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Locke Lord QuickStudy: When Chapter 11 Plan Distributions are not Collateral: Enforcing Intercreditor Waterfall Provisions in Bankruptcy
On June 19, 2019, Circuit Judge Stephanos Bibas (United States Court of Appeals for the Third Circuit) delivered an important opinion analyzing the enforceability of an intercreditor agreement relative to the distribution waterfall contained in a Chapter 11 plan.1 The ruling was designated as nonprecedential under Third Circuit rules. However, the opinion does serve as an important primer for finance and bankruptcy practitioners drafting intercreditor agreements, and reflects agreement with the approach taken by one of the judges in the United States Bankruptcy Court for the Southern District of New York.
This decision stems from the 2014 bankruptcy filing by Energy Future Holdings Corp. and its subsidiaries (collectively, “Energy Future”). Prior to filing for bankruptcy, Energy Future incurred indebtedness owing to two different groups of creditors, with one set of notes issued to noteholders in 2007, and another set of notes issued in 2011 (hereafter, the “2007 Creditors” and “2011 Creditors”). The 2007 Creditors and 2011 Creditors held liens on the same collateral pledged by Energy Future, and entered into an intercreditor agreement (the “Intercreditor Agreement”) to govern the relationship and relative distribution rights between the two groups of creditors.
The 2007 Creditors and 2011 Creditors were both undersecured in the Energy Future bankruptcy proceeding, and a dispute arose as to how certain plan distributions and adequate protection payments (such distributions and payments, collectively, the “Distributions”) would be allocated between the two competing groups of creditors. Central to this issue was the interpretation of the “waterfall” provision in the Intercreditor Agreement. If the Distributions were “Collateral” within the meaning of the Intercreditor Agreement, then the 2011 Creditors would be entitled to recover an additional $90,000,000 in interest accrued after the bankruptcy filing date. If the Distributions were not covered by the Intercreditor Agreement, then the parties’ distribution rights would be determined as of the bankruptcy filing date, and the 2011 Creditors would forego this additional interest.
The 2007 Creditors successfully moved for judgment on the pleadings, based on the argument that both creditor groups were undersecured, and that Section 502(b)(2) of the Bankruptcy Code precluded the award of post-judgment interest. The 2011 Creditors appealed this ruling to the Third Circuit, which ultimately affirmed the judgment in favor of the 2007 Creditors. In so ruling, the Third Circuit panel held that the waterfall provision in the Intercreditor Agreement did not apply to the Distributions and, accordingly, the amount of Distributions owed to the 2007 Creditors and 2011 Creditors must be calculated based on the amount owed to each of these creditor groups by Energy Future at the time of the bankruptcy filing.
By its terms, the waterfall provision contained in the Intercreditor Agreement applied only to (1) distributions of collateral and (2) proceeds received in connection with a sale, collection or disposition of collateral upon an exercise of remedies by the collateral agent. Based on a careful reading of the Intercreditor Agreement, Judge Bibas concluded that the Distributions were neither collateral nor were they proceeds received in connection with an exercise of remedies by the collateral agent. In essence, he determined that the confirmation of Energy Future’s plan created a new set of obligations to the 2007 and 2011 Creditors, and that the distributions made on account of these obligations (along with the adequate protection payments made during the course of the bankruptcy proceeding) were not “Collateral” entitled to the protections of the Intercreditor Agreement. This analysis is in line with the approach taken to this issue by the United States Bankruptcy Court for the Southern District of New York in the Momentive proceeding, wherein Judge Drain ruled that certain plan distributions were not “collateral” to be governed by the waterfall provision.2
Based on what appears to be an emerging consensus view of this issue, practitioners should be mindful of the risk that adequate protection payments and plan distributions may not be deemed to be “collateral” within the meaning of an intercreditor agreement. The good news: there is a simple drafting solution to this problem. If the parties to an intercreditor agreement intend to prohibit all Chapter 11 adequate protection and plan distributions to junior creditors (whether such distributions are made from collateral proceeds, an exercise of remedies or otherwise) until such time that the senior creditors have been paid in full, or to allocate all payments made from whatever source in some particular fashion, then the intercreditor agreement should reflect that arrangement explicitly.
