On March 15, 2021, the Third Circuit Court of Appeals (the “Third Circuit”) held that a stalking horse bidder may assert an administrative expense claim pursuant to section 503(b)(1)(A) of the Bankruptcy Code for costs incurred in attempting to close on an unsuccessful transaction, even when the stalking horse bidder is not entitled to a breakup or termination fee.
In In re Energy Future Holdings Corp., 2021 U.S. App. LEXIS 7400 (3d Cir. 2021) (“EFH II”), the debtors terminated a merger agreement with a stalking horse bidder due to the stalking horse bidder’s failure to obtain the regulatory approval necessary to consummate the contemplated merger. After the stalking horse bidder’s application for payment of a termination fee was denied by the Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) and affirmed by the Third Circuit in In re Energy Future Holdings Corp., 904 F.3d 298 (3d Cir. 2018) (“EFH I”), the stalking horse bidder filed an administrative expense application for costs incurred in connection with its unsuccessful efforts to complete the merger. In response, various bondholders jointly filed a motion to dismiss the administrative claim and a motion for summary judgment. Although the Bankruptcy Court granted both motions and the District Court for the District of Delaware (the “District Court”) affirmed, the Third Circuit ruled that the administrative claim should not be denied on the motion to dismiss or motion for summary judgment, as the stalking horse bidder plausibly alleged that it benefitted the estate by providing valuable information, accepting certain risks, and paving the way for a later successful deal.
In holding so, the Third Circuit adopted an expansive view of what constitutes a plausible administrative expense claim under section 503(b)(1)(A) of the Bankruptcy Code. Going forward, the Bankruptcy Court may have to order factual discovery and hold evidentiary hearings before it can reject administrative expense applications. As such, the Third Circuit’s opinion in EFH II provides stalking horse bidders substantial leverage and may establish an alternative way for them to recover transactional expenses. Accordingly, debtors should not rely on section 503(b)(1)(A) of the Bankruptcy Code as the sole authority to dispose swiftly of stalking horse bidders’ administrative claims; rather, they should consider drafting clear transactional documents to narrow the scope of recoverable administrative claims.
Factual Background and Procedural History
On April 29, 2014, the electric energy giant Energy Future Holdings Corp. and its affiliates (the “Debtors”) filed for chapter 11 bankruptcy. On the petition date, one of the Debtors’ most valuable assets was their 80 percent indirect economic interest in non-Debtor Oncor Electric Delivery Company LLC (“Oncor”), Texas’s largest electric power transmission and distribution company. Oncor is subject to the regulatory control of the Public Utility Commission of Texas (“PUCT”), which imposed certain restrictions on Oncor’s ability to distribute dividends upstream (the “Ring Fence”).
On September 19, 2016, the Bankruptcy Court approved a proposed merger (the “Merger”) between the Debtors and NextEra Energy Inc. (“NextEra”), for a price that would have brought $9.8 billion into the Debtors’ bankruptcy estate. The underlying merger agreement (the “Merger Agreement”) included a $275 million termination fee (the “Termination Fee”) payable to NextEra if the Debtors were to terminate the Merger Agreement for any reason. The Merger contemplated seeking PUCT approval without the Ring Fence.
On October 31, 2016, Oncor and NextEra filed an application with PUCT seeking approval of the Merger and removal of the Ring Fence. After PUCT denied the application, NextEra filed an appeal in Texas state court.
On July 7, 2017, while the state court appeal was pending, the Debtors terminated the Merger Agreement. Six weeks later, the Bankruptcy Court approved a merger between the Debtors and Sempra Energy (“Sempra”), for a purchase price of approximately $350 million less than what NextEra had agreed to pay. Unlike NextEra, Sempra agreed to have the Ring Fence remain in place after the Merger.
Following the termination of the Merger Agreement, a group of creditors (collectively, the “Creditor Group”) moved for the Bankruptcy Court to reconsider its initial approval of the Termination Fee. The Bankruptcy Court granted the Creditor Group’s motion for reconsideration and revoked approval of the Termination Fee, explaining that it fundamentally misunderstood the critical fact that the Termination Fee would be payable even if PUCT declined to approve the Merger.1 Had it understood this critical fact, the Bankruptcy Court stated that it would not have approved the Termination Fee, which allowed NextEra to “hold out and to pursue numerous motions for reconsideration and a fruitless appeal until the Debtors were forced by economic circumstances to terminate the Merger Agreement.”2
NextEra appealed the Bankruptcy Court’s decision to the Third Circuit. The Third Circuit affirmed in EFH I, ruling that the Bankruptcy Court did not abuse its discretion in disapproving the Termination Fee, because the Termination Fee was not designed to induce competitive bidding.3 Furthermore, the Termination Fee carried a perverse incentive that would allow NextEra to avoid compromising on its positions and force the Debtors to terminate.4 Nonetheless, the Third Circuit recognized that breakup fees may be allowed as administrative expense under section 503(b)(1)(A) of the Bankruptcy Code to promote more competitive and reliable bidding.5
In a separate effort to recover its expenses incurred in connection with the Merger Agreement, NextEra filed with the Bankruptcy Court an administrative expense application (“the Administrative Expense Application”) under section 503(b)(1)(A) of the Bankruptcy Code, seeking allowance and payment of a $60 million administrative claim for expenses incurred in its efforts to close on the Merger. In response, the Creditor Group and another creditor jointly filed a motion to dismiss or, in the alternative, a motion for summary judgment to deny the Administrative Expense Application.
