In the March/April 2015 issue of the Business Restructuring Review, we discussed a ruling by the U.S. District Court for the District of Delaware addressing the propriety of an unusual pre-confirmation tender offer in the chapter 11 cases of Energy Future Holding Corporation and its affiliates (collectively, "Energy Future"). In that ruling, Del. Trust Co. v. Energy Future Intermediate Holdings, LLC (In re Energy Future Holding Corp.), 527 B.R. 157 (D. Del. 2015), the district court affirmed a bankruptcy court order approving a settlement between Energy Future and certain secured noteholders. The vehicle for the settlement was a postpetition tender offer of old notes for new notes to be issued under a debtor-in-possession ("DIP") financing facility. The district court ruled that a tender offer may be used to implement a classwide debt exchange in bankruptcy outside a plan of reorganization. It also held that the Bankruptcy Code’s confirmation requirements do not apply to a pre-confirmation settlement and that the settlement at issue did not constitute a sub rosa chapter 11 plan.
The U.S. Court of Appeals for the Third Circuit recently affirmed the district court’s decision. In In re Energy Future Holding Corp., 2016 BL 142290 (3d Cir. May 4, 2016), a three-judge panel of the Third Circuit ruled in a nonprecedential opinion (per the court’s designation) that a pre-confirmation tender offer "is not precluded by the Bankruptcy Code and [that] the Bankruptcy Court acted within its discretion to approve the offer as a means to settle certain claims against the estate." The court also ruled that the settlement was neither "inconsistent with the equal treatment rule" nor a sub rosa plan.
Tender Offers and Securities Law Exemptions in Bankruptcy
Debt-for-equity swaps and debt exchanges are common features of out-of-court as well as chapter 11 restructurings. For publicly traded securities, out-of-court restructurings in the form of "exchange offers" or "tender offers" are, absent an exemption, subject to the rules governing an issuance of new securities under the Securities Act of 1933 (the "SA") as well as the SA tender offer rules. By contrast, it is generally understood that the SA rules do not apply if an exchange or tender offer takes place as part of a restructuring under chapter 11 of the Bankruptcy Code, which provides in section 1145 that certain federal and state securities laws do not apply to the offer or sale of securities under a chapter 11 plan.
Known as TXU Corp. until 2007, when it was acquired in what was then the largest leveraged buyout ever, Texas-based Energy Future filed for chapter 11 protection on April 29, 2014, in the District of Delaware to implement a restructuring that would split the company between groups of creditors and eliminate more than $26 billion in debt. Energy Future is organized into two principal businesses, one of which is Energy Future Intermediate Holdings, LLC ("EFIH"). EFIH owns 80 percent of Oncor Electric Delivery Co. LLC, the largest regulated utility in Texas.
EFIH’s capital structure includes $4 billion of first-lien notes, $2.2 billion of second-lien notes, and $1.7 billion of unsecured notes. The first-lien notes consist of two separate tranches: $3.5 billion of 10 percent notes due 2020 (the "10% Notes") and $500 million of 6⅞ percent notes due 2017 (the "6⅞% Notes"). Both issuances of first-lien notes include identical "make-whole" provisions that protect the noteholders from early redemption. However, the amounts of the make-whole premiums payable in respect of the 10% Notes and the 6⅞% Notes differ to account for the different interest rates and maturity dates governing the instruments.
On the bankruptcy petition date, Energy Future filed a restructuring support and lockup agreement that documented a broad settlement reached among Energy Future and various creditors. This "global settlement" included a settlement between Energy Future and some of the first-lien noteholders (the "first-lien settlement") that was to be implemented by means of a postpetition "tender offer." The tender offer proposed a "roll-up"—an exchange of existing first-lien notes for new notes bearing a lower interest rate to be issued under a $5.4 billion DIP financing facility.
In exchange for new notes valued at 105 percent of outstanding principal and 101 percent of accrued interest, participating noteholders would agree to release their make-whole premium claims (the allowance of which in bankruptcy was disputed by Energy Future). However, although the settlement offered all first-lien noteholders principal and accrued interest premiums as an inducement to settle their claims for a make-whole premium, the amounts the two classes of noteholders would receive compared to "the maximum potential value" of their make-whole claims (the "MPV") were unequal, due to the varying principal amounts and maturities. Specifically, for holders of the 6⅞% Notes (the "6⅞% Noteholders"), 5 percent of their principal represented 64 percent of the MPV, whereas for the holders of the 10% Notes (the "10% Noteholders"), 5 percent of principal amounted to only 27 percent of the MPV.
Ninety-seven percent of the 6⅞% Noteholders and 34 percent of the 10% Noteholders accepted the tender offer. While settling noteholders released the disputed make-whole claims, nonsettling noteholders retained the right to litigate the validity of their make-whole premium claims.
On the basis of these results, the bankruptcy court approved the first-lien settlement under Fed. R. Bankr. Proc. 9019 ("Rule 9019"). However, Energy Future subsequently abandoned the other elements of the global settlement.
