Mediation in Large Chapter 11 Cases

Mediation has become an invaluable tool in large chapter 11 cases. Traditionally viewed as a means for resolving discrete disputes between a debtor’s estate and an adversary party, in recent years mediation has in certain complex cases evolved into a multiparty undertaking involving claimants from all levels of a debtor’s capital structure, with the ambitious goal of resolving the entire case through a consensual plan of reorganization.

Recent examples include Residential Capital, LLC (ResCap) and Cengage Learning Inc. (Cengage). These cases illuminate the primary benefits of mediation: the potential to expedite the plan process with a mediator’s assistance, which can save both the estate and creditors from incurring enormous fees related to litigation, and can take advantage of the mediator’s ability to help parties craft unique solutions that might not be available through litigation. Over the past few months, mediation has led to a possible exit path in Energy Future Holdings Corp. (EFH), one of the most seemingly intractable chapter 11 cases ever filed. Although numerous hurdles remain for EFH and opposition from certain key parties remains, the mediation process in that case has led to a structure that could permit a consensual plan of reorganization to be confirmed by the end of 2015.

ResCap: Alleviating Complexity

Bankruptcy practitioners and judges are facing increasingly complex capital structures and novel legal issues in chapter 11 cases.[1] One way for resolving these complexities is through intensive negotiations facilitated by a neutral third party.[2] Because of time constraints, caseload, and the natural reluctance of contesting parties to speak freely before the ultimate case arbiter, bankruptcy judges are often unable to serve this function in the matters before them. Mediators ably fulfill this function.[3]

The ResCap case[4] marked a major success for bankruptcy mediation, primarily because the mediation was able to resolve complex legal issues related to asset-stripping while deciphering a labyrinthine capital structure and esoteric RMBS put-back liability.[5] On May 14, 2012, Residential Capital, LLC and 50 affiliates (ResCap) each filed a voluntary petition for chapter 11 bankruptcy protection. In the year leading up to the petition date, ResCap developed a prepackaged bankruptcy plan, relying heavily on a $750 million settlement payment from its corporate parent, Ally Financial Inc., that resolved claims that the parent stripped valuable assets from the debtors.[6] The debtors’ capital structure included (1) a revolving line of credit supplied by Ally, (2) a secured line of credit through Ally, (3) a repo facility, (4) various collateralized borrowings in securitization trusts, (5) eight public issuances of junior secured and unsecured notes, and (6) trade debt,[7] and the case was further complicated by litigation exposure under numerous RMBS facilities.[8]

The prepackaged plan fell by the wayside fairly quickly. The creditors’ committee requested standing to prosecute claims subject to the Ally settlement agreement.[9] Nearly the entire capital structure started infighting. A sale of the debtors’ primary business operations realized significant value, but with a daily run rate for legal fees of nearly $1 million, the estates needed a quick resolution.[10]

Through mediation, the parties were able to first achieve resolution of the claims against Ally. Although Ally’s settlement payment of $2.1 billion ultimately proved to be nearly three times what was initially contemplated, it obtained a full release of all claims related to ResCap. The parties were then able to confront the morass created by the debtors’ capital structure, the intercreditor agreements and the RMBS issues, and quickly developed a new plan of reorganization. Although one group of junior secured noteholders attempted to litigate their entitlement to post-petition interest, the traction of the mediation process held strong and created a sufficiently strong consensus that a few months later led the noteholders to join in the settlement.[11]

As discussed earlier, ResCap serves as an object lesson not only for cost and time savings, but also for alternative benefits, such as quickly capping nondebtor liabilities. The Ally settlement reached in mediations provided an enormous influx of capital to the estates and paved the way for substantially better recoveries for the unsecured creditors of the estate and, later in the case, resolving the litigation brought by the junior secured creditors.[12] The Ally settlement also benefitted Ally by giving the parent a thoroughly vetted, and eventually court-approved, settlement to all liability related to what could have been crushing liability for fraudulent transfers related to the asset-stripping charges.

Cengage: Balancing Bargaining Power

When one tier of creditors in a debtor’s capital structure holds tremendous bargaining power, mediation can provide parties with ancillary benefits that litigation might not be able to offer: a case in point comes from the Cengage case.[13] In mediation, the creditors in the capital structure quickly reached a resolution of claims against the estates and developed a unique distribution scheme for the plan.[14] The first-lien prepetition lenders held significant leverage over the debtors, but the second-lien creditors and the general unsecured creditors tempered that power with their own hold-up value.

