Tension Within Chapter 11: Break-Up Fee Enforceability and In re Energy Future Holdings

[1]The recent case of In re Energy Future Holdings[2] highlights the difficulties and risks of using break-up fees within chapter 11 cases. Break-up fees, also referred to as termination fees, originated in the context of mergers and acquisitions.[3] Break-up fees act as a type of liquidated damages clause in an asset-purchase agreement, in effect compensating an original prospective purchaser, commonly referred to as the “stalking horse,” for the time and expense spent developing a bid to purchase the target asset(s) in the event that the transaction is not consummated, most frequently due to a higher bidder.[4]

Whereas state law governing commercial asset sales generally mandates break-up fee review under the business-judgment rule, there is much less clarity under chapter 11.[5] As a matter of state corporate law, there are questions as to the efficiency of break-up fees: Do break-up fees stifle auction activity and thereby deprive shareholders of the full market value, or do break-up fees encourage acquisition activity and competitive bidding, thereby driving the purchase price up?

Nonetheless, these fees are presumptively valid as a matter of business judgment.[6]  Therefore, absent a showing of managerial self-dealing within commercial asset-sale agreements, courts typically uphold break-up fee arrangements under the business-judgment rule’s deferential standard.[7]

As a matter of corporate governance inside of bankruptcy, however, bankruptcy courts are much less consistent.[8]  Reflecting the complicated corporate governance issues that arise when large publicly traded corporations operate under chapter 11 protection, bankruptcy courts have developed three alternative standards for assessing the validity of break-up fees within chapter 11 asset-sale agreements: (1) the administrative-expense standard; (2) the best-interests-of-the-estate test; and (3) a modified business-judgment rule.[9] In re Energy Future Holdings[10] demonstrates this complexity. Citing a misunderstanding of the terms to

the agreement and a complicated record, the U.S. Bankruptcy Court for the District of Delaware overturned its authorization of the $275 million break-up fee nearly a year later. While the case uniquely demonstrates the pertinent procedures for such reconsideration, the case more broadly highlights the uncertain enforce- ability of break-up fees. Further, the court’s application of the Third Circuit’s administrative-expense standard highlights the tradeoff inherent in approving break-up fees: The fact-intensive administrative-expense analysis employed to determine a break-up fee’s monetizable benefit is consistent with maximizing estate value and other types of liquidated damages provisions. However, fact-intensive scrutiny also introduces legal uncertainty that may undermine the ability of break-up fees to incentivize stalking-horse bidding.

In re Energy Future Holdings Corp.[11] Timeline

The Delaware bankruptcy court recently granted a motion to reconsider its previous authorization of a $275 million break-up fee. NextEra Energy Inc., as the stalking-horse, and Energy Future Holdings (EFH), as the debtor, entered into a merger agreement in July 2016 for the acquisition of Oncor Electric Delivery Co. LLC, which was worth approximately $18.7 billion. After sale discussions began in April 2016, the parties sought court approval of the subsequent plan and merger agreement (together, the “agreement”) on July 29, 2016, which included a break-up fee provision for $275 million if EFH sought out an “alternative proposal.” The court approved the agreement on Sept. 19, 2016, over the last remaining objection.

The material issue facing the court at the time was whether the break-up fee provision would be triggered in the event that the Public Utility Commission of Texas (PUCT) did not subsequently authorize the transaction. The court’s approval of the agreement did not limit nor preclude assertion of the break-up fee in the event that the PUCT denied the change-in-control application. On Sept. 22, 2016, the PUCT held a hearing to address its concerns about the break-up fee inappropriately pressuring the PUCT to rescind previous regulatory requirements that it imposed on Oncor and authorize the transaction, or otherwise subject the estate to the $275 million break-up fee. In response to the PUCT’s concerns, both EFH and NextEra clarified the scope of the break-up fee in a Sept. 25, 2016, letter to the court that, in essence, stated that the break-up fee would not be payable in the event that NextEra cancelled the agreement, but would be payable in the event that EFH terminated the agreement due to the PUCT not rescinding certain “burdensome conditions” or failing to approve the transaction in total.