The indenture trustee for the 10% Notes appealed the order approving the first-lien settlement, contending that: (i) Energy Future’s use of a tender offer as the vehicle for the settlement was improper; (ii) approval of a settlement which offered disparate make-whole claim recoveries to similarly situated creditors violated section 1123(a)(4) of the Bankruptcy Code; and (iii) the first-lien settlement constituted an improper sub rosa chapter 11 plan.
The District Court’s Ruling
On appeal, the indenture trustee argued, among other things, that a tender offer is improper in a chapter 11 case because the Securities and Exchange Commission (the "SEC") plays only a limited role in chapter 11 bankruptcies, and it was improper for Energy Future "to invoke an SEC-governed procedure in lieu of seeking judicial approval to initiate the [first-lien settlement] offer." The district court rejected this argument. According to the court, pre-confirmation settlements are allowed under section 363(b) of the Bankruptcy Code and Rule 9019 as a way "to minimize litigation and expedite the administration of the bankruptcy estate." Moreover, it wrote, the Bankruptcy Code "does not impose any restrictions on a debtor’s ability to propose pre-confirmation settlements."
A tender offer, the district court explained, is nothing more than "a vessel to comply with certain disclosure rules when offering securities publicly for sale or exchange," and the SEC’s limited role in chapter 11 cases does not suggest that it is improper for a debtor to comply with securities laws. Section 1145 of the Bankruptcy Code, the court noted, delineates specific situations where certain federal and state securities laws do not apply to, among other things, the offer or sale of securities under a chapter 11 plan. Because section 1145 does not encompass pre-confirmation settlement offers, the court wrote, Energy Future may have "deemed it necessary to comply with the appropriate securities laws." According to the court, regardless of whether this assessment was correct, "the Court cannot accept the argument that the SEC’s limited role in chapter 11 litigation somehow categorically forbids a debtor from complying with securities laws."
"Plans of reorganization," the district court concluded, "are not the exclusive mechanism to exchange debt or pay off existing creditors in chapter 11." Noting that the first-lien settlement was simply a roll-up of the first-lien notes with new DIP financing, the court ruled that the use of a tender offer to accomplish this exchange was not improper under bankruptcy law.
The district court also rejected the indenture trustee’s contention that the first-lien settlement should not have been approved because it violated section 1123(a)(4) of the Bankruptcy Code—the "equal treatment" rule. Section 1123(a)(4) provides that a plan must "provide the same treatment for each claim . . . of a particular class, unless the holder of a particular claim . . . agrees to a less favorable treatment." By its express terms, the district court reasoned, section 1123(a)(4) applies only to plan confirmations. Although other courts have applied to pre-confirmation settlements certain chapter 11 plan confirmation requirements—such as the "absolute priority" rule (see, e.g., Motorola, Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating LLC), 478 F.3d 452 (2d Cir. 2007); United States v. AWECO, Inc. (In re AWECO, Inc.), 725 F.2d 293 (5th Cir. 1984))—the district court in Energy Future noted that courts in the Third Circuit (which includes the District of Delaware) have not adopted, and in some cases have expressly rejected, this approach.
Furthermore, the court explained, even if section 1123(a)(4) did apply in this context, the first-lien settlement did not violate the provision. As noted, section 1123(a)(4) permits creditors to agree to less favorable treatment of their claims. To the extent that the first-lien settlement treated the make-whole claims of the 10% Noteholders and the 6⅞% Noteholders differently, the district court wrote, "those parties voluntarily accepted that treatment."
In addition, the district court concluded that the indenture trustee’s interpretation of the phrase "equal treatment" was flawed. According to the district court, although the phrase is not "precisely" defined in the Bankruptcy Code or its legislative history, courts have interpreted "equal treatment" to mean that "all claimants in a class must have the same opportunity for recovery" (citation omitted and emphasis added). Here, the court wrote, although the first-lien settlement treated the make-whole claims of the 10% Noteholders and the 6⅞% Noteholders differently, "each noteholder had the opportunity to decline the settlement offer and litigate the full value of the claim."
Finally, the district court ruled that the first-lien settlement did not constitute an improper sub rosa chapter 11 plan. A sub rosa plan, the court explained, is a broad settlement that amounts to a de facto plan of reorganization but is not subject to the plan confirmation requirements and other creditor protections set forth in the Bankruptcy Code. Energy Future, however, withdrew its request for approval of the global settlement. Thus, the district court found that the indenture trustee failed to demonstrate how the first-lien settlement by itself "disposes of all claims against the estate or restricts creditors’ rights to vote."
The district court accordingly affirmed the bankruptcy court’s order approving the first-lien settlement. The indenture trustee appealed the ruling to the Third Circuit.
The Third Circuit’s Ruling
A three-judge panel of the Third Circuit affirmed the rulings below for substantially the same reasons articulated by the district court.
