In the high-profile bankruptcy case of Energy Future Holdings Corp. (“EFH”) a Delaware bankruptcy court recently called into question reliance on structural subordination as a way to protect a borrower’s assets from satisfying claims against an affiliated company. In the EFH bankruptcy case, holders of unsecured PIK notes issued by EFH subsidiary Energy Future Intermediate Holdings Company LLC (“EFIH”) sought to collect post-petition interest at the rate stated in the notes issued by EFIH. The Court denied the noteholders’ request for post-petition interest at the contract rate, instead ordering post-petition interest payable at the federal judgment rate – a rate significantly less than the contract rate.1
Fixed income investors and analysts know there are two ways to accomplish subordination. One is structural and the other is contractual. Structural subordination results from the independent legal relationship between a parent and its subsidiary. On account of structural subordination, a parent company’s creditors will not have access to the assets of the parent’s subsidiary to satisfy their claims until all creditors of the subsidiary are paid in full. The net result is that creditors of a subsidiary will be repaid in full prior to the distribution of the subsidiary’s assets to the parent in order to satisfy creditors of the parent. A benefit of structural subordination is that it is selfeffectuating, relying solely on courts to respect the formal relationship between the parent and the subsidiary. Contractual subordination is, as the name suggests, imposed by contract and is less efficient because parties must negotiate a subordination agreement and rely on courts to properly enforce the agreement – often after significant litigation.
In the EFH bankruptcy case, the noteholders made two arguments for the contract rate of interest to apply. The first was that the Court should apply the contract rate as “the legal rate” of interest mandated by the Bankruptcy Code to be paid to unsecured creditors of solvent debtors. The second was that EFIH’s proposed reorganization plan was not fair and equitable in regard to EFIH PIK noteholders because it denied them full repayment of the contract rate of interest while at the same time providing for a distribution to EFIH’s parent company so that it could satisfy EFH “enterprise” creditor claims. To hold otherwise, noteholders argued, would allow EFIH to use bankruptcy to avoid making interest payments to EFIH creditors merely to benefit creditors of its parent. In short, the noteholders asked the Court to respect the structural subordination of EFH’s creditors that they had relied on when underwriting the EFIH notes.
On the first point, the Court held that the legal rate should be interpreted to mean the federal judgment rate. This part of the Court’s ruling was in accord with prior decisions of other courts, including those in Delaware. On the important second point, the Court held that “to require the payment of post-petition interest [at the contract rate] … would reduce the consideration available to pay other creditors of the enterprise, not the ultimate equity holders.” The Court went on to note that it would be “inequitable” to allow payments of post-petition interest, especially when those payments would reduce payments of principal owed to “lower priority creditors.” But within the existing structural subordination framework, creditors of a subsidiary’s parent are not lower priority creditors of the subsidiary – they are not creditors of the subsidiary at all – and distributing payments from EFIH noteholders to creditors of EFH rather than EFH’s equity holders does not make the result any more equitable. In allowing the scale of “equities” to tip in favor of EFH’s enterprise creditors, the Court dashed the EFIH unsecured noteholders’ well-founded expectation that structural subordination would be respected to protect a “full” recovery.
Bankruptcy courts have considerable “equitable powers,” including the ability to grant adequate protection and relief from the automatic stay and award pre-payment premiums and default interest to secured and unsecured creditors. If in exercising these equitable rights, Bankruptcy Courts refuse to respect the bedrock principals of structural subordination, financing parties may need to employ contractual subordination in circumstances once thought unnecessary. In the EFH case, for example, EFIH unsecured noteholders clearly would have benefited from a standard subordination agreement with EFH unsecured noteholders as such an agreement would not have permitted EFH creditors to receive distributions absent payment in full of the EFIH PIK noteholders’ claims at the contract rate of interest. Unfortunately for market participants, the need for subordination agreements in these circumstances will only serve to increase costs and make capital markets transactions less efficient.2
For the foreseeable future, distressed investors and analysts will no longer have the luxury of assuming structural subordination will protect expected recoveries. Indeed, this recent decision in the EFH bankruptcy will likely incentivize parent company creditors to create equitable arguments to more liberally distribute recoveries to enterprise creditors without strict adherence to the well-established doctrine of structural subordination.