The Third Circuit Finds Support for Awarding an Administrative Expense Claim For an Asset Purchaser’s Efforts in Pursuing an Unsuccessful Merger with the Debtors
In a recent decision, The Third Circuit Court of Appeals held that despite NextEra Energy Inc.’s (“NextEra”) contractual undertaking to bear its own costs in connection with a merger, it had made a plausible claim for allowance of an administrative expense claim for these costs. This followed an earlier opinion (“EFH I”), where the Third Circuit held that NextEra was not entitled to receive a termination fee payable upon the Debtors’ termination of the merger agreement (the “Merger Agreement”).
On September 19, 2016, over two years into the Chapter 11 bankruptcy case of Energy Future Holdings Corp. et al. (the “Debtors”), the Bankruptcy Court approved the Merger Agreement. Under the Merger Agreement, NextEra was to satisfy a substantial portion of the Debtors’ debt in exchange for acquiring its interests in Oncor Electric Delivery Company LLC (“Oncor”). Oncor is a Texas electric power company subject to state regulatory control. Each party agreed to bear its own costs in pursuing the merger. Consummation of the merger was conditioned on the Texas Public Utility Commission’s (“PUCT”) removal of a protective “ring fence” intended to shield Oncor from economic risk.
PUCT refused to remove the ring fence, prompting NextEra to pursue two unsuccessful motions for rehearing, followed by an appeal in Texas state court. Although NextEra had the right to do so, it chose not to terminate the Merger Agreement, instead prosecuting its state court appeal. Some four months following the PUCT denial, the Debtors, as was their right (and while the appeal was pending), opted to terminate the Merger Agreement and merge with another entity---Sempra Energy---for less money than under the NextEra deal (though not subject to the condition that the PUCT remove the ring fence).
Because the Debtors caused the termination, under the Merger Agreement they became liable for the termination fee, whereas no fee would have been payable if NextEra had been the terminating party. But before the Debtors made payment to NextEra, certain creditors persuaded the Bankruptcy Court to reconsider its initial approval of the fee. The Bankruptcy Court did so, stating that had it been made aware of the specific provisions governing the right to the termination fee where PUCT refused to remove the “ring fence”, the Court would not have approved it in the first instance. NextEra appealed, leading to the Third Circuit’s decision in EFH I which upheld the denial.
In addition to its appeals of the orders denying the termination fee, NextEra alternatively filed an application for allowance of an administrative expense claim, based on the substantial costs it incurred in pursuing the merger, and the benefits those costs allegedly conferred on the Debtors’ estates.
The creditors filed motions to dismiss the administrative expense application and for summary judgment. The Bankruptcy Court granted both. On appeal, the Delaware District Court affirmed, prompting NextEra to appeal to the Third Circuit for the second time.
The Third Circuit reversed. On the summary judgment motion, the Bankruptcy Court had held that NextEra contractually agreed not to assert an administrative claim for its costs expended during the merger process. Notably, the Merger Agreement provided “all costs and expenses incurred in connection with the Merger Agreement shall be paid by the party incurring such expense…” The Third Circuit had to decide whether this language unambiguously foreclosed an administrative expense claim.
The Third Circuit found there existed a genuine issue of material fact as to the scope of the cost and expense provision in the Merger Agreement. For example, certain provisions in the Merger Agreement preserved any “administrative expenses… addressed in the Plan of Reorganization”. The Plan in turn incorporated the Bankruptcy Code’s definition of administrative claims, leading ultimately back to the central issue – whether NextEra made a plausible claim for an administrative expense claim under the Bankruptcy Code.
On this issue, the Bankruptcy Court had granted the motion to dismiss. In reversing, the Third Circuit started with the Bankruptcy Code definition. Pursuant to Section 503(b)(1)(A), an administrative expense can be allowed if “actual and necessary” to preserving the estate. As interpreted by courts in the Third Circuit, “actual and necessary” expenses arise where (a) there is post-petition transaction and (b) the expenses involved with this transaction benefit the estate.
No dispute existed as to the first prong since the Merger Agreement was entered post-petition. Instead, the case revolved around whether there was a benefit to the estate. NextEra presented two benefit theories. The first - that its efforts in connection with the merger encouraged later, higher bidders – was partially rejected by the Third Circuit since Sempra Energy paid less, not more, than NextEra. The Third Circuit further critiqued NextEra’s analogy to it acting like a “stalking horse” since NextEra failed to promote “competitive bidding”. On the other hand, the offers by NextEra and Sempra Energy could not be so easily compared since their respective demands pertaining to the “ring fence” differed. Moreover, the Third Circuit agreed that NextEra’s efforts provided necessary information that other bidders could use to make an informed bid similar to a “stalking horse”.
For this reason too, the Third Circuit agreed with NextEra’s other argument: that it made a plausible claim that its “due diligence” provided a “roadmap for future bids” on the Debtors’ asset (i.e. Oncor). As described by the Third Circuit, “NextEra’s roadmap argument is that by negotiating the Merger Agreement and Plan, and by settling objections with creditors as well as by providing further due diligence, it created guideposts that directly facilitated the Sempra merger.” The Third Circuit found support for this argument in the record. As a result of NextEra’s efforts, the Debtor was able to obtain concessions from Sempra Energy such as its willingness not to demand removal of the “ring fence” around Oncor.
In conclusion, the Third Circuit found that NextEra made a plausible claim for an administrative expense based on its costs in attempting to merge with the Debtors. The court was careful to note that this did not conclude the matter for NextEra. While NextEra appears to have provided a benefit, it must also show that this benefit exceeded any associated increased costs to the estate, which may include additional interest expenses the estate allegedly incurred while NextEra pursued its state court appeal. The Third Circuit remanded the decision for the Bankruptcy Court to consider this issue.
The Merger Agreement included a provision requiring each side to bear its own costs and expenses. If counseling a debtor, such a provision should make explicit that this is meant to prohibit the purchaser from seeking an administrative expense claim except as otherwise agreed (i.e. one based on a termination or breakup fee). The creditors’ case against NextEra’s administrative claim was further undermined by other references in the Merger Agreement that preserved administrative expenses under the Plan. Counsel to the debtor should seek to remove such references from the agreement.
If counseling the bankruptcy purchaser, the asset purchase or merger agreement should preserve the client’s ability to seek an administrative expense claim for the costs spent in trying to close a failed transaction.
 In re Energy Future Holdings Corp., No. 19-3492 (3d Cir. Mar. 15, 2021).
 In re Energy Future Holdings Corp., 904 F.3d 298 (3d Cir. 2018).
 The “ring fence” required that Oncor maintain an independent board of directors free of interference from any controlling interest, and further placed restrictions on upstream distributions. As a result of the “ring fence”, Oncor was shielded from the impact of the Debtors’ bankruptcy case.
 See e.g., Goody’s Family Clothing, 610 F.3d 812, 818 (3d Cir. 2010).
 The Third Circuit indicated that the same set of facts actually supported both of NextEra’s theories and indeed described the two theories as being “not analytically distinct”.
 For purposes of disclosure, McElroy Deutsch served as co-counsel to Debtors Energy Future Competitive Holdings Company LLC and Texas Competitive Electric Holdings Company.