On Oct. 21, 2016, the parties submitted their joint change-in-control application (the “joint application”) to the PUCT, which made clear that NextEra would not go forth with the deal in the event that two previously imposed regulations on Oncor (the “burdensome conditions”) were left in place: the mandate that (1) an independent board of directors be maintained by Oncor, and (2) certain minority shareholders’ maintain the ability to veto dividends.

On March 30, 2017, the PUCT held a meeting on the transaction and discussed significant concerns over NextEra’s unwillingness to proceed with the transaction in the event that the two provisions were not rescinded; the PUCT denied the joint application two weeks later. NextEra subsequently filed three rehearing requests (May 8, June 7 and June 29, 2017), which were all denied for the same reasons. NextEra did not terminate the agreement, but instead placed insurmountable financial pressure on the debtor to terminate the agreement and trigger the break-up fee or remain gridlocked with costs for the foreseeable future.

The debtors terminated the agreement and pursued an alternative transaction on July 7, 2017, citing a failure to obtain regulatory approval and breaches of contract in support. A motion to reconsider the break up fee approval from the Sept. 19, 2016, order was filed.

Mo​tion for Reconsideration

The court held that Bankruptcy Rule 9023[12] applied to the motion to reconsider because the original order was interlocutory in nature. In justification, the court noted that it retained jurisdiction over the break- up fee due to the order’s mandate that the court address the allocation of the break-up fee “when it becomes ‘due and payable pursuant to the terms and conditions of the Merger Agreement.’” The policy behind granting interlocutory rehearings applies where a court overlooks or does not fully understand a material fact. Therefore, to grant the motion for reconsideration, Rule 9023[13] required the court to find the reconsideration that was necessary to prevent manifest injustice or to correct a clear error of fact or law. In turn, a manifest injustice required an indisputable error correlated with a “patently unfair and tainted” record; a “clear error” finding required an indisputable disregard of the law or evidence. The Delaware bankruptcy court emphasized that NextEra’s reliance arguments could not be reasonable due to the record:

Whatever interests NextEra may have in the Termination Fee must give way to the interest in ensuring that the Court’s decisions are based on a complete record and a proper application of controlling precedent. Likewise, granting reconsideration here does not impugn all termination fees. Parties that accurately and properly negotiate, structure, and disclose termination fees to a court can still rely on orders approving such fees.

In turn, the court reasoned that it fundamentally misunderstood that NextEra could perpetually file motions for rehearings with the PUCT due to the merger agreement’s lack of a time limit. The court would have logically determined that allowing NextEra to use the full process and time for appealing the PUCT denial in order to force the debtors to terminate the agreement was insufficient for approval of the break-up fee.

Thr​ee Applicable Break-up Fee Standards

Of particular relevance, the Third Circuit relied on the administrative-expense standard as instituted in O’Brien.[14] The administrative expense standard is rooted in § 503 of the Bankruptcy Code: “After notice and a hearing, there shall be allowed administrative expenses ... including ... the actual, necessary costs of preserving the estate.”[15] A break-up fee, in turn, must be “actual” and “necessary” to preserve the value of the estate; this stringent review primarily relies on three determinations: whether the break-up fee (1) induced higher bids; (2) induced the stalking horse into research and valuation of the assets, such that the true value of the assets was ascertained; and (3) “chilled” the bidding process.[16]

Alternatively, the leading case within the Second Circuit’s jurisprudence relies on the business-judgment rule.[17] The U.S. Bankruptcy Court for the Southern District of New York set forth the factors to be considered in applying the business-judgment rule to a break-up fee within the bankruptcy context:

