”

Energy Future Holdings – Kicking a Very Large Can Down the Road

Energy Future Holdings (“EFH” or “Debtors”) has cleared all of the preliminary hurdles in its path as it moves towards the confirmation of its plan of reorganization (the “Plan”). Last week Judge Christopher Sontchi of the United States Bankruptcy Court for the District of Delaware approved the Debtors’ disclosure statement in support of the Plan, authorized the Plan to be distributed to creditors for voting purposes, and scheduled the hearing on Plan confirmation to begin on November 3. In view of the complexity and contentiousness of these cases, bringing them to the verge of completion in less than eighteen months is a notable achievement for EFH and its professionals.

The final step, however, will be by far the toughest. EFH has reached this point mainly by successfully deferring the battle on certain crucial issues. In order to gain Judge Sontchi’s approval of the Plan and overcome the strong objections of key parties, EFH will need to show, among other things, that the Plan is “feasible,” and that under its terms many of its largest creditors will be “unimpaired.” These requirements will be the focal point of a proceeding that, absent an unexpected settlement, is expected to take several weeks. (Kelley Drye & Warren LLP represents certain creditors in the EFH cases, but will not be taking any position on the issues discussed here.)

EFH entered bankruptcy in April 2014 with over $42 billion in claims, and for most of the time since then these cases have looked to be among the most intractable ever filed. The Debtors’ business operations are divided into two distinct silos: a majority interest in a regulated electrical utility, Oncor, indirectly owned by EFH subsidiary Energy Future Intermediate Holding Company LLC (the so-called “E side” of EFH), and non-regulated electricity generation, mining, and commodity risk management and trading operations, indirectly owned by EFH subsidiary Texas Competitive Holdings Company LLC (the so-called “T side” of EFH). For the first year of these cases, EFH had the support of its E side creditors, who stood to see a substantial recovery from a proposed sale of the Oncor interests, but was facing intense opposition from junior creditors on the T side, who appeared to be out of the money.

Over the past summer, however, the T side creditors began to coalesce around a bold strategy to backstop a real estate investment trust (“REIT”) structure to take control of the Oncor assets, an approach projected to attract enough new capital to pay all E side creditors in full in cash immediately upon the effectiveness of the Plan. Such treatment of the E side creditors would render them “unimpaired” under section 1124 of the Bankruptcy Code, meaning that the Plan would not alter their “legal, equitable and contractual rights.” Unimpaired creditors are presumed to support a plan of reorganization and are not entitled to vote to approve or reject it.

The E side creditors, however, are attacking such characterization of their treatment. They contend that the Plan will not in fact pay all of their claims in full, and therefore that they are “impaired” creditors and entitled to vote. The E side creditors also believe that the Oncor sale process, which they view as a far more certain path towards getting repaid, was abandoned too soon, and have asserted that the REIT structure contemplated by the Plan has too many contingencies to succeed. This is another fundamental objection, as under the Bankruptcy Code Judge Sontchi must expressly determine that the Plan is “feasible.” In view of the numerous approvals which must be obtained from regulators and the IRS, and the billions of dollars of new capital which needs to be raised in a volatile financial environment, the E side creditors intend to show during the Plan confirmation hearing that the Debtors cannot demonstrate a sufficient likelihood that the Plan will ever become effective, and that it is the E side creditors who will bear all the economic risk if the REIT structure does not succeed.

Judge Sontchi has so far been supportive of EFH’s approach, and has approved the disclosure statement and other key agreements while deferring the major substantive objections to the Plan. He has made clear, however, that when the time comes he will be holding the Debtors’ feet to the fire. One argument made by the E side creditors against their supposed non-impairment under the Plan, for example, has been that it does not pay interest accrued on their billions of dollars in claims at the rates set forth in the underlying contracts or indentures, but instead proposes to pay at the much lower federal funds rate. Judge Sontchi has noted the importance of this issue, observing that EFH has placed “all of its eggs in the ‘unimpairment’ basket,” and has expressly warned EFH not to “get cute.”

In a similar vein, earlier this week he turned aside a request from certain E side creditors to postpone the start of the confirmation hearing until after Thanksgiving. This stemmed from a change in the Plan made immediately prior to the disclosure statement hearing, in which EFH suggested that, rather than paying certain E side unsecured note claims in cash, it instead may “reinstate” those claims under the Plan, with the note obligations being assumed by the reorganized T side companies. Technically, reinstatement can be one way to treat claims as “unimpaired,” and the Debtors contend that it is expressly permitted under the indenture governing the notes. However, while Judge Sontchi denied the requested delay, he appeared to agree that such reinstatement raises substantial questions about the future financial condition of the reorganized companies that payment in cash would not, and suggested that the Debtors were being somewhat “disingenuous” in trying to equate the two.

EFH has come this far in large part by convincing Judge Sontchi to push off several contentious and complex issues. Those issues must now finally be confronted. Although it is possible that the Debtors will manage to settle with the objecting E side creditors and avoid a lengthy and adversarial confirmation hearing, the one certainty here is that there is no more road down which the Debtors can kick what has become a very large can.

Energy Future Holdings – Another Major Success for Chapter 11 Mediation?

Mediation has become an invaluable tool in large chapter 11 cases. Traditionally viewed as a means for resolving discrete disputes between a debtor’s estate and an adversary party, in recent years mediation in certain complex cases has evolved into a multi-party undertaking involving claimants from all levels of a debtor’s capital structure, with the ambitious goal of resolving the entire case through a consensual plan of reorganization.

Recent examples include Residential Capital, LLC and Cengage Learning, Inc. These cases illuminate the primary benefits of mediation: the potential to expedite the plan process through a mediator’s assistance which can save both the estate and creditors from incurring enormous fees related to litigation, and a mediator’s ability to help parties craft unique solutions which would not be available through litigation. This year, over the past few months, mediation has led to a possible exit path in Energy Future Holdings Corp. (“EFH”), one of the most seemingly intractable chapter 11 cases ever filed. Although numerous hurdles remain for EFH and opposition from certain key parties remains, the mediation process in that case has led to a structure that could permit a consensual plan of reorganization to be confirmed by the end of 2015. (Kelley Drye & Warren LLP represents certain creditors in the EFH cases, but has had no role in the mediation process.)

EFH arose out of one of the largest leveraged buyouts ever undertaken. Falling natural gas prices upended all of the financial assumptions on which its capital structure was based, and when it filed for chapter 11 in spring 2014 its total debt exceeded $42 billion. Its business operations are divided into two distinct silos: a majority interest in a regulated electrical utility, Oncor, indirectly owned by EFH subsidiary Energy Future Intermediate Holding Company LLC (the so-called “E side” of EFH), and non-regulated electricity generation, mining, and commodity risk management and trading operations, indirectly owned by EFH subsidiary Texas Competitive Holdings Company LLC (the so-called “T side” of EFH). A sale process earlier in the case that was being undertaken for the Oncor interest suggested that the E side creditors would see substantial recoveries; however, it was clear from the outset that there would be insufficient value on the T side to provide recoveries to any but the most senior creditors.

The array of disputes complicating the cases has been substantial. Junior creditors on the T side have sought standing to commence litigation against the senior T side lenders arising from the leveraged buyout and subsequent refinancings. There has been extensive litigation over make-whole premiums. Conflicts of interest between the T side and the E side have necessitated detailed corporate governance protocols and the retention of numerous other professional advisors. In addition, there are difficult and highly technical issues arising from the EFH’s tax structure and the potential disposition of its subsidiaries’ assets, which threaten to impose multi-billion dollar tax liabilities on the EFH estates.

A mediation process was initiated earlier this year in an effort to resolve the intercreditor T side disputes. After several weeks, however, it became clear by statements being made in open court that the process had overrun its boundaries and had led to much more comprehensive discussions regarding overall case resolution. A seemingly pie-in-the-sky idea to create a real estate investment trust (“REIT”) structure to take control of the Oncor assets began to appear viable, and the junior T side creditors who had been prepared to prosecute a campaign of scorched earth litigation began instead to negotiate the terms under which they would agree to backstop it. When it became clear that a plan of reorganization based on the REIT structure could (i) garner support from all levels of the T side capital structure, and (ii) generate sufficient value to pay all E side creditors in full, EFH agreed to discontinue the Oncor sale process and to put forward a plan based on the terms reached with and among the T side creditors during the course of the mediation.

The REIT-based plan will not be easy to implement. Approvals must be obtained from Texas state regulators and the IRS, and billions of dollars of new capital need to be raised in a volatile financial environment. The E side creditors’ committee and other major E side creditors are opposed, believing that the Oncor sale process was abandoned too soon, that the REIT plan is not feasible, and that it will be the E side creditors who will bear all the economic risk if the REIT plan does not succeed.

Notwithstanding, the fact that the EFH chapter 11 cases have moved in a relatively short period of time from being poised for months (if not years) of contentious litigation, to being on the verge of a consensual plan that can obviate opposition by being able to pay the claims of non-consenting creditors in full, stands as a strong testament to the broad possibilities of bankruptcy mediation. If ultimately successful, the resolution achieved in EFH will likely cement the role of mediation in virtually all “mega” chapter 11 cases going forward.

Energy Future Holdings – More Bad News for Bondholders on Make-Whole Premiums

For the second time in the past few months, Judge Christopher Sontchi has dashed the hopes of certain creditors in the Energy Future Holdings (“EFH”) chapter 11 case that they would be paid a make-whole premium worth over $400 million.

