In a recent non-precedential opinion, the United States Court of Appeals for the Third Circuit upheld decisions by the United States District Court for the District of Delaware and United States Bankruptcy Court for the District of Delaware in ruling that the plain meaning language in an intercreditor agreement did not govern allocation of adequate protection payments or plan distributions where payments were neither collateral or proceeds of a sale of collateral conducted by the collateral agent. [1] The Third Circuit’s decision is consistent with Judge Drain’s decision in Momentive.[2]

Procedural and Factual Background

The First Lien Creditors and the Intercreditor Agreement

Energy Future Holdings, an electric company in Texas, filed bankruptcy in 2014 along with certain of its subsidiaries. One of those subsidiaries, Texas Competitive Electric Holdings Company LLC (TCEH), owed money to two groups of first lien creditors: (i) approximately $22.6 billion pursuant to a 2007 term loan and revolving loan debt (the First Lien Bank Debt held by the First Lien Creditors); and (ii) approximately $1.75 billion of senior secured notes (the First Lien Notes held by First Lien Noteholders) issued under a 2011 indenture. As of the bankruptcy filings, the First Lien Bank Debt and First Lien Notes (collectively, the First Lien Debt) were undersecured. The same collateral secured both groups’ debts, consisting of almost all of TCEH’s assets, and both groups had equal priority to the shared collateral.

Pursuant to an intercreditor agreement (the Intercreditor Agreement) governing the relationship between the First Lien Creditors and the First Lien Noteholders (collectively, the Creditors), a waterfall provision was implemented which directs how to distribute collateral, or proceeds thereof, if TCEH defaulted on the First Lien Debt. Specifically, Section 4.1 of the Intercreditor Agreement provides:

Application of Proceeds. Regardless of any Insolvency or Liquidation Proceeding which has been commenced by or against the Borrower or any other Loan Party, Collateral or any proceeds thereof received in connection with the sale or other disposition of, or collection on, such Collateral upon the exercise of remedies under the Security Documents by the Collateral Agent shall be applied in the following order ….

With respect to all Collateral other than Deposit L/C Collateral:

[F]irst, on a pro rata basis, to the payment of all amounts due to the Collateral Agent, any Agent, and the Issuing Lenders … under any of the Financing Documents;

[S]econd, on a pro rata basis to any Secured Party which has advanced or paid any fees to any Agent or Issuing Lender which has not been previously reimbursed;

[T]hird, on a pro rata basis, to the payment of, without duplication, (a) all principal and other amounts then due and payable in respect of the Secured Obligations (including Cash Collateralization of all outstanding Revolving Letters of Credit) and (b) the payment of Permitted Secured Hedge Amounts then due and payable to any Secured Commodity Hedge Counterparty under any Secured Commodity Hedge and Power Sales Agreement; and

[L]ast, the balance, if any, after all of the Secured Obligations have been indefeasibly paid in full in cash, to the Loan Parties or as otherwise required by applicable law.

Additionally, section 4.2 of the Intercreditor Agreement placed certain limitations on cash payments from collateral proceeds post-default and provides:

After (a) the commencement of any Insolvency or Liquidation proceeding in respect to any Loan Party … no payment of cash (or the equivalent of cash) shall be made from the proceeds of Collateral by any Loan Party to the Collateral Agent for the benefit of any Secured Party, except as provided for in Section 4.1.

The Bankruptcy Distributions

After the filing of the bankruptcy petitions, TCEH sought to use the Creditors’ collateral to keep running its business. To protect against this risk of diminution of the collateral, the Bankruptcy Court ordered TCEH to make monthly adequate-protection payments (the Adequate Protection Payments) to the Creditors and required that any disputed portion of such payments be escrowed pending further order resolving such dispute.

More than two years later, the Bankruptcy Court approved TCEH’s chapter 11 plan (the Plan). Under the Plan, in exchange for claims on account of their First Lien Debt, Creditors received three types of Plan distributions (the Plan Distributions): (1) cash; (2) stock in a newly formed company; and (3) the right to receive tax benefits that the government owed the subsidiary.

