Business Restructuring Review

Chapter 11 Plan Distributions Are Not Collateral Covered by Intercreditor Agreement's Waterfall Provision

In In re Energy Future Holdings Corp., 2019 WL 2535700 (3d Cir. June 19, 2019), a panel of the U.S. Court of Appeals for the Third Circuit ruled that adequate protection payments made during a bankruptcy case and distributions under a chapter 11 plan are not distributions of collateral for purposes of a "waterfall" provision in an intercreditor agreement.

Intercreditor and Subordination Agreements

 An intercreditor agreement is an agreement among creditors specifying in advance how their competing claims against the borrower will be dealt with in terms of priority, receipt of payment, recourse to assets, and other related rights. Such agreements sometimes include a "waterfall" provision that establishes the order in which the parties will receive payments from a pool of the borrower's assets upon the occurrence of default or another specified event.

To the extent that an intercreditor agreement provides for subordination of debt or security, the agreement will generally be enforced in a bankruptcy case pursuant to section 510(a) of the Bankruptcy Code, which provides that a subordination agreement is enforceable in a bankruptcy case to the same extent that it would be enforceable under applicable nonbankruptcy law.

In construing the validity, enforceability, and application of a subordination agreement, section 510(a) directs the bankruptcy court to look to applicable nonbankruptcy law—generally state law—as well as the terms of the agreement itself. See Collier On Bankruptcy ¶ 510.03 (16th ed. 2019). If there is ambiguity in the agreement concerning the terms or extent of the subordination, a bankruptcy court may refuse to enforce it. See In re Bank of New England Corp., 364 F.3d 355, 367 (1st Cir. 2004) (remanding case to bankruptcy court to determine under New York law whether subordination agreement actually provided for payment of postpetition interest on senior debt prior to any payment on junior debt), on remand, 404 B.R. 17 (Bankr. D. Mass. 2009) (finding that parties did not intend to subordinate claims for postpetition interest), aff'd, 426 B.R. 1 (D. Mass. 2010), aff'd, 646 F.3d 90 (1st Cir. 2011).

Moreover, a chapter 11 plan need not necessarily give effect to the explicit terms of a subordination agreement in providing for the treatment of creditor claims. See In re Tribune Media Co., 587 B.R. 606, 614 (D. Del. 2018) (because section 510(a) is expressly excepted from section 1129(b)(1) of the Bankruptcy Code, a nonconsensual chapter 11 plan that does not fully enforce a subordination agreement may be confirmed as long as "the plan does not discriminate unfairly, and is fair and equitable").

Energy Future

Texas Competitive Electric Holdings Company LLC ("TCEH") was a subsidiary of electric utility company Energy Future Holdings Corp. ("Energy Future"). TCEH had various secured noteholders, including creditors holding $26 billion in first-lien secured notes issued in 2007 (the "2007 Notes") and 2011 (the "2011 Notes"). Liens on substantially all of TCEH's assets collateralized all of the notes, which were of equal priority but bore different interest rates.

An intercreditor agreement among the noteholders contained a waterfall provision. It provided that "[r]egardless 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 order specified in the agreement.

In April 2014, Energy Future, TCEH, and various affiliates filed for chapter 11 protection in the District of Delaware. Because the debtors needed to use the noteholders' collateral to keep operating, the bankruptcy court directed the debtors to make monthly adequate protection payments to the noteholders. In 2016, the court confirmed the debtors' chapter 11 plan. The plan provided that the noteholders, which were undersecured, would receive a combination of cash, stock in reorganized TCEH, and the right to receive certain tax benefits in respect of their claims.

The noteholders disagreed as to whether the adequate protection payments and the plan distributions should be allocated in accordance with the intercreditor agreement. The holders of the 2007 Notes (the "2007 Noteholders") maintained that the intercreditor agreement was not applicable. As such, they argued that the noteholders' respective share of adequate protection payments and plan distributions should be based on the value of their claims against TCEH as of the petition date. The holders of the 2011 Notes (the "2011 Noteholders") countered that the intercreditor agreement did apply, and under its waterfall provision, the noteholders' share of the distributions should be based on what TCEH owed the noteholders on the effective date of the chapter 11 plan, which included two years of postpetition interest. Because the 2011 Notes bore a higher rate of interest, this approach would allocate $90 million more to the 2011 Noteholders than the 2007 Noteholders than if the intercreditor agreement did not apply.

The collateral and administrative agent (the "collateral agent") for the 2011 Noteholders commenced an adversary proceeding to resolve the dispute. Three of the 2007 Noteholders intervened in that litigation. The bankruptcy court ruled in favor of the 2007 Noteholders, and the district court affirmed on appeal. The collateral agent for the 2011 Noteholders appealed to the Third Circuit.

The Third Circuit's Ruling

 A three-judge panel of the Third Circuit affirmed the decisions below in a nonprecedential ruling.

The Third Circuit panel concluded that, for several reasons, the waterfall provision did notapply to the adequate protection payments and plan distributions. First, it determined that neither constituted collateral. The plan distributions were made from assets on which the noteholders did not have liens. As to the adequate protection payments, even though it appeared that substantially all of TCEH's assets served as collateral for the 2007 Notes and the 2011 Notes, the court ruled that: (i) "payment of collateral reduces the amount of money owed on a debt"; and (ii) the adequate protection payments did not decrease the amount of money TCEH owed on the notes because TCEH made such payments "in exchange for the creditors' agreement to let [TCEH] use the collateral for other purposes."

The Third Circuit panel also ruled that the waterfall provision would apply only if the adequate protection payments were proceeds of collateral received in connection with the sale or other disposition of, or collection on, collateral upon the exercise of remedies under the relevant security documents. According to the court, the adequate protection payments did not satisfy those requirements. The court rejected the 2011 Noteholders' argument that TCEH's chapter 11 restructuring amounted to a sale or disposition of collateral and that the collateral agent's participation in the bankruptcy case was a remedy. The court wrote that:

This corporate restructuring, blessed by the bankruptcy court, is a far cry from a collateral agent's typical remedy: selling the collateral at a foreclosure sale. Because the restructuring was not a remedy implemented by the collateral agent, the plan distributions are not proceeds under the waterfall provision.

The Third Circuit accordingly affirmed the rulings below and held that "each creditor is entitled to payments and distributions based on what [TCEH] owed it when [TCEH] filed for bankruptcy."


 The Third Circuit panel's ruling in Energy Future is a reminder that intercreditor agreements will apply only in accordance with their terms. Although the parties could have drafted the intercreditor agreement in Energy Future to apply to any consideration received from TCEH by either the 2007 Noteholders or the 2011 Noteholders, they did not. Therefore, the intercreditor agreement did not apply to the adequate protection payments and plan distributions made to the noteholders. Creditors have recently learned similar lessons in other cases. See In re MPM Silicones LLC, 518 B.R. 740 (Bankr. S.D.N.Y. 2014) (common stock in reorganized debtor that junior lienholders were to receive under chapter 11 plan was not "common collateral" or proceeds thereof within meaning of intercreditor agreement and the Uniform Commercial Code because neither senior nor junior lienholders had lien on old or new stock and no "sale" or "disposition" occurred), aff'd, 596 B.R. 416 (S.D.N.Y. 2019).

Because the ruling was unpublished, the decision is not binding on courts in the Third Circuit.

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