Make-whole premiums are often used in connection with the issuance of debt in order to protect noteholders with long term investment horizons from being repaid early. At the time of the bankruptcy filing of EFH in April 2014, certain of the EFH debtors were obligated under a series of 10% First Lien Notes (the “Notes”) issued by EFH subsidiary Energy Future Intermediate Holding Company (“EFIH”). Under the indenture governing the Notes (the “Indenture”), EFIH’s bankruptcy filing caused the automatic acceleration of the Notes. Shortly after the filing, EFIH sought approval of debtor-in-possession financing, in part to repay all principal and accrued interest under the Notes with less expensive debt. The indenture trustee for the noteholders (the “Trustee”) objected, contending that the repayment by EFIH constituted an “Optional Redemption” under the Indenture, and that such a redemption gave rise to a secured claim under the Indenture for the make-whole premium. EFIH argued in response that no Optional Redemption had occurred because of the automatic acceleration under the Indenture. Once the acceleration occurred the Notes were due and owing, such that the repayment of the Notes could not constitute an Optional Redemption. Judge Sontchi overruled the Trustee’s objection without prejudice and permitted EFIH to make the repayment in June 2014, while reserving the Trustee’s right to continue to seek the make-whole premium. (Kelley Drye & Warren LLP represents certain creditors in the EFH cases, but has had no role in these proceedings.)

In March of this year, Judge Sontchi, following the reasoning of a similar decision involving a make-whole premium in the Southern District of New York case of MPM Silicones, LLC, et al. (“Momentive”), agreed with EFH and EFIH, holding that due to the automatic acceleration, the repayment of the Notes in June 2014 did not constitute an Optional Redemption, and that EFIH therefore had no obligation to pay a make-whole premium.

This did not fully resolve the issue, however. The Trustee contended that even if the automatic acceleration could eliminate the EFIH’s obligation to pay the make-whole premium, under the Indenture the Trustee had the right to deliver, and in June 2014 in fact did deliver, a notice that rescinded the automatic acceleration (the “Rescission Notice”). The EFH and EFIH responded that the Rescission Notice was null and void by virtue of the automatic stay under section 362 of the Bankruptcy Code. (Upon the commencement of a bankruptcy case, section 362(a) expressly stays, among other things, “any act to collect, assess, or recover a claim against the debtor . . . .”) In his March opinion, Judge Sontchi noted that under section 362(d) of the Bankruptcy Code, the automatic stay can be lifted for “cause”, and he further ruled that the Trustee was entitled to a separate hearing in order to seek to show that “cause” existed to lift the automatic stay retroactively. Judge Sontchi acknowledged that if “cause” existed to lift the automatic stay effective as of June 2014, it would effectively resuscitate the Rescission Notice and thereby trigger the right to payment of the make-whole premium.

Although Judge Sontchi left a door open for the Trustee and the noteholders in March, it has now been slammed shut. After holding an evidentiary hearing in April, Judge Sontchi, again following a similar ruling in Momentive, has now ruled that the Trustee failed to make its showing. In an opinion issued last week, Judge Sontchi rejected the Trustee’s arguments for lifting the automatic stay.

Under applicable Third Circuit precedents, the factors for assessing whether “cause” exists to lift the automatic stay in any particular case are: (1) whether any great prejudice would result to the debtor; (2) whether the hardship to the creditor seeking relief from the automatic stay “considerably outweighs” the hardship to the debtor; and (3) the probability of the creditor prevailing on the merits.

Judge Sontchi first rejected the Trustee’s argument that “cause” existed because EFIH was presumed for purposes of these proceedings to be solvent, and therefore no prejudice would result to the debtor or its bankruptcy estate. In what will probably be the most commented on portion of the opinion, he held that in determining harm to a debtor’s estate from lifting the automatic stay, the interests of equity holders must be considered. “While equity lies at the bottom of the waterfall of priorities under the Bankruptcy Code, its interests cannot and should not be ignored. Equity may be structurally subordinate to the creditors but it is not a second class citizen in a debtor’s capital structure.” Judge Sontchi noted that the impact of the make-whole premium would be $431 million, and found “great prejudice” to EFIH “[r]egardless of those amounts are going to creditors, equity or creditors of equity[.]”

He then examined whether the harm to the noteholders from maintaining the automatic stay would “considerably outweigh” the harm to the debtors from lifting the stay. Observing that the harm that would result to either side was effectively the same – the estimated $431 million make-whole premium, he held that “the harms . . . are, in the best case for the Trustee, in equipoise[.]” Because in this instance the harm to both sides would be equal (i.e., the harm to either side would be either the payment or non-payment of the amount of the make-whole premium), Judge Sontchi held that the Trustee could not meet its burden of showing that the harm of maintaining the automatic stay would “considerably outweigh” the harm to EFIH.

