In re Optim Energy: Court Denies Creditor Derivative Standing to Seek Recharacterization of Equity Sponsors' Debt Claims

Practical Law Legal Update 4-569-2985 (Approx. 6 pages)

In re Optim Energy: Court Denies Creditor Derivative Standing to Seek Recharacterization of Equity Sponsors' Debt Claims

by Practical Law Bankruptcy

Background

In January of 2007, Cascade Investments, LLC (Cascade), through its wholly-owned subsidiary, ECJV Holdings, LLC (ECJV) and PNM Resources, Inc. (PNMR), formed Optim Energy, LLC (Optim). Each made a $10 capital contribution, followed by additional $2.5 million contributions to fund start-up costs. Optim and its 100% owned subsidiaries (collectively, Debtors) own and operate three power plants in Texas. ECJV owns 100% of Optim and indirectly owns all of the other Debtors. This renders both Cascade and ECJV statutory insiders under section 101(31)(B)(iii) and (E) of the Bankruptcy Code.

In a series of transactions later that year, the Debtors acquired certain assets, which they financed with a $1 billion five-year unsecured revolving credit facility with Wells Fargo Bank, National Association (Wells Fargo). Cascade and ECJV jointly and severally guaranteed the Debtors' obligations to Wells Fargo (Cascade Guarantees) and agreed to subordinate their guaranty claims to the claims of Wells Fargo. The Debtors agreed to reimburse Cascade and ECJV for any payments made under the Wells Fargo Guarantee and to pay quarterly fees to Cascade for entering into the guaranty (Guaranty Reimbursement Agreement). The Debtors also agreed to secure their reimbursement obligations by granting Cascade and ECJV security interests in substantially all of their assets (Pledge and Security Agreement). The Guaranty Reimbursement Agreement stated that the Debtors' reimbursement obligations constituted indebtedness of the Debtors and would in no way be considered an equity or capital contribution by Cascade or ECJV.

In 2011, PNMR, ECJV and Cascade restructured Optim. The Restructuring Agreement:

Increased ECJV's ownership in the Debtors to 99% and reduced PNMR's ownership to 1%.
Required ECJV to make a $5 million payment directly to Wells Fargo to partially pay down the Debtors' loan. The Restructuring Agreement deemed this payment to be a capital contribution to Optim and required that Optim adjust ECJV's capital account to reflect this contribution. In exchange, Optim issued shares to ECJV.
Gave ECJV the option to purchase PNMR's remaining 1% interest in Optim for fair market value, which it did on January 3, 2012, for a price of $0, as the fair market value of this interest was less than zero.

As the Debtors were preparing to file for bankruptcy in early 2014, Cascade paid Wells Fargo the outstanding amounts due on the Debtors' loan. This triggered the Debtors' obligations under the Guaranty Reimbursement Agreement and the Pledge and Security Agreement, making Cascade and ECJV senior secured lenders. On February 12, 2014, the Debtors filed voluntary Chapter 11 petitions.

Cascade and ECJV provided the Debtors with DIP financing. In the DIP financing order, the Debtors released and waived all of their claims against Cascade and ECJV, but preserved the rights of "a party in interest with requisite standing other than the Debtors or an appointed committee" to pursue these claims. Because no creditors' committee was appointed, Walnut Creek Mining Company (Walnut Creek), as the largest non-insider general unsecured creditor, sought derivative standing to pursue the following claims on behalf of the estate against Cascade and ECJV:

Recharacterization of Cascade and ECJV's alleged debt to equity.
Equitable subordination of Cascade and ECJV's claims.
Damages for ECJV's breach of fiduciary duties and Cascade's aiding and abetting breach of fiduciary duties.

Under Third Circuit precedent, there is no bright line test for recharacterization, but rather an inquiry about whether the parties to the transaction in question intended the loan to be a disguised equity contribution. Walnut Creek argued that the debt should be recharacterized because:

Optim was inadequately capitalized at the time of these transactions.
No prudent, bona fide lender would have guaranteed the Debtors' obligations to Wells Fargo.
The Debtors granted security interests to Cascade and ECJV at a time when they did not owe Cascade and ECJV any debt.
Cascade and ECJV waived payment of their fees under the Guaranty Reimbursement Agreement on at least one occasion.
The Debtors' obligations to Cascade and ECJV were subordinated to the Debtors' obligations to Wells Fargo.
Cascade and ECJV made various capital contributions to the Debtors for the purpose of paying down the debt to Wells Fargo.

Outcome

The Court denied derivative standing to Walnut Creek after applying the test set forth by the US Court of Appeals for the Third Circuit in Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery, which requires that the moving party to demonstrate that:

The debtor-in-possession (DIP) has unjustifiably refused to pursue the claim or refused to consent to the moving party's pursuit of the claim on behalf of the DIP.
It has alleged colorable claims.
It has received leave to sue from the bankruptcy court.