The Bankruptcy Court held a hearing on the Administrative Expense Application and subsequently granted both motions. In granting the motion to dismiss, the Bankruptcy Court found that NextEra did not foster any competitive bidding.6 Instead, NextEra “forced the Debtors to find an alternative transaction at far less value.”7 Accordingly, NextEra’s expenses failed to benefit the Debtors’ estate as required under section 503(b)(1)(A) of the Bankruptcy Code and thus cannot qualify as an administrative expense under the same section.8 In granting the motion for summary judgment, the Bankruptcy Court observed that the Merger Agreement provided that each party pays its own expenses, except for those fees that are recounted in specifically enumerated sections of the Merger Agreement or are administrative expenses addressed in the Debtors’ bankruptcy plan (the “Plan”).9 Because NextEra’s expenses fit into neither of those categories, the Merger Agreement unambiguously barred the Administrative Expense Application.10 The District Court affirmed, prompting NextEra to appeal to the Third Circuit.
In EFH II, the Third Circuit reversed the Bankruptcy Court’s denial of the Administrative Expense Application on the motion to dismiss and motion for summary judgment.
First, the Third Circuit held that the plain language of the Merger Agreement permitted recovery of expenses specified under section 503(b)(1)(A) of the Bankruptcy Code. Under the Merger Agreement, NextEra may recover expenses “addressed” in the Plan.11 The definitional section of the Plan mirrors section 503(b)(1)(A) of the Bankruptcy Code by providing that an administrative claim is a claim for costs and expenses of administration of the estates under sections 503(b), including the actual and necessary costs and expenses incurred to preserve the applicable estates and operating the businesses of the Debtors.12 Additionally, Article II of the Plan specifies that an allowed administrative claim is entitled to receive cash equal to the amount of that administrative claim, paralleling the Bankruptcy Code’s priority treatment of an administrative claim under section 503(b)(1)(A).13 As such, the Third Circuit concluded that any expense that constitutes an administrative expense under section 503(b)(1)(A) of the Bankruptcy Code is allowed and thus “addressed” in the Plan.14
Second, the Third Circuit ruled that NextEra plausibly pleaded that it incurred expenses benefitting the estate and hence its Administrative Expense Application should not be denied on a motion to dismiss or motion for summary judgment. Pursuant to section 503(b)(1)(A) of the Bankruptcy Code, an administrative expense includes the actual, necessary costs of preserving the estate.15 To be considered actual and necessary, the expenses at issue must yield benefits to the estate that are not outweighed by the costs to the estate.16 For example, a breakup fee can benefit the estate when it fosters more competitive bidding and encourages a prospective bidder to perform due diligence that increases the likelihood that the price at which the debtor’s asset is sold will reflect its true worth.17 Although NextEra’s Termination Fee was disallowed in EFH I, the Third Circuit found that NextEra plausibly alleged in EFH II that it performed due diligence in unsuccessfully pursuing PUCT approval of a sale without the Ring Fence, thereby informing future bidders that the Debtors’ interest in Oncor would necessarily have the Ring Fence attached. Additionally, NextEra provided the estate with strategic documents that later benefited the estate in the structuring and negotiation of the subsequent sale to Sempra.18 Although the extent to which such benefits offset interest expenses the estate incurred as a result of NextEra’s continued pursuit of PUCT approval remained an unsettled factual issue, the Third Circuit held that NextEra’s Administrative Expense Application did not warrant denial on a motion to dismiss or motion for summary judgment as all inferences must be made in NextEra’s favor.19
In EFH II, the Third Circuit applied a broad standard for pleading a plausible administrative expense claim under section 503(b)(1)(A) of the Bankruptcy Code. The Third Circuit’s expansive view that unsuccessful efforts to close on a transaction can nevertheless benefit the estate may make it harder in the future for the Bankruptcy Court to reject a stalking horse bidder’s administrative expense application on a motion to dismiss or motion for summary judgment. From a practical perspective, a stalking horse bidder’s administrative expense application will unlikely be denied without a discovery process and evidentiary hearing. For stalking horse bidders that are otherwise not entitled to a breakup fee, this may provide a source of leverage to recover some transactional expenses from the estates nonetheless because it may be costly for financially distressed debtors to litigate the issue. At its core, the Third Circuit’s decision in EFH II establishes a viable means for stalking horse bidders to recover expenses incurred in connection with consummating transactions, even when they are not entitled to breakup fees.
That said, debtors’ counsel might be able to avoid the possibility of such predicament by narrowing the scope of recoverable administrative claims in clearly drafted transactional documents. Indeed, the Debtors may have succeeded in denying NextEra’s administrative claim in EFH II had the Merger Agreement expressly precluded recovery of expenses qualifying under section 503(b)(1)(A) of the Bankruptcy Code.