Together, the second-lien creditors and the general unsecured creditors were able to strike a novel deal with the first-lien lenders: For a significant “tip” of 5.5 percent of the estates’ assets, the out-of-the-money creditors would agree to support several of the first-lien lenders in their bid to supply exit financing.[15] A bankruptcy judge adjudicating discrete legal issues would not be able to fashion this kind of relief. Mediation, however, provided the ideal platform for understanding the interests of the first-lien lenders and finding a way to reward their bargaining power while providing value to the other constituencies.

EFH: Facilitating Creative Solutions

EFH arose out of one of the largest leveraged buyouts ever undertaken.[16] Falling natural gas prices upended all of the financial assumptions on which its capital structure had been based, and when it filed for chapter 11 in the spring of 2014 its total debt exceeded $42 billion. Its business operations were divided into two distinct silos: a majority interest in a regulated electrical utility, Oncor, indirectly owned by EFH subsidiary Energy Future Intermediate Holding Company LLC (the so-called “E side” of EFH), and nonregulated electricity generation, mining and commodity risk management and trading operations, indirectly owned by EFH subsidiary Texas Competitive Holdings Company LLC (the so-called “T side” of EFH). A sale process earlier in the case that was being undertaken for the Oncor interest suggested that the E side creditors would see substantial recoveries; however, it was clear from the outset that there would be insufficient value on the T side to provide recoveries to any but the most senior creditors.

The array of disputes complicating the cases has been substantial. Junior creditors on the T side have sought standing to commence litigation against the senior T side lenders arising from the leveraged buyout and subsequent refinancings. There has been extensive litigation over make-whole premiums. Conflicts of interest between the T side and the E side have necessitated detailed corporate governance protocols and the retention of numerous other professional advisors. In addition, there are difficult and highly technical issues arising from EFH’s tax structure and the potential disposition of its subsidiaries’ assets, which threaten to impose multibillion-dollar tax liabilities on the EFH estates.

A mediation process was initiated earlier this year in an effort to resolve the intercreditor T side disputes. After several weeks, however, it became clear based on the statements being made in open court that the process had overrun its boundaries and had led to much more comprehensive discussions regarding overall case resolution. A seemingly pie-in-the-sky idea to create a real estate investment trust (REIT) structure to take control of the Oncor assets began to appear viable, and the junior T side creditors that had been prepared to prosecute a campaign of scorched-earth litigation began instead to consider the terms under which they would agree to backstop it. When it became clear that a plan of reorganization based on the REIT structure could (1) garner support from all levels of the T side capital structure and (2) generate sufficient value to pay all E side creditors in full, EFH agreed to discontinue the Oncor sale process and to put forward a plan based on the terms reached with and among the T side creditors during the course of the mediation.

The REIT-based plan will not be easy to implement. Approvals must be obtained from Texas state regulators and the IRS, and billions of dollars of new capital needs to be raised in a volatile financial environment. The E side creditors’ committee and other major E side creditors are opposed, believing that the Oncor sale process was abandoned too soon, that the REIT plan is not feasible, and that it will be the E side creditors who will bear all of the economic risk if the REIT plan does not succeed.

Notwithstanding the fact that the EFH chapter 11 cases have moved in a relatively short period of time from being poised for engaging in months (if not years) of contentious litigation to being on the verge of a consensual plan that can obviate opposition by being able to pay the claims of nonconsenting creditors in full, this stands as a strong testament to the broad possibilities of bankruptcy mediation. If ultimately successful, the resolution achieved in the EFH case will likely cement the role of mediation in virtually all “mega” chapter 11 cases going forward.

Conclusion

The purpose of mediation is for all parties to discover a way to find common ground while protecting their interests. Its ultimate success in large and complex chapter 11 cases stems from facilitating parties’ goals rather than simply evaluating the merits of their positions. In this regard, the ResCap mediation facilitated Ally’s interest in achieving a complete settlement of its ResCap exposure, and the interests of all creditors for an expeditious resolution, rather than years of deadlocked litigation. Similarly, the Cengage mediation facilitated the first-lien lenders’ attempt to provide exit financing, which had previously drawn objections from the unsecured creditors. The EFH mediation has led to unsecured T side creditors agreeing to paying off E side claims in full so that they could backstop the REIT plan, rather than litigating for an uncertain recovery. The use of mediation in chapter 11 cases to achieve creative solutions is invariably going to continue to grow.

Disclosure: Kelley Drye & Warren LLP represented certain creditors in ResCap, and currently represents certain creditors in the EFH case, but has taken no part in the mediation processes in either case.