The Disputes Among the Creditors

Disputes arose among the Creditors regarding whether Plan Distributions and Adequate Protection Payments must be allocated to Creditors in accordance with the waterfall provision in Section 4.1 of the Intercreditor Agreement and whether the division of Adequate Protection Payments and Plan Distributions among the Creditors must be inclusive of post-petition accrued interest or distributed pro rata based on amounts owed as of the petition date. The parties estimated that $90 million hinged on the answers to these questions.

Delaware Trust Company (DT), as collateral agent for the First Lien Noteholders, sought a declaratory judgment that the waterfall provisions in the Intercreditor Agreement govern and that post-petition interest should accrue on the First Lien Debt for purposes of allocating Adequate Protection Payments and Plan Distributions between and among the Creditors, thereby benefitting the First Lien Noteholders who were entitled to a higher rate of interest.

DT asserted that the Plan Distributions, as a whole, constituted collateral under section 4.1 of the Intercreditor Agreement because they are (i) “consideration received from the sale, exchange, license, lease or other disposition of any asset or property that constitutes [c]ollateral;” and (ii) amounts “receivable or received when [c]ollateral or proceeds are sold, exchanged, collected or otherwise disposed of.” Specifically, DT argued that as part of the spin-off transaction in the Plan, substantially all of the collateral would be sold by TCEH to reorganized TCEH in exchange for 100% of reorganized TCEH’s stock and the proceeds from a debt offering and preferred stock sale, which would then be distributed to Creditors under the Plan. As a result, according to DT, the Plan Distributions constituted collateral because substantially all of the TCEH’s subsidiaries constituted collateral, and, under the Plan, these subsidiaries’ assets were “sold” to reorganized TCEH, which, in turn, was distributed as stock in the reorganized entity to the Creditors. DT contended that this was a direct transfer of collateral to the Creditors; effectively no different than if the Creditors had foreclosed or otherwise collected on the subsidiaries themselves. Alternatively, DT maintained that the Plan Distributions were proceeds of collateral.

DT further argued that the Adequate Protection Payments were also collateral because: (i) they constitute “amounts from time to time paid or payable under or in connection with any of the Collateral[;]” (ii) the payments are being made “in connection with” and as an express condition of TCEH’s continued use of the collateral; and (iii) pursuant to the cash collateral order, TCEH stipulated that its “Cash on Hand” constituted collateral.

Certain First Lien Creditors intervened, opposing the relief sought by DT and seeking a judgment that the Adequate Protection Payments and Plan Distributions be allocated on a pro rata basis based on the amounts owed as of the Petition Date (the Petition Date Allocation Method), thereby benefitting the First Lien Creditors who held a larger percentage of the First Lien Debt as of the petition date.

The Lower Court Decisions

The Bankruptcy Court determined that there are four conditions precedent to the application of the Section 4.1 Waterfall [3]:

1. Collateral or any proceeds of collateral are to be distributed to the Creditors;
2. The collateral must be “received” by the Collateral Agent;
3. The collateral or the proceeds of collateral must have resulted from a sale or other disposition of, or collection on, such collateral; and
4. The sale, disposition, or collection must have resulted from the exercise of remedies under the security documents.

The Bankruptcy Court determined that because Section 4.1 is the only section in the Intercreditor Agreement regarding application and distribution of proceeds, if any of four requirements are not met, then the Adequate Protection Payments and the Plan Distributions would be distributed outside of the Intercreditor Agreement (i.e. pursuant to the terms of the Bankruptcy Code, orders of the Bankruptcy Court, and the Plan).

The Bankruptcy Court did not find DT’s argument that the Plan Distributions constitute collateral persuasive and, adopting the reasoning of Judge Drain in Momentive [4], held that the Creditors did not have a lien on the new common stock issued as part of the debt-for-equity swap in the Plan; therefore, to consider the new stock received under the Plan as proceeds of collateral would improperly add to the Creditors’ collateral. Notably, in addressing whether the proposed spinoff transaction was a “sale or other disposition” of collateral, Judge Sontchi concluded, in further reliance on Momentive, that the Plan gave no indication that reorganized TCEH was “purchasing” the collateral, nor that reorganized TCEH was a third-party purchaser, noting the absence of any “‘economic event’ that would create that sort of relationship.”