Judge Sontchi did find that the final prong favored the Trustee, as the lifting of the stay to permit the delivery of the Rescission Notice would mean that the payment by EFIH constituted an Optional Redemption and give rise to the noteholders’ right to receive the make-whole premium. That was not enough, however, based on his analysis of the other two factors for weighing the existence of “cause,” to warrant the lifting of the automatic stay.

Disputes over the payment of make-whole premiums have loomed large in major chapter 11 cases the past few years, as debtors have looked to take advantage of the current low interest rate environment to reduce or eliminate more expensive debt. Judge Sontchi’s decisions in March and last week, together with the rulings in Momentive, make clear that only clear and express language in the applicable debt documents will serve to support a claim for such payments, and that the automatic acceleration of debt due to bankruptcy cannot be undone for purposes of imposing make-whole premium liability on debtors.

Baker Botts v. Asarco: The Supreme Court Shows Again That It Really Doesn’t Understand Corporate Bankruptcy Cases

The Supreme Court has not handled its recent major bankruptcy decisions well. The jurisdictional confusion engendered by its 2011 decision in Stern v. Marshall was only partially clarified by this term’s opinion in Wellness International Network v. Sharif. The Court’s ruling this week in Baker Botts v. Asarco, while narrower, stands as another example of obtuse judicial reasoning that will create unnecessary problems for practitioners and bankruptcy court judges.

The law firm of Baker Botts was retained to represent Asarco in its chapter 11 bankruptcy case. During the case, Baker Botts sued Asarco’s parent company to recover improperly transferred assets, and won a huge recovery for the benefit of Asarco’s creditors. At the end of the chapter 11 case Baker Botts, as the Bankruptcy Code requires for all professional firms that represent debtors or official committees, applied to the bankruptcy court for final approval of $120 million in fees and expenses, plus a performance bonus of $4.1 million. Asarco, which wound up back under the control of its parent company after all of its creditors were paid in full, objected to Baker Botts’ fee application. Following a multi-day trial, the bankruptcy court approved Baker Botts’ requested fees and also awarded it over $5 million to cover the costs incurred in defense of those fees. The Fifth Circuit reversed the award of fees for defending fees, and the Supreme Court upheld that reversal.

The Court’s analysis was straight-forward: under American jurisprudence, each side in a litigated dispute bears its own attorneys’ fees, unless there is an applicable statute or agreement that provides otherwise. Section 330(a)(1) of the Bankruptcy Code states, “After notice to the parties in interest and . . . a hearing . . . the court may award to . . . a professional person . . . reasonable compensation for actual, necessary services . . . .” In the Court’s view, the plain text of the statute does not support a deviation from the “American Rule” regarding attorneys’ fees. Citing to Webster’s New International Dictionary, the Court’s majority stated, “The word ‘services’ ordinarily refers to ‘labor performed for another.’” Since Baker Botts was litigating to defend its own fees, the Court reasoned, it was not providing an “actual, necessary service” to the bankruptcy estate and therefore was not entitle to compensation for such time.

The problem with this analysis is that the statutory language of Section 330(a) of the Bankruptcy Code is nowhere near as unambiguous as the majority read it. Unsurprisingly, the dissent offered an equally plausible alternative reading, focusing on the words “reasonable compensation.” Although the work undertaken by a law firm defending its fees may not be a “service,” in the dissent’s view, “[t]he statute permits compensation for fee-defense work as a part of compensation for the underlying services in a bankruptcy proceeding” – not for the “service” of defending the fee application. The dissent noted that Section 330(a)(6) expressly contemplates that compensation should be awarded for preparing a fee application. It reasoned that if compensation should be awarded for the preparation of a fee application, then time spent in defending the application should also be compensable.

While this may all seem to be an academic debate, the implications in chapter 11 cases could be substantial. The requirement of bankruptcy court approval for all fees paid by the bankruptcy estate to professionals employed by a debtor, a trustee or an official committee helps to maintain the fairness and integrity of the bankruptcy process, and is accepted as an inconvenient but necessary requirement by law firms and other professional firms that undertake such work. That fees may only be allowed after a “hearing” necessarily implicates a contested process, and challenges from other parties have always been a recognized hazard for such firms. Indeed, threats to contest professionals’ fees are an ingrained part of the hard-nosed negotiating process that is the hallmark of corporate restructuring practice. The common view, reflected in the vast proportion of lower court decisions, has long been that “reasonable compensation” should be provided for responding to such challenges. In other words, the dissent’s reading of Section 330(a) is more consistent with both the understanding of most bankruptcy practitioners and basic fairness.

The majority opinion needlessly ignores the realities of large corporate bankruptcy cases and long-standing commercial practice. By determining that compensation cannot be given for defending fee applications, the Court’s ruling in Baker Botts v. Asarco will invariably encourage more litigation challenges to the allowance of professional fees, and increase the costs and time necessary to wind down chapter 11 bankruptcy estates.

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