As winter draws near, so does the risk of another major weather event impacting the energy production industry, and, specifically, the wind power generation industry in Texas. Last year, Winter Storm Uri significantly disrupted the Texas power grid and forced several energy originators, distributors, and buyers to consider restructuring alternatives. However, the structure of the energy production industry naturally creates obstacles for companies seeking to exercise their rights to file for bankruptcy protection.
In bankruptcy nomenclature, these impediments to file may result from the existence of “blocking rights,” an overarching term describing the ability of certain parties to unilaterally prevent a bankruptcy filing.
Section I of this article will discuss the wind power generation and sale industry generally, its key and typical players, and the conflicts of interest that may naturally arise. Section II will discuss “blocking rights” and how courts throughout the country have viewed such rights in the context of motions to dismiss a bankruptcy case for failure to obtain requisite internal filing authority. Finally, Section III will provide action steps and best practices for potential debtors, as well as for lenders, hedge providers, and equity holders.
Section I: The industry
A wind power generation project usually consists of more than one wind generation facility, which is often referred to as a “Project.” To finance, construct, operate, and manage these various Projects, parties in interest will generally install a capital and debt structure that includes multiple stakeholders, each playing a different role in the Project. These entities include, but are not limited to, the borrower (or wind power generation facilities, usually each with its own legal entity), lenders, tax equity investors, operators, and hedge providers.
In this capital and debt structure, it is not unusual for one entity to take on different roles. For example, an affiliate of a tax equity investor may act as the secured lender for a project or an affiliated project. This naturally may create conflicts of interest, which may go unnoticed until a significant event brings insolvency considerations to the forefront. On February 13, 2021, Winter Storm Uri highlighted these issues.
Winter Storm Uri ravaged the state of Texas, causing an unprecedented period of subfreezing temperatures. The extreme weather event led to system-wide failures and interruptions to the Texas electric generation and distribution market operated by the Electric Reliability Council of Texas Inc. (ERCOT).
ERCOT reacted, in part, by raising the real-time settlement price of energy to $9,000/MWh, up almost 180x from the historical market price per MWh. This extreme price fluctuation, along with the physical effects of the storm, caused the suspension of energy production, failure to deliver power, and eventual defaults in payment. The financial impact of such an increase in real-time settlement price required many of the wind energy production entities to examine their respective Project’s organizational structure. Further, Winter Storm Uri forced many wind power generation entities to evaluate whether they could obtain the requisite internal Project authority to effectuate a bankruptcy filing, as required under the Bankruptcy Code.
Section II: Blocking rights
Chapter 11 of the Bankruptcy Code requires any ultimate distributions in a bankruptcy case to stakeholders to be made according to a statutory priority scheme – administrative expenses and secured creditors are paid first, followed by unsecured creditors, with equity paid last (if at all). As discussed above, inherent conflicts of interest may exist with regard to tax equity partners and the lender or hedge provider. Any proposed bankruptcy action could logically have an adverse effect on a wind power generation company’s tax equity partner, who may only receive pennies on the dollar through a restructuring plan or plan of liquidation.
Accordingly, to the extent a bank, through its subsidiary entities, controls both the tax equity position and the secured lender position of a company, the conflict of interest naturally may come to a head in the face of a bankruptcy filing. Whether the bank is undersecured or oversecured – whether the value of the bank’s loan to the debtor is worth more or less than the value of its collateral – may control its decision as to whether it should attempt to exercise its “blocking right.”
While “blocking rights” is the general term, parties may be more familiar with such terms as “golden share” or “veto right.” At their most basic, blocking rights provide one party with the ability to unilaterally prevent a proposed bankruptcy filing or simply to withhold consent to such action. In the past five years, several courts around the country have taken up the question of how to balance a debtor’s constitutional right to file for bankruptcy protection against a party’s contracted-for right to prevent a filing. This balancing act involves fiduciary duty considerations and equity principles.
First, in 2016, the Delaware bankruptcy court in In re Intervention Energy Holdings, LLC looked to whether the exercise of a “golden share” was tantamount to an absolute waiver of the debtor’s right to seek bankruptcy protection and thus void by reason of public policy. 553 B.R. 258 (Bankr. D. Del. 2016). In order to avoid foreclosure by one of its creditors, the debtor in question granted the creditor one unit of common interest in the limited liability company. This one unit of equity provided the creditor unilateral authority to block a proposed bankruptcy action, as such action required unanimous shareholder consent. Id. at 261.