Nor did the Bankruptcy Court agree with the Noteholders that the Plan Distributions were proceeds of collateral. Instead the Bankruptcy Court remarked that the language of the security agreement limited proceeds to: (i) any consideration received from the sale/disposition of assets, (ii) value received by TCEH as a consequence of possessing the collateral, or (iii) insurance proceeds, none of which apply to the Plan Distributions.

Further, the Bankruptcy Court held that Adequate Protection Payments were not collateral as argued by the First Lien Noteholders, but rather constituted a protection against diminution in value of collateral.

On appeal, the United States District Court for the District of Delaware upheld the Bankruptcy Court in determining that the Intercreditor Agreement did not apply to the Plan Distributions or the Adequate Protection Payments. [5]

The District Court determined: (i) the stock distribution under the Plan was not collateral because it was issued as part of the Plan and because the shares of stock did not exist before the bankruptcy filings, the Creditors did not have a lien on them and they are not collateral; (ii) the stock distribution was not a sale or disposition of collateral because the transaction under the Plan was akin to a standard debt-for-equity swap, no sale for a price occurred, and reorganized TCEH was not a third-party buyer; (iii) any cash distributions under the Plan were not collateral or proceeds of collateral because the First Lien Creditor waived their section 552(b) rights [6] to assert that they had a valid lien on post-petition cash that was proceeds of the prepetition collateral by failing to raise the argument before the Bankruptcy Courts, and notwithstanding, the First Lien Creditors failed to trace the post-petition cash generated by TCEH to prepetition collateral; (iv) any tax attributes under the Plan are not collateral or proceeds of collateral because the definition of “General Intangibles” in the security documents does not include tax attributes; and (v) the Adequate Protection Payments were not collateral because they were designed to protect the creditors from diminution in value of their collateral, and each such payment is not collateral itself.

The Third Circuit Affirms

In affirming the District Court, the Third Circuit held that “[t]he waterfall provision would apply to the adequate-protection payments and plan distributions if they were collateral. But they are not.”

The Third Circuit determined that the Plan Distributions were made from assets on which the Creditors had no liens and that the Adequate Protection Payments were not payments of collateral because they did not reduce the amount of money TCEH owed on the First Lien Debt, rather they were payments in exchange for Creditors to let TCEH use the collateral for other purposes.

Furthermore, the Third Circuit found that the distributions to the Creditors were not proceeds of collateral because the waterfall imposed two requirements: “First the proceeds must be from a sale, collection, or disposition of collateral. Second, that sale, collection, or disposition must be part of a remedy implemented by the collateral agent [ ].” The Third Circuit determined that neither the Plan Distributions or Adequate Protection Payments satisfied both requirements. The Third Circuit held that while the Plan Distributions might meet the first requirement (a sale or disposition), they did not meet the second (part of a collateral agent’s remedy) because the corporate restructuring under the Plan was a “far cry from a collateral agent’s typical remedy: selling the collateral at a foreclosure sale.” The Third Circuit also found that the Adequate Protection Payments failed the two-part requirement because no sale, collection, or disposition of collateral was identified by the First Lien Creditors and proceeds cannot be from a sale where no sale existed. The Third Circuit also stated that the First Lien Creditors were correct that each Creditors’ share should not include post-petition interest.

Accordingly, the Third Circuit, relying on plain meaning language of the Intercreditor Agreement, affirmed the Petition Date Allocation Method, finding the Creditors were entitled to payment and distributions based on what TCEH owed on the petition date.

Practical Effect on Indenture Agreements

The Third Circuit’s decision places the Third Circuit in line with Judge Drain’s decision from Momentive in the Second Circuit. Going forward, there is a more definite roadmap and lien creditors should carefully review applicable intercreditor agreements and security documents to determine the enforceability of treatment and waterfall provisions to chapter 11 plan distributions. Parties should also consider these issues when agreeing to adequate protection payments at the beginning of a case. If the waterfall provisions are restrictive and have significant financial implications, creditors may seek to steer a debtor in a direction of disposing of, or dealing with assets in a manner that either complies with or doesn’t comply with the intercreditor agreement’s waterfall provisions, depending of course on where the creditor stands with respect to those provisions.

As a result of the Third Circuit’s decision, expect to see intercreditor agreements more specifically worded to address the issues raised in Energy Future Holdings and ensure that waterfall provisions govern distributions under chapter 11 plans as well as adequate protection payments or similar payments. Parties to intercreditor agreements should review all relevant language governing priority of distributions and consider broadening such language to specifically include payments pursuant to orders of a bankruptcy court, or other courts, or a bankruptcy plan.

Where consensual amendments to existing intercreditor agreements are not attainable, creditors seeking to enforce a waterfall provision in a bankruptcy case should be actively involved to protect their rights. In connection with a motion seeking to use cash collateral, a typical “first day” motion, creditors will want to ensure that the terms of any order clearly sets forth what is “collateral” under the intercreditor agreement and that the order not only preserves the creditors’ rights to “proceeds, products, offspring, or profits” of the collateral under section 552(b)(1) of the Bankruptcy Code, but also explicitly states that such products, offspring, or profits of the collateral are governed by the intercreditor waterfall.

Creditors seeking adequate protection in connection with a cash collateral or financing motion should seek to have such protection, whether in the form of payments, replacement liens, or other relief, explicitly governed by the waterfall provisions in the intercreditor agreement. Where disputes arise as to whether adequate protection is a payment of collateral or a protection against diminution of collateral, creditors may still have strong arguments that adequate protection payments are a payment of collateral. [7] Despite its form, the entitlement to and measure of adequate protection is always determined by the extent of the anticipated or actual decrease in the value of the secured creditor’s collateral during the bankruptcy case. [8] As such, adequate protection can be viewed as a replacement of collateral, similar to insurance proceeds when collateral is destroyed, which typically are included in waterfall provisions.

Creditors should also engage debtors in the plan drafting process to ensure the plan contains language holding that any payments made to parties to an intercreditor agreement are on account of the sale or disposition of collateral, or value received by the debtor as a consequence of possessing the collateral, and that the distribution shall be deemed a remedy under the terms of the intercreditor agreement (or similar language that will satisfy the intercreditor agreement in question).

To possibly capture payments made in a chapter 11 case, parties will need to focus on how to design security documents and bankruptcy orders, whether under an adequate protection, cash collateral, or confirmation order, to include adequate protection or plan payments as collateral or disposition of collateral, or more specifically earmark adequate protection and plan payments as payments subject to an intercreditor waterfall.

[1] In re Energy Future Holdings Corp., No. 18-1957, 2019 WL 2535700 (3d Cir. June 19, 2019).

[2] BOKF, N.A. v. JP Morgan Chase Bank, N.A. (In re MPM Silicones, LLC), 518 B.R. 740 (Bankr.S.D.N.Y.2014), aff’d sub nom. In re MPM Silicones, L.L.C., 596 B.R. 416 (S.D.N.Y. 2019).

[3] In re Energy Future Holdings Corp., 546 B.R. 566 (Bankr. D. Del. 2016).

[4] BOKF, N.A. v. JP Morgan Chase Bank, N.A. (In re MPM Silicones, LLC), 518 B.R. 740 (Bankr.S.D.N.Y.2014), aff’d sub nom. In re MPM Silicones, L.L.C., 596 B.R. 416 (S.D.N.Y. 2019).

[5] In re Energy Future Holdings Corp., 585 B.R. 341 (D. Del. 2018), aff’d, No. 18-1957, 2019 WL 2535700 (3d Cir. June 19, 2019).

[6] Section 552(b)(1) of the Bankruptcy Code provides: Except as provided in sections 363, 506(c), 522, 544, 545, 547, and 548 of this title, if the debtor and an entity entered into a security agreement before the commencement of the case and if the security interest created by such security agreement extends to property of the debtor acquired before the commencement of the case and to proceeds, products, offspring, or profits of such property, then such security interest extends to such proceeds, products, offspring, or profits acquired by the estate after the commencement of the case to the extent provided by such security agreement and by applicable nonbankruptcy law, except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise.

[7] The concept of adequate protection is designed to protect an entity with an interest in property of the estate against an unconstitutional taking of its property interest through suspension or abrogation its right to look to its collateral to repay the debt. In re Gallegos Research Group, Corp., 193 B.R. 577 (Bankr. D. Colo. 1995) (citing Wright v. Union Cent. Life Ins. Co., 311 U.S. 273, 61 S. Ct. 196, 85 L. Ed. 184 (1940)).

[8] In re First South Savings Assoc., 820 F.2d 700, 710 (5th Cir.1987).