What Is Collateral in a Bankruptcy Reorganization?

The bankruptcy of Energy Future Holdings has spawned numerous decisions in the various segments of its Chapter 11 case. Yet another such decision was handed down by the U.S. District Court for the District of Delaware in March of this year, in which the court addressed the question of what constitutes collateral, and proceeds of collateral, in a complex Chapter 11 reorganization. The court agreed with the bankruptcy court below that neither the securities issued in the reorganization nor certain other distributions were collateral, raising a cautionary flag for drafters of intercreditor documentation.

Background

In re Energy Future Holdings Corp. (D. Del. March 29, 2018) relates to the reorganization of Texas Competitive Electric Holdings (TCEH), the electricity generation business of Energy Future Holdings. In the reorganization, TCEH transferred its interest in various subsidiaries to a newly formed subsidiary, referred to in the decision as Reorganized TCEH and now known as Vistra Energy. In exchange, TCEH received (i) 100% of the membership interests of Reorganized TCEH, which upon the entity’s conversion into a corporation became common stock, and (ii) the net cash proceeds of newly issued debt of Reorganized TCEH. The decision refers to this corporate choreography as the “internal spin-off transaction.” In addition, Reorganized TCEH transferred certain assets to a new subsidiary for that entity’s common stock and a class of preferred stock. Reorganized TCEH then sold the preferred stock to certain third-party investors, allowing it to realize certain tax benefits.

            The distributions

Under the plan of reorganization, the following were distributed to the first lien creditors of TCEH: (i) all the common stock of Reorganized TCEH, referred to in the decision as the stock distribution; (ii) all cash on the balance sheet of TCEH, including the cash received from Reorganized TCEH, referred to as the cash distribution; and (iii) certain rights to receive payments under a tax receivable agreement (TRA Rights) entered into by Reorganized TCEH. According to the decision, the first lien creditors received approximately 41% of the value of their claims in the reorganization.

The issue was how to whack up the distributions among three different classes of TCEH’s first lien creditors. Each class of first lien creditor had a different interest rate under its respective claims, and depending on the allocation mechanism, one or the other of the classes would receive a larger or smaller piece of the pie.

            The waterfall of the intercreditor agreement

The dispute among the holders of the different types of first lien claims revolved around the formulation of Section 4.1 of an intercreditor agreement among the parties. To appreciate the basis of contention, it is necessary to examine the structure of Section 4.1.

Section 4.1 contained a waterfall, preceded by some all-important introductory provisions. The introduction read in relevant part:

Regardless of any Insolvency or Liquidation Proceeding which has been commenced by or against the Borrower or any other Loan Party, Collateral or any proceeds thereof received in connection with the sale or other disposition of or collection on, such Collateral upon the exercise of remedies under the Security Documents by the Collateral Agent shall be applied in the following order …

The waterfall itself provided for several tiers of recovery, the first being to pay expenses, the second to repay advances made to fund expenses and the third, which is the one of relevance, providing as follows:

… third, on a pro rata basis, to the payment of, without duplication, (a) all principal and other amounts then due and payable in respect of the Secured Obligations … and (b) the payment of Permitted Secured Hedge Amounts then due and payable to any Secured Commodity Hedge Counterparty under any Secured Commodity Hedge and Power Sales Agreement …

The issue was whether the waterfall governed the allocation of distributions among the first lien creditors. If it did, the appellant in the district court case, with a higher rate of interest on its debt and particularly given the impact of the higher rate on post-petition interest,¹ would stand to recover more. According to the court, the swing was approximately $90 million. 

The question in turn depended on (i) whether the introductory portion of Section 4.1 qualified the applicability of the waterfall and (ii) if it did, whether the various distributions made to the first lien creditors constituted collateral or proceeds of collateral. The bankruptcy court held that, yes, the introduction was to be given effect and, no, the distributions were not collateral or its proceeds. Delaware Trust Co., in its capacity as a first lien indenture trustee, appealed to the district court.

The Court’s Analysis

The district court began its analysis with the recitation of the usual principles of contract interpretation applied to indentures under New York law. While the court quoted the full litany of standard interpretive principles, the one with particular relevance to the case was this:

The rules of construction of contracts require us to adopt an interpretation which gives meaning to every provision of a contract or, in the negative, no provision of a contract should be left without force and effect.

The district court rejected the appellant’s contention that the introduction to Section 4.1 should be ignored, with the waterfall governing distributions irrespective of the provisions of the introduction. (The court only weakly hinted at the basis of this position, which on its face seems implausible.) The court then approvingly quoted the bankruptcy court’s framework of analysis, which read into the introduction four conditions precedent to the application of the waterfall:

• Collateral or its proceeds must be distributed to the first lien creditors.
• The collateral must be received by the collateral agent.
• The collateral or its proceeds must have resulted from a sale or other disposition of, or other collections on, the collateral.
• The sale, disposition or collection must be the result of the exercise of remedies under the security documents.