(see 330 F.3d 548 (3d Cir. 2003)).

The Court began by determining whether Walnut Creek alleged colorable claims. A colorable claim is one that is able to survive a motion to dismiss for failure to state a claim, which requires that a claim for relief be "plausible on its face."

First, the Court held that the claims for breach of fiduciary duties and aiding and abetting fiduciary duties were futile because the Debtors' operating agreement contained a specific statement that no fiduciary duties were owed by any member or manager of the Debtors. Because these types of waivers are permitted under the Delaware Limited Liability Company Act, the Court held that these claims were not colorable.

Second, the Court considered the recharacterization claim. Noting that a claim for recharacterization turns on whether the parties intended the loan to be a disguised equity contribution, the Court held that the evidence did not support this conclusion. The Court specifically addressed each of Walnut Creek's arguments and held that the recharacterization claim was not colorable because:

Optim was adequately capitalized. The Court found the age of the transactions significant, noting that the Cascade Guarantees and the Guaranty Reimbursement Agreement were in place for seven years before the Debtors' bankruptcy filing. The Court also noted the absence of allegations that the Debtors were unable to pay their operating costs and obligations during the seven years before the bankruptcy proceedings.
Additionally, the Court noted that neither new equity nor expanded ownership equity rights were provided with the Cascade Guarantees and the Guarantee Reimbursement Agreement. If these obligations were intended as equity, ECJV's contribution would have been $1 billion more than PNMR's. However, ECJV and PNMR had equal shares in Optim, indicating that no equity contribution was intended as a result of the Cascade Guarantees.
Walnut Creek failed to plead facts sufficient to show that no third-party lender would have guaranteed the Wells Fargo loans or would have extended additional financing to the Debtors. Having already found that Optim was not undercapitalized in 2007, the Court rejected the argument that an insider guarantee of a loan is per se evidence of undercapitalization.
The Debtors' grant of security interest to Cascade and ECJV was not unusual, as they were granted in connection with the Guaranty Reimbursement Agreement, the Wells Fargo credit agreement and all of the other transactions that occurred on the same day. Further, these transactions were all required by Wells Fargo because the Debtors' receipt of the loan was contingent on the Debtors' grant of security interests.
The waiver of fees and the entry into a forbearance agreement were consistent with a lender-debtor relationship because it is legitimate for a lender to take actions to protect its existing loans, including granting forbearance.
Cascade and ECJV's claims against the Debtors were subordinated only to Wells Fargo's claims, and not to all of the Debtors' obligations. Furthermore, it is customary to subordinate guarantor claims to the claims of a lender.
The capital contributions made by Cascade and ECVC were unrelated to the Guaranty Reimbursement Agreement and the Cascade Guaranties, and the contribution agreements clearly stated that the parties intended the payments as equity.

Finally, the Court held that Walnut Creek did not have a colorable equitable subordination claim. Under section 510(c)(1) of the Bankruptcy Code, a court has the ability to subordinate all or part of an allowed claim to another allowed claim. However, it is considered a drastic remedy and requires a showing of inequitable conduct. Because both Cascade and ECJV are insiders of the Debtors, the Court applied heightened scrutiny to evaluate their conduct and still found no support for an equitable subordination claim. Walnut Creek merely alleged that Cascade and ECJV performed on their guarantees, but did not allege that they engaged in any inequitable conduct.

Practical Implications

This case affirms that courts will apply a strict standard to individual creditors seeking derivative standing to pursue claims against a debtor's estate, requiring, among other things, that the creditor plead substantial facts to support its claims. This should comfort sponsors that lend to their portfolio companies, as this case demonstrates that courts will protect a sponsor's contractual rights from individual creditors' attacks if the sponsor's loans are properly documented and the sponsor has not acted inequitably. The decision also affirms that mere insider status, or holding both debt and equity in an entity that is the subject of a bankruptcy proceeding, are not enough to support recharacterization and equitable subordination claims.

In addition, this decision may mark a shift in Delaware recharacterization law. Historically, Delaware courts applied an 11-factor test derived from the US Court of Appeals' for the Sixth Circuit's decision in Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.) (see 269 F.3d 726, 748 (6th Cir. 2001)). However, in this case, the Court did not even mention the AutoStyle test and instead focused only on the indicia of the parties' intent.

For more information on debt recharacterization and equitable subordination, see the following Practice Notes:

In re Optim Energy: Court Denies Creditor Derivative Standing to Seek Recharacterization of Equity Sponsors' Debt Claims | Practical Law