Energy Future Holdings (EFH), f/k/a TXU Corp., an energy company centered in Texas, was taken private in 2007 in the largest leveraged buyout transaction that has ever taken place. The deal was largely predicated on an anticipated rise in natural gas prices; when prices instead plummeted the company, which had borrowed nearly $40 billion, was left with a massively unbalanced capital structure. The chapter 11 cases of EFH and its subsidiaries commenced earlier this year have been proportionately contentious and complex. (Kelley Drye & Warren LLP represents a creditor of certain EFH subsidiaries, but has taken no part in the matters discussed here).
EFH conducts business through two separate holding companies. Through its subsidiary Energy Future Intermediate Holding Company LLC (EFIH), it owns an 80% interest in Oncor, a regulated electricity transmission and distribution company. Through its indirect subsidiary Texas Competitive Electric Holdings Company LLC (TCEH), it engages in competitive energy market activities, including electricity generation, wholesale and retail electricity sales, and commodity trading.
Allocating the enterprise value of EFH and its subsidiaries among its numerous creditor constituencies would be difficult enough under normal circumstances, given the amount of debt and the intricacies of the capital structure. Increasing the difficulty factor of these cases even further has been the overhang of billions of dollars of potential tax liabilities due to the structuring of the leverage buyout. Developing a reorganization plan that will not trigger such liabilities has been the among the fundamental challenges facing EFH, its secured and unsecured creditors, and its private equity sponsors.
The attempt to thread the needle through federal tax law and the requisite IRS guidelines, however, could wind up benefitting certain EFH affiliates at the expense of others. The EFH cases highlight certain pitfalls for fiduciaries of large business enterprises where significant potential conflicts exist among individual members of the corporate structure.
Prior to the commencement of the chapter 11 cases, EFH entered into a restructuring support agreement (RSA), intended to be effectuated through a bankruptcy plan of reorganization, with certain EFIH secured and unsecured creditors and TCEH first lien secured creditors. The RSA contemplated a tax-free spin-off of TCEH to its first lien creditors and a recapitalization of EFIH’s debt, but provided no recovery for second lien and unsecured creditors of TCEH.
Unsurprisingly, the junior creditors of TCEH have sought from the beginning of the cases to protect the interests of the so-called “T side” of the EFH capital structure. Even the first day motion seeking procedural consolidation of the numerous proceedings of EFH and its subsidiaries – a routine ministerial request in virtually all other cases – gave rise to an objection. The junior “T side” creditors have consistently raised the argument that EFH’s professionals and the overlapping EFH, EFIH and TCEH boards of directors are conflicted, and that no independent fiduciaries are looking out for the interests of the TCEH estate.
Following the receipt of an unsolicited offer from an outside party for a controlling interest in Oncor, an offer that placed a higher value on Oncor than was contemplated under the RSA, EFH announced that it would abandon the RSA and would instead conduct an auction for Oncor. Although this step was favored in principle by most of the parties in the cases, including the junior “T side” creditors, the bidding procedures that were to govern the sale process wound up triggering an intense courtroom battle. In addition to opposing the proposed accelerated time frame for the sale, the junior “T side” creditors argued that the bidding procedures were intended to lock in a tax-free deal structure similar to what was contemplated under the RSA, and that it would be similarly detrimental to their recoveries. They reiterated their contentions that the fiduciary duties owed to the TCEH estate and its creditors were being ignored by EFH, its professionals and its board members.
Judge Christopher Sontchi held an evidentiary hearing that stretched out over four full days in late October and early November. Both sides presented testimony as to what specific actions had been approved by which boards of directors. EFH, EFIH and TCEH denied the conflict allegations, asserting that overlapping boards in large corporate structures are the norm, and that each of their boards had at least one independent director to protect the specific interests of each company’s bankruptcy estate. However, the junior “T side” creditors successfully demonstrated that evidence was lacking to show that the independent directors on any of those boards had actually approved the bidding procedures. As counsel for one of the creditor groups argued in closing, “everyone seemed to say it was approved, but no one could say who actually approved [it].”
Judge Sontchi ultimately ruled that EFH and the other debtors could proceed with the sale process, but offered up some pointed words about what he described as “flawed and insufficient corporate governance.” He directed each of the debtors to take steps to ensure that there would be specific votes taken for each step of the process – the approval of the bidding procedures, the selection of a stalking horse bidder and the sale itself. He also stated that, because of the potential conflicts, these actions must be approved by the independent directors of each company.
EFH is no longer seeking to put the sale process on a fast track. Since the battle over the bidding procedures, activity in the cases has slowed. At a court hearing late in November, EFH counsel announced that settlement conferences to which all the major creditor constituencies were invited have begun taking place. It was also announced that in response to Judge Sontchi’s comments on the bidding procedures, separate counsel had been retained for the independent directors of each of EFH, EFIH, and TCEH.