The Third Circuit recently affirmed that a debtor in Chapter 11 can use a tender offer to settle claims without running afoul of the Bankruptcy Code. Although In re Energy Future Holdings Corp. is limited to its particular facts and circumstances, the decision could lead to increased use of tender offers prior to confirmation of a bankruptcy plan. A tender offer mechanism would be particularly attractive where creditors hold over-secured debt, because a bankruptcy settlement may stop the accrual of interest on the debt, thereby preserving assets for the remainder of the estate.
The debtors in the Third Circuit case were the largest electrical energy company in Texas, Energy Future Holdings Corp. ("EFH"), and its subsidiary Energy Future Intermediate Holdings Corp. ("EFIH") (collectively, the "Debtors").1 Tumbling energy prices combined with a debt load incurred in a 2007 leveraged buyout caused the Debtors to struggle financially, and they filed for bankruptcy in 2014. The Debtors had issued two series of first lien notes with an aggregate principal amount of $4 billion. The indenture for each series of notes contained a "make-whole premium" intended to compensate noteholders for lost interest if Debtors redeemed the notes before their final maturity date.
During the two years prior to the bankruptcy filing, the Debtors had been in negotiation with certain of their creditors, including some of the holders of their first lien notes. The result of those negotiations was a restructuring support agreement providing for an out-of-court global restructuring. Ultimately, the Debtors were unable to avoid a bankruptcy filing, but one week after filing for bankruptcy, the Debtors launched a tender offer for the first lien debt on terms set forth in the restructuring support agreement. Under the terms of the offer, first lien noteholders would exchange their notes for a principal amount of new first lien DIP loans equal to 105% of the principal amount, declining to 3.25% after 14 days, and 101% of accrued interest. In return, holders would release the Debtors from having to pay the make-whole premium. Holders were advised that the Debtors intended to commence litigation to disallow the make-whole premium associated with any first lien notes not tendered in the exchange.2
Each issuance of first lien notes had a different interest rate and redemption date, thus affecting the size of the potential claim. The great majority of noteholders with the smaller potential make-whole claim tendered into the exchange, while the majority of holders with the larger potential make-whole claim did not do so. After initiating the tender offer, the Debtors filed a motion for approval of the settlement embodied in the tender offer. In June 2014, the bankruptcy court approved the settlement over the objections of the trustee for the first lien notes.
The Court's Analysis
The first lien notes trustee argued that a tender offer is an impermissible way of settling claims in Chapter 11 bankruptcy proceedings. This claim was rejected on appeal by both the district court and the Third Circuit. In re Energy Future Holdings Corp., No. 14-723 (D. Del. Feb. 19, 2015), affirmed No. 15-1591 (3d Cir. May 4, 2016). "Any danger with a tender offer," the appeals court said, "results from the specific offer itself and how it is used, and not from an inherent problem with tender offers as a means to settle bankruptcy claims."
As a preliminary matter, the Third Circuit observed that the tender offer was "merely a mechanism to communicate the settlement offer." The appeals court found no section of the bankruptcy code that forbids settlement using a tender offer process.
The issue was then whether the bankruptcy court acted within its discretion to approve the tender offer. In exercising its authority to approve a settlement, the appeals court said, the bankruptcy court must determine whether the settlement is "fair and equitable," a point disputed by the first lien notes trustee. The factors to be considered in this determination are (1) the probability of success in litigation; (2) the likely difficulties in collection; (3) the complexity of the litigation involved, and the expense, inconvenience and delay necessarily attending it; and (4) the paramount interest of the creditors. Applying these factors, the appeals court concluded that the bankruptcy court acted within its discretion to settle claims against the estate.
The appeals court next addressed the argument of the trustee that the settlement violated the equal treatment rule of Section 1123(a)(4) of the Bankruptcy Code, requiring that similarly situated creditors in a bankruptcy get equal treatment. While Section 1123(a)(4) is not, strictly speaking, applicable to a settlement, the appeals court opined that the equal treatment rule is a basic tenet of the bankruptcy process, which may be applied flexibly in a settlement but should not be disregarded. The court concluded that in fact equal treatment was satisfied because all holders of the first lien notes were given the same opportunity to accept the offer and settle, or not to settle and retain their entire secured claim against the assets of the estate. Different choices made by individual creditors, the court said, do not violate the equal treatment rule. Also, the court observed that the settlement did not adversely impact uninvolved creditors, and in fact benefited them by saving millions of dollars a month in interest payments.
The appeals court also rejected the trustee's contentions that the tender offer was a sub rosa plan and that the tender offer was not a proper settlement because the Debtors launched the tender offer before seeking approval of the bankruptcy court. While it may be preferable, where possible, to seek prior approval from the bankruptcy court, the lack of prior approval does not dictate whether a tender offer is fair and equitable.
It is unusual for debtors to settle or resolve claims through a mechanism like a tender offer so early in a case. However, this made sense in Energy Future Holdings, given the litigation over enforceability of make-whole claims in Chapter 11 and the magnitude of the $4 billion of first lien notes outstanding. While the EFIH bankruptcy presents specific circumstances that may not regularly recur, the Third Circuit's decision lends legitimacy to the use of tender offers to settle claims with creditors in bankruptcy cases in appropriate circumstances.
On the other hand, the Third Circuit itself observed that its decision was "not a blanket endorsement of all tender offers in bankruptcy." Some factors, it seems, that may enter into the calculus of whether a tender offer qua settlement is fair and equitable, and is faithful to the principle of equal treatment, may include whether an offer is open to all class members (which, for example, might not be the case if securities are being offered and only accredited investors may participate), the sophistication of the class members, whether there are elements of coerciveness to the offer and the adequacy of the disclosure given to the offerees. EFIH passed the test. Future cases will no doubt turn on their own facts and circumstances, but the door is now open.
1 Kramer Levin represents the trustee for the holders of 11% second lien notes of EFIH due 2021 and the 11.75% second lien notes of EFIH due 2022 in the EFH bankruptcy.
2 In March 2015, the bankruptcy court rendered a decision in which it determined that the holders of the first lien notes were not entitled to receive a make-whole. The court rendered a similar decision with respect to the second lien notes. These decisions are on appeal to the Third Circuit, and Kramer Levin represents the trustee for the second lien notes indenture in the appeal.
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