Writing for the panel, circuit judge Patty Schwartz explained that, although the parties referred to the arrangement in question as a "tender offer," it was nothing more than a vehicle for conveying a settlement offer. She further noted that the indenture trustee failed to identify any section of the Bankruptcy Code that forbids settlements using a tender offer process, which has been used to settle claims in other bankruptcy cases, including In re AMR Corp., 485 B.R. 279 (Bankr. S.D.N.Y. 2013); In re Eastman Kodak Co., 479 B.R. 280 (Bankr. S.D.N.Y. 2012); and In re Standard Oil & Expl. of Del., Inc., 136 B.R. 141 (Bankr. W.D. Mich. 1992).
Although the debtors in those cases sought approval from the court prior to launching their tender offers, Judge Schwartz wrote, "we see no reason to hold that the order of events dictates whether a settlement achieved by a tender offer is fair and equitable." Instead, the bankruptcy court "retains the discretion to determine whether the circumstances and timing surrounding an offer undermine its fairness." Here, Judge Schwartz concluded, the bankruptcy court appropriately exercised that discretion in approving the settlement.
The Third Circuit panel rejected the indenture trustee’s argument that the tender offer process is incompatible with various provisions of chapter 11, including section 1125 (requiring court approval of a disclosure statement for solicitation of a plan), section 1126(c) (providing for class voting on and acceptance of plans), section 1128 (plan confirmation hearing), and chapter 11’s "class-based" procedures for negotiating the terms of a plan. According to Judge Schwartz, "None of the sections apply to court-approved settlements entered before the plan confirmation process has begun . . . [and consequently], there is nothing to show [that] the use of such a process contravenes the Bankruptcy Code."
The Third Circuit panel also rejected the indenture trustee’s contention that the settlement violated the "equal treatment" rule set forth in section 1123(a)(4) because various first-lien noteholders received different percentages of the potential full value of the make-whole premiums. Citing In re Jevic Holding Corp., 787 F.3d 173 (3d Cir. 2015), Judge Schwartz explained that core bankruptcy principles applicable in the plan confirmation context, such as the absolute priority rule (section 1129(b)(2)) and the equal treatment rule, "are not categorically applied in the settlement context." Instead, she wrote, although a "settlement’s fidelity to the requirements of the Bankruptcy Code will generally be the most important factor in determining whether a settlement is fair and equitable," a settlement may deviate from such rules if the bankruptcy court "ensur[es] the evenhanded and predictable treatment of creditors" and has "specific and credible grounds to justify the deviation" (citing Jevic, 787 F.3d at 178, 184).
According to the Third Circuit panel, the bankruptcy court properly concluded that there was in fact equal treatment because each first-lien noteholder was offered: (i) the same percentage of both principal and accrued interest; and (ii) the opportunity to retain its rights to seek a make-whole premium. This choice to participate or not, Judge Schwartz wrote, "is all that the Bankruptcy Code requires" (citing In re W.R. Grace & Co., 729 F.3d 332, 344 (3d Cir. 2013) ("[C]ourts have interpreted the same treatment requirement to mean that all claimants in a class must have the same opportunity for recovery.")). She explained that "mere differences in potential final outcomes resulting from choices made by individual creditors do not violate the equal treatment protections of § 1123(a)(4)."
Finally, the Third Circuit panel ruled that, in the absence of evidence that uninvolved creditors’ recoveries were impacted by the settlement or that any requirement of chapter 11 was subverted by it, the settlement did not constitute a sub rosa chapter 11 plan.
Energy Future is a highly unusual case. In addition to being nonprecedential, the Third Circuit’s ruling should not be read as an endorsement of the tender offer as a preferred vehicle for effectuating a debt restructuring in chapter 11. In fact, one of the principal advantages of chapter 11 over out-of-court restructurings for public companies is not having to comply with the registration requirements of laws that govern the offer or sale of securities outside bankruptcy. Compliance with such nonbankruptcy laws is generally unnecessary in the chapter 11 plan process in light of the Bankruptcy Code’s disclosure requirements in connection with the solicitation of votes on a plan and the chapter 11 plan confirmation standards.
Energy Future filed for chapter 11 protection to implement a prenegotiated restructuring that contemplated a series of exchange offers, cash tender offers, and related transactions. Instead of attempting to implement the exchanges as part of a chapter 11 plan, Energy Future elected to seek court approval of the restructuring under Rule 9019 as part of a global settlement. Because the offers would not be subject to chapter 11’s disclosure statement and plan confirmation requirements, Energy Future decided to comply with securities laws in making the offers, presumably to ward off objections directed toward the propriety of the process.
Why it chose this strategy is unclear. Perhaps it calculated that the transactions comprising the global settlement were more likely to be approved under the standards governing a Rule 9019 motion—in the Third Circuit, a settlement must be "fair and equitable" and "above the lowest point in the range of reasonableness" (see In re Capmark Financial Group, Inc., 438 B.R. 471, 475 (Bankr. D. Del. 2010))—than under the more exacting chapter 11 plan confirmation requirements.
The Third Circuit’s rejection of the approach employed by the Fifth Circuit (and, to a lesser extent, the Second Circuit) in applying plan confirmation requirements to pre-confirmation settlements is notable. To the extent that a proposed settlement does not comply with such requirements, it puts the burden squarely on objecting parties to demonstrate that the settlement is not fair and equitable.