In Energy Future Holdings Corp. v. Morgan Stanley Capital Grp., Inc., 2019 U.S. App. LEXIS 18458 (3d Cir. 2019) ("EFH"), the United States Court of Appeals for the Third Circuit issued an important, albeit nonprecedential, opinion about whether adequate protection payments and plan distributions made during a bankruptcy case should be re-allocated in accordance with the waterfall provisions of an intercreditor agreement. The Third Circuit held that neither the adequate protection payments nor the plan distributions were collateral nor were they proceeds of a sale of collateral conducted by the collateral agent. As a result, the Third Circuit determined that the intercreditor agreement waterfall did not apply.
A subsidiary of Energy Futures Holding owed money to two groups of creditors: one group held debt from 2007 while the other held debt from 2011. The 2007 debt had a lower rate of interest than the 2011 debt. Both the 2007 debt and 2011 debt were secured by equal priority liens over the same collateral, comprising substantially all assets of the subsidiary. The 2007 creditors and 2011 creditors signed an intercreditor agreement that included a waterfall provision setting forth how, following a default, the creditors would allocate rights to the common collateral and proceeds thereof resulting from a sale, disposition of or collection on the common collateral.
Energy Future and its subsidiary filed for bankruptcy in 2014. During the bankruptcy case, the subsidiary used the collateral to continue to run its business. The Bankruptcy Court ordered the subsidiary to make adequate protection payments to the 2007 and 2011 creditors.
More than two years later, the Bankruptcy Court approved the subsidiary's plan of reorganization, which called for, inter alia, a corporate restructuring of the subsidiary including several asset exchanges. A majority of the 2007 and 2011 creditors voted in support of the plan. Under the plan, the creditors surrendered their claims on collateral in exchange for plan distributions consisting of cash, stock in a newly formed company, and the right to receive certain tax benefits owed by the government to the subsidiary.
The 2007 creditors and 2011 creditors disputed how to split up the adequate protection payments and the plan distributions (collectively the "Bankruptcy Payments"). The 2011 creditors claimed that the intercreditor agreement gave them a greater share of the Bankruptcy Payments, based on what the subsidiary owed when the Bankruptcy Payments were made and therefore favoring the 2011 creditors because of the higher interest rate on the 2011 debt.
The 2007 creditors argued that each creditor's share of the Bankruptcy Payments should be based on what the subsidiary owed that creditor at the time of the bankruptcy petition. Bankruptcy Code Section 502(b)(2), which generally disallows claims for post-petition interest, supports this argument.
The parties agreed that, if the 2011 creditors prevailed, approximately $90 million of accrued interest would be allocated from the 2007 creditors to the 2011 creditors.
The 2007 creditors prevailed in the Bankruptcy Court, and the District Court affirmed. The 2011 creditors appealed to the Third Circuit, which affirmed the judgment in favor of the 2007 creditors. The Third Circuit held that the waterfall provisions of the intercreditor agreement did not apply to the Bankruptcy Payments, explaining that none of the Bankruptcy Payments were collateral. In so holding, the Third Circuit did not have to consider whether the waterfall provision favored the 2011 creditors.
The Third Circuit explained that not every payment from the subsidiary's assets is a payment of collateral: "A payment of collateral reduces the amount of money owed on a debt. The subsidiary, however, made the adequate protection payments in exchange for the creditors' agreement to let the subsidiary use the collateral for other purposes."
In addition, the plan distributions were made from assets over which the creditors had no lien: "The plan specified that the creditors' liens did not extend to any assets the subsidiary had because of the plan. The plan distributions were made from those assets." Consequently the plan distributions were not payments or proceeds of collateral, and therefore the intercreditor waterfall provisions were not applicable.
Waterfall Provision of the Intercreditor Agreement
The waterfall provision in the intercreditor agreement covered payments and distributions "received in connection with the sale or other disposition of, or collection on, [the] Collateral upon the exercise of remedies under the Security Documents by the Collateral Agent." The Third Circuit explained that the contract language imposed two requirements: first, that the proceeds result from a sale or disposition of collateral; and, second, that such sale or disposition be part of a remedy pursued by the collateral agent.
The adequate protection payments did not relate to a sale, collection or disposition of collateral, nor were they proceeds of collateral, because there was no sale. Furthermore, the adequate protection payments were made in exchange for the subsidiary being permitted to use the collateral to protect against the collateral's diminution in value, not to reduce the amount of the debt.
And even if the plan distributions were considered to be from a sale or disposition, they did not result from the collateral agent exercising or implementing remedies, for example by way of a foreclosure sale. Furthermore, even if the collateral agent's actions in the bankruptcy case constituted a remedy, the restructuring was not a part of any remedy implemented by the collateral agent; the creditors voted for the restructuring and the Bankruptcy Court approved it. Thus, because the restructuring was not a sale of collateral pursued by the collateral agent, the plan distributions were not proceeds under the waterfall provision of the intercreditor agreement.
Although the Third Circuit's decision in EFH is not binding precedent, it is nevertheless significant. First, the EFH decision is consistent with the approach taken by the bankruptcy court in BOKF, N.A. v. JPMorgan Chase Bank, N.A. (In re MPM Silicones, LLC), 518 B.R. 740 (Bankr. S.D.N.Y. 2014) ("Momentive"). In Momentive, the bankruptcy court determined that new common stock issued to creditors under a bankruptcy plan of reorganization was not proceeds of common collateral under the relevant intercreditor agreement, because the new common stock was not proceeds of the debtors' assets that constituted common collateral.
Second, the Third Circuit's EFH decision, as well as Momentive, underscores the importance of the specific language used in an intercreditor agreement. If parties to an intercreditor agreement intend that the waterfall provision should apply not only to actual sales of collateral but also to adequate protection payments and plan distributions, then the agreement must make such intent clear and unambiguous. EFH reminds lenders and other creditors that courts will examine intercreditor agreements closely and interpret the contract language narrowly.
 EFH, 2019 U.S. App. LEXIS 18458 at *2.
 11 U.S.C. § 502(b)(2).
 Id. at *6.
 Id. at *7-*8.
 Id. at *8.
 Id. at *8-*9 (quoting the waterfall provision language).
 Id. at *9.
 Id. at *9-*10.
 Momentive, 518 B.R. at 754-56. The plaintiffs in Momentive argued, inter alia, that new stock issued under the plan constitutes "proceeds" within the meaning of Section 9-102(a)(64) of the New York Uniform Commercial Code (noting that "proceeds" includes property (A) acquired upon the disposition of collateral or (B) distributed on account of collateral). But the bankruptcy judge was unpersuaded and concluded that the new stock was not something that any secured party's existing lien would attach to even under the most liberal interpretation of U.C.C. § 9-102(a)(64) because the common stock was received "on account of or based on rights arising out of the defendants' liens and claims, not on account of the Common Collateral or based on rights arising out of the Common Collateral." Id. at 754.
 In a payment subordination transaction, the issues in EFH and Momentive may be less likely to arise. In a typical payment subordination arrangement, the senior creditor generally will be paid in full before distributions would be made to the junior creditor. By contrast in a shared collateral arrangement, the secured creditors negotiate priority only with respect to the shared collateral but otherwise are generally pari passu with respect to unencumbered assets.