In a move that surprised bankruptcy practitioners and other observers, a Delaware bankruptcy court recently rescinded an order approving a $275 million break-up fee relating to a failed merger. Judge Christopher Sontchi held that Debtor Energy Future Holdings could not pay the merger termination fee to NextEra Energy, the prospective buyer of nondebtor subsidiary, Oncor Electric Delivery Co., in part because the fee did not provide an actual benefit to the Debtors’ estate.

In justifying the “extraordinary step” of reversing his own year-old order approving the fee, Judge Sontchi found that he had previously relied on “imprecise and incorrect testimony by the Debtors’ witness.” However, he also determined that, ultimately, the Court bore the blame for misunderstanding when the fee would be payable and when it would not be. The ruling may cause some parties to reexamine how they structure bankruptcy sale procedures, particularly those including termination fees.

The Energy Future chapter 11 cases were originally filed in Delaware in early 2014. In April 2016, following a lengthy marketing process, the Debtors began negotiating with Florida-based NextEra Energy regarding the sale of the Debtors’ economic interest in Texas-based Oncor, which culminated in a merger agreement dated July 29, 2016. The total deal was valued at approximately $18.7 billion, and the merger agreement included a fee of $275 million owing to NextEra in the event of the termination of the merger agreement.

The Debtors moved to approve the merger agreement, including the termination fee. The merger was subject to the regulatory approval of the three-member Public Utility Commission of Texas (“PUCT”). In April 2017, the PUCT unanimously rejected the transaction following hearings in which the commissioners expressed concern over the proposed debt load to be borne by Oncor.

Under the merger agreement, the termination fee was not payable if PUCT approval was not obtained and NextEra terminated the agreement. However, the termination fee was payable if the Debtors terminated the agreement, either to accept another proposal or, importantly, if PUCT approval was not obtained and the Debtors were compelled to terminate the agreement. That is exactly what happened in July 2017, when the Debtors terminated the merger agreement with NextEra, purportedly triggering the termination fee.

In reversing its prior approval of the termination fee, the Court focused on the fact that, despite numerous opportunities to do so, no party had brought to the Court’s attention that NextEra might never be required to terminate the agreement following a regulatory rejection, and instead might simply wait for the Debtors to decide to terminate at some point. The Court acknowledged that NextEra might have relied on the earlier order and, as a result, incurred significant legal fees to defend its entitlement to the termination fee. However, any interest that NextEra had in the termination fee “must give way to the interest in ensuring that the Court’s decisions are based on a complete record and a proper application of controlling precedent.” In other words, the Court felt that it had been misled, or that it had misunderstood critical facts, during the original hearing to approve the termination fee.

The Court’s analysis stemmed in large part out of the decision in In re O’Brien Environmental Energy, Inc., 181 F.3d 527 (3d Cir. 1999), which sets the Third Circuit’s standard for evaluating termination fees. Under O’Brien, a court is required to determine whether the movant has carried the “heavy burden of demonstrating that a post-petition transaction ‘provided an actual benefit’ to the debtor’s estate” in order to justify a termination fee. In general, courts find termination fees to provide an actual benefit when they induce higher and better bids at auction or if they increase the chances that the price obtained will reflect the true value of the asset to the debtor. With the benefit of additional information introduced at rehearing, the Court decided that the termination fee was not designed to induce competitive bidding for Oncor, but was designed to induce NextEra to follow through with obtaining regulatory approval. The Court found that a termination fee triggered on the failure of a court or a regulator to approve a transaction can never meet the O’Brien standard. Additionally, the Court was concerned that the termination fee was drafted in such a way that NextEra would never have an economic incentive to terminate the merger agreement, even if the PUCT refused to approve the merger. Instead, NextEra could indefinitely appeal the ruling, thereby requiring the Debtors to terminate the agreement and giving rise the termination fee.

Termination fees are certainly not dead, but the Delaware bankruptcy court’s decision to reverse the Energy Future termination fee should give pause to debtors, practitioners and would-be buyers alike. Termination fees must be carefully structured to induce competitive bidding or to provide some other clear and tangible benefit to the debtor’s estate. The fee cannot be drafted in a way that permits the would-be buyer to take no action and to force the debtor to terminate the proposed transaction, thereby requiring the estate to pay the fee. Also, parties should be prepared to clearly describe for the court all the scenarios under which the termination fee will and will not be paid.