 (1) whether the relationship of the parties who negotiated the break-up fee is tainted by self-dealing or manipulation; (2) whether the fee hampers, rather than encourages, bidding; and (3) whether the amount of the fee is unreasonable relative to the proposed purchase price.[18]

Bankruptcy courts applying the best-interests-of-the-estate test articulate differing factors for break-up fee analysis.[19] Nonetheless, the primary determination centers on whether the break-up fee “act[s] to further the diverse interests of the debtor, creditors and equityholders, alike.”[20] Factors stemming from this determination generally include whether the break-up fee was the product of an arm’s-length transaction, whether the break-up fee was a reasonable percentage of the overall purchase price, and whether unsecured creditors would be adversely impacted if the break-up fee was authorized.[21]

The Court’s O’Brien Analysis

Citing the O’Brien[22] administrative-expense standard, the Delaware bankruptcy court sought to re-determine whether the break-up fee induced a higher bid or played a critical role in determining Oncor’s accurate valuation — the two primary determinations warranting approval of a break-up fee. The court explained that the ancillary motivations behind the break-up fee were substantially unrelated to those justifiable purposes, clinging to the rationale that the break-up fee served the primary purpose of leveraging PUCT approval and protecting NextEra if the PUCT did not rescind its regulatory requirements nor authorize the transaction:

Payment of a termination or break-up fee when a court (or regulatory body) declines to approve the related transaction cannot provide an actual benefit to a debtor’s estate sufficient to satisfy the O’Brien standard.... Allowance of a termination or break-up fee when a debtor chooses to pursue a higher and better offer is appropriate. In this case, the Debtors were forced to terminate the Merger Agreement to pursue a lower offer because NextEra had the debtors in a corner.

Emphasizing that reconsideration is an extraordinary and unusual step, the court found its own misunderstanding in conjunction with the confusing record sufficient to justify granting the motion for rehearing regarding the break-up fee provision’s validity.

Potential Implications f​or Break-up Fee Review

The legal standards governing break-up fee analysis within bankruptcy represent larger complexities surrounding the use of chapter 11 to facilitate large-scale asset sales. Specifically, it highlights the emphasis placed on asset-sale procedures as a means of balancing the tension between maximizing the value of an estate and protecting the interests of creditors. Faced with the concern that free-and-clear asset sales might be shifting value from the estate to the purchasers, courts are justifiably concerned with actively monitoring asset sale procedures. Energy Future Holdings[23] can be understood as the difficulty facing courts in trying to monitor asset-sale procedures.

Further, it highlights the distinction between Delaware’s fact-specific analysis with New York’s more deferential standard.[24] For example, in Energy Future Holdings,[25] it is quite likely that had the debtors petitioned in New York, the bankruptcy-modified business-judgment rule would be applied.[26] The break-up fee likely was not the product of self-dealing or manipulation; in fact, the debtors contributed to letters and documentation supporting the authorization of the break-up fee.

Although a determination on the record would be required, the debtors received a bid shortly after the agreement was terminated, making a finding that the break-up fee stifled any auction activity unlikely. In addition, the break-up fee constituted under 2 percent of the overall purchase price. In turn, the break-up fee likely would have been approved and upheld had the case been filed in New York and analyzed under the bankruptcy-modified business-judgment rule.

Viewing the case in this way, Energy Future Holdings[27] demonstrates the tradeoff underlying these two legal standards. In O’Brien,[28] the post-sale analysis of the break-up fee’s actual, monetizable contribution to maximizing the value of the estate might protect against the unjustifiable disposition of estate funds; how- ever, it creates ex ante legal uncertainty regarding the enforceability of contractually agreed-upon break-up fee provisions. In contrast, the New York approach provides greater certainty for stalking-horse bidders, but it might also create barriers that hinder or prevent competitive bidding.

Energy Future Holdings[29]Energy Future Holdings[30]highlights the importance of this issue, as chapter 11 continues to be a popular procedure for conducting asset sales.