This decision stems from the 2014 bankruptcy filing by Energy Future Holdings Corp. and its subsidiaries (collectively, “Energy Future”). Prior to filing for bankruptcy, Energy Future incurred indebtedness owing to two different groups of creditors, with one set of notes issued to noteholders in 2007, and another set of notes issued in 2011 (hereafter, the “2007 Creditors” and “2011 Creditors”). The 2007 Creditors and 2011 Creditors held liens on the same collateral pledged by Energy Future, and entered into an intercreditor agreement (the “Intercreditor Agreement”) to govern the relationship and relative distribution rights between the two groups of creditors.
The 2007 Creditors and 2011 Creditors were both undersecured in the Energy Future bankruptcy proceeding, and a dispute arose as to how certain plan distributions and adequate protection payments (such distributions and payments, collectively, the “Distributions”) would be allocated between the two competing groups of creditors. Central to this issue was the interpretation of the “waterfall” provision in the Intercreditor Agreement. If the Distributions were “Collateral” within the meaning of the Intercreditor Agreement, then the 2011 Creditors would be entitled to recover an additional $90,000,000 in interest accrued after the bankruptcy filing date. If the Distributions were not covered by the Intercreditor Agreement, then the parties’ distribution rights would be determined as of the bankruptcy filing date, and the 2011 Creditors would forego this additional interest.
The 2007 Creditors successfully moved for judgment on the pleadings, based on the argument that both creditor groups were undersecured, and that Section 502(b)(2) of the Bankruptcy Code precluded the award of post-judgment interest. The 2011 Creditors appealed this ruling to the Third Circuit, which ultimately affirmed the judgment in favor of the 2007 Creditors. In so ruling, the Third Circuit panel held that the waterfall provision in the Intercreditor Agreement did not apply to the Distributions and, accordingly, the amount of Distributions owed to the 2007 Creditors and 2011 Creditors must be calculated based on the amount owed to each of these creditor groups by Energy Future at the time of the bankruptcy filing.
By its terms, the waterfall provision contained in the Intercreditor Agreement applied only to (1) distributions of collateral and (2) proceeds received in connection with a sale, collection or disposition of collateral upon an exercise of remedies by the collateral agent. Based on a careful reading of the Intercreditor Agreement, Judge Bibas concluded that the Distributions were neither collateral nor were they proceeds received in connection with an exercise of remedies by the collateral agent. In essence, he determined that the confirmation of Energy Future’s plan created a new set of obligations to the 2007 and 2011 Creditors, and that the distributions made on account of these obligations (along with the adequate protection payments made during the course of the bankruptcy proceeding) were not “Collateral” entitled to the protections of the Intercreditor Agreement. This analysis is in line with the approach taken to this issue by the United States Bankruptcy Court for the Southern District of New York in the Momentive proceeding, wherein Judge Drain ruled that certain plan distributions were not “collateral” to be governed by the waterfall provision.2
Based on what appears to be an emerging consensus view of this issue, practitioners should be mindful of the risk that adequate protection payments and plan distributions may not be deemed to be “collateral” within the meaning of an intercreditor agreement. The good news: there is a simple drafting solution to this problem. If the parties to an intercreditor agreement intend to prohibit all Chapter 11 adequate protection and plan distributions to junior creditors (whether such distributions are made from collateral proceeds, an exercise of remedies or otherwise) until such time that the senior creditors have been paid in full, or to allocate all payments made from whatever source in some particular fashion, then the intercreditor agreement should reflect that arrangement explicitly.
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1. In re: Energy Future Holdings Corp., et al. v. Morgan Stanley Capital Grp., Inc. and Wilmington Trust, N.A., 2019 WL 2535700 (3d Cir. June 19, 2019).
2. BOKF NA v. Wilmington Sav. Fund Soc’y FSB (In re MPM Silicones LLC), Case No. 15-2280, 2019 WL 121003 (S.D.N.Y. Jan. 4, 2019).
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