The district court focused only on the first and third of these conditions.  Since these conditions failed, the court did not find it necessary to address the others.   

Were the distributions collateral or proceeds of collateral?

The stock distribution. The court took it as axiomatic that the stock distribution could not be collateral by definition, because it was issued as part of a reorganization. The court also rejected the contention that the stock distribution constituted proceeds of collateral — that is, that the internal spinoff was in effect a “sale or disposition” of collateral. Citing to Judge Drain’s decision in In re MPM Silicones, LLC, 518 B.R. 740 (Bankr. S.D.N.Y. 2014) (Momentive), the court reasoned that the spinoff was most akin to a “standard for debt for equity reorganization,” and not a sale or disposition. While the court conceded that the term “disposition” captures a broader range of transfers than the term “sale,” there was no “disposition” here, as no collateral was transferred to “another’s care or possession.”²

The cash distribution. At least some of the cash may indeed have constituted proceeds, but the appellant here was foiled procedurally. Cash held as of the date of the cash collateral order could be collateral or proceeds, but the appellant failed to specify any portion of the debtor’s cash that constituted cash held as of that date. The appellant also failed to establish that the cash generated after the date of the order was proceeds of collateral, because it was unable to trace the cash as required by Section 552(b) of the Bankruptcy Code. 

TRA Rights. Next, the court addressed the appellant’s argument that the so-called TRA Rights constituted collateral. The argument rested on the tax attributes’ being a form of general tangibles under the security documents. The court rejected this argument as well, because the TRA Rights did not fall within the particular definition of general intangibles contained in the security documents (“contracts, agreement, instruments, and indentures”). 

Adequate protections payments. Finally, the court rejected the argument that adequate protection payments in the case constituted collateral proceeds. The court affirmed the bankruptcy court’s reasoning that adequate protection payments could not themselves be collateral, because their purpose was to protect against any diminution in the value of the collateral.

Was there a “collection” with respect to collateral?

The third condition extracted by the bankruptcy court from the introduction to Section 4.1 required that there be a “sale, disposition or collection” in order for the waterfall to apply. Having established that no sale or disposition of the collateral occurred, the district court was left with a determination of whether there was a “collection” on the collateral. 

The appellant argued that there had been a “collection,” as the collateral agent had filed a proof of claim. The court rejected this reasoning. While the collateral agent had filed a proof of claim, “collection on debt is distinct from collection on Collateral.” At most the appellant established that the proof of claim constituted collection of a debt; it provided no support, however, for the proposition that the actions of the collateral agent also constituted collection on collateral.

Takeaways

As is most often the case, it was the particular terms of the relevant agreement that were outcome determinative. Nonetheless, a number of takeaways of general application may be derived from the court’s decision.

Securities issued in a bankruptcy reorganization may not constitute collateral or its proceeds. With both Momentive and Energy Future Holdings now taking that position, drafters of intercreditor agreements who wish to ensure that these securities are treated in the priority contemplated by their agreements are advised to explicitly address the allocation of such securities in a restructuring.

While cash would in principle seem to be proceeds of collateral, the tracing requirement of the bankruptcy code could frustrate intended allocations. Again, the remedy would appear to be careful and express drafting in intercreditor arrangements.

It is somewhat curious that the court here excluded the rights under the tax receivables agreement from the pool of general intangibles. The court’s determination may have turned on a narrow formulation of this concept in the particular security documents of the case. Once more, the decision is a yellow flag for drafters, who may now wish to be explicit about the inclusion of tax rights in the litany of pledged collateral or otherwise deal with their disposition in the event of a restructuring.

Praemonitus, praemunitus – forewarned is forearmed. Energy Future Holdings provides a useful reminder that certain common forms of distributions in reorganization cases may not be adequately addressed in standard intercreditor documentation. The benefits of one treatment over another are, of course, not unidirectional. But in all cases, drafters are well-advised to be alert to the issues.

¹ Whether the first lien creditors were in fact entitled to post-petition interest was itself an issue of contention among the first lien creditors, which the court found unnecessary to address.

² In an attempt to distinguish Momentive, the appellant noted that, in Momentive, certain creditors retained their liens post-reorganization, whereas here all liens were extinguished, exhausting all economic value of the collateral. The court was unconvinced. Unlike in a 363 sale, the assets constituting the collateral continued to provide value to the former lienholders.