Recently, the bankruptcy court presiding over the Energy Futures chapter 11 case issued an opinion analyzing the interplay between an intercreditor agreement’s distribution waterfall and payments to be made under the debtors’ multi-step reorganization plan. The court rejected a secured creditor’s argument that the intercreditor agreement’s distribution waterfall was triggered by one step of that reorganization. In a ruling that may have far-reaching impacts on confirmation of chapter 11 plans, the court held that when evaluating the various transactions involved in a chapter 11 plan, the proper frame of reference is the reorganization as a whole, rather than the individual steps that constitute the reorganization.

The facts of this case are rather complex, but are necessary for a full understanding of the implications of the opinion. Texas Competitive Electric Holdings (“TCEH”), together with its subsidiaries and parent, Energy Future Competitive Holdings (“EFCH”), filed under chapter 11 on April 29, 2014. As of the petition date, the debtors had over $25 billion in principal amount of first lien debt, comprised of (i) term and revolving loan debt, (ii) interest rate swaps and secured hedge and power sales agreements, and (iii) senior secured notes (the “Notes”). The holders of this debt (the “First Lien Creditors”) were secured by substantially all of the debtors’ assets. An intercreditor agreement (the “Intercreditor Agreement”) governed the relationship among all the first lien debt holders with respect to their shared collateral. Though interests in the collateral were to be pari passu as among all the First Lien Creditors, section 4.1 of the Intercreditor Agreement provided a distribution waterfall for collateral or proceeds received “in connection with the sale or disposition of, or collection on, such Collateral upon the exercise of remedies under the Security Documents by the Collateral Agent.” Such collateral and proceeds were to be distributed first, to the payment of all amounts due to Delaware Trust Company (“DTC”), the collateral agent for the Notes under the relevant financing documents, second, to any secured party who had advanced or paid fees to an agent or issuing lender, and third, to the payment of principal and other amounts then due and payable in respect of the “Secured Obligations.”

When the debtors filed an amended plan of reorganization, DTC sought declaratory relief to settle the method for distributing plan payments to the First Lien Creditors. DTC claimed that the structure of the reorganization under the amended plan triggered the application of section 4.1 of the Intercreditor Agreement, and that as a result, any distributions to the First Lien Creditors would have to be made according to the waterfall contained in section 4.1.

The amended plan called for a complicated, multi-step reorganization process, including the sale of preferred stock in the reorganized TCEH to third-party investors for cash. The sale would be effectuated by contributing the assets of certain debtors into a newly-created entity (the “Preferred Stock Entity”), which would be authorized to issue such preferred stock to the purchasing third-party investors. This sale (the “Spin-Off Preferred Stock Sale”) was devised based on a private letter ruling from the IRS, and was intended to achieve a step-up in basis of the assets to be held by the reorganized TCEH, resulting in future tax savings.

In support of its position, DTC argued that the amended plan was not a “simple debt-for-equity reorganization . . . [but] a complex web of transactions, including a ‘Preferred Stock Sale’” involving the exchange of TCEH First Lien Collateral from reorganized TCEH to a third party, in return for common stock and preferred stock, which was immediately sold to third party investors. DTC also argued that the “consideration [plan distributions] . . . generated by a series of transactions that hinge on a ‘sale or disposition’ of the TCEH First Lien Collateral constitutes the ‘proceeds’ of that Collateral and that consummation of the [amended plan] requires an exercise of the remedies by the Collateral Agent.” In effect, DTC urged the court to view each step of the multi-step reorganization individually.

The court rejected DTC’s argument and instead reviewed the reorganization holistically. The court reasoned that “the economic reality is that TCEH (and eventually its successor, Reorganized TCEH) remained the holder of 100% of the common stock of the Preferred Stock Entity at all relevant times,” and that the preferred stock sale was not a change in ownership of the assets, but a single step in a change of control. The Preferred Stock Entity continued to be a member of the TCEH consolidated group for income tax reporting purposes after the preferred stock sale,“confirming that it was not sold to a ‘third party.’” In addition, adopting the reasoning of a decision in the MPM Silicones, LLC bankruptcy, the court held as follows:

The TCEH Collateral does not change in any way (other than a Step-Up Basis for tax purposes) as a result of the Plan Distributions. As in Momentive, the Plan Distributions are not ‘“proceeds of collateral” when it gets stock in the reorganized entity, unless, that stock was paid by a third-party buyer in return for the debtors’ assets comprising the collateral. Here, no substitute for the Collateral was received by the TCEH First Lien Lenders through Plan Distributions.

Noting that the reorganization did not permanently remove assets from reorganized TCEH, the court emphasized the fact that the new plan was structured “solely for tax purposes and without bidding procedures, an auction and typical Section 363 sale attributes.” Viewing the steps of the reorganization together, the court declined to “metamorphasize this tax structure” into a sale or disposition of the TCEH Collateral.

The court’s decision in Energy Futures provides support for debtors and creditors who would benefit from a holistic analysis of the plan in the context of contested plan confirmations. Debtors and creditors would be well-served by consideration of the Energy Futures court’s distinction between a change in control and a change in asset ownership when formulating plans and confirmation objections.