And that is what happened – the creditor attempted to block the action – but the debtor filed for bankruptcy anyway. Upon the creditor’s motion to dismiss the bankruptcy case, the Delaware bankruptcy court found that, because the “primary relationship with the debtor is that of creditor – not equity holder – and which owes no duty to anyone but itself in connection with a limited liability company’s decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right.” Id. at 265; see also MBNA American Bank, N.A. v. Trans World Airlines (In re Trans World Airlines, Inc.), 275 B.R. 712, 723 (Bankr. D. Del. 2002) (“Prepetition agreements purporting to interfere with a debtor’s rights under the Bankruptcy Code are not enforceable.”). Accordingly, the Delaware bankruptcy court set up this rough test of analyzing which hat the party in question was wearing when it voted to block a proposed filing.
In 2018, the Fifth Circuit Court of Appeals in In re Franchise Services North America, Inc. helped to further shape this analysis. 891 F.3d 198 (5th Cir. 2018). The Fifth Circuit acknowledged that while blocking rights exercised by a “pure” creditor would be invalid, the exercise of such blocking rights by a “bona fide” equity holder, even if it also held a claim against the company, was a valid exercise of such rights and not void by reason of public policy. Under the circumstances, the blocking party made a $15 million equity investment in the prepetition debtor. At the same time, the debtor owed $3 million for reimbursement of professional fees to the blocking party’s parent entity. The court determined that, despite the competing creditor status of the parent entity, the significantly greater investment signified that the blocking party wore the hat of bona fide equity holder when it voted to block the bankruptcy filing. Accordingly, the court granted the blocking party’s motion and dismissed the bankruptcy cases for failure to obtain the requisite filing authority.
The Fifth Circuit also reviewed the fiduciary duty considerations underlying the circumstances of the exercise of the blocking right. The court questioned whether the blocking party could be considered a “controlling shareholder,” and whether affording the blocking party such status necessarily imposed fiduciary duties on them. Finding that the shareholder here was not a controlling shareholder with attendant fiduciary duties, the court ruled that there was no reason to prevent the blocking party from acting in its own best interests. However, this discussion provides another consideration for potential debtors evaluating their filing authority.
In 2020, Judge Mary F. Walrath of the Delaware bankruptcy court issued a noteworthy unpublished bench ruling on blocking rights in In re Pace Industries, LLC, Case No. 20-10927 (MFW) (Bankr. D. Del. May 5, 2020). Judge Walrath held that, under the facts and circumstances of the case, the exercise of a blocking right by either an equity holder or creditor, which has the effect of restricting a debtor’s “constitutional right to file bankruptcy” is void as against public policy. The court further held that it may impose fiduciary duties on a party seeking to exercise blocking rights, so as to require the party to act in the best interests of the company and its stakeholders as a whole.
While Judge Walrath cabined her decision by the specific facts and circumstances of the case, the Pace decision deepened the divide regarding the balance between public policy and contract rights. It also highlights that Delaware may be a preferred jurisdiction in cases involving blocking right considerations.
In July 2020, the New Jersey bankruptcy court in In re 3P Highstown, LLC aligned more closely with the Fifth Circuit. 631 B.R. 205 (Bankr. D.N.J. 2021). The LLC agreement in question limited the debtor’s management’s ability to take certain actions, including initiating bankruptcy proceedings. Voting rights were afforded to preferred unit holders (to the extent any were deemed outstanding). The New Jersey bankruptcy court declined to follow Judge Walrath’s approach in Pace and, instead, relied heavily on the dynamic established by the Fifth Circuit in Franchise Services. Specifically, the bankruptcy court found that nothing in the record suggested that the equity transaction in question was “merely a ruse to ensure” the debtor repay a comparatively insignificant loan obligation. Accordingly, the court determined that the contractual provision in the LLC agreement was not void merely because the blocking party wore two hats (equity and creditor).
The New Jersey bankruptcy court also acknowledged that the LLC agreement restricted members’ fiduciary duties in accordance with the Delaware LLC Act. See 6 Del. C. § 18-1101(c). So, unlike Franchise Services, the court did not need to discuss at length whether fiduciary duty considerations could provide another avenue for the debtor to restrain blocking parties.
Finally, late last year, Judge Walrath again ruled on this issue. In In re PWM Property Management, LLC, Case No. 21