United States: 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.

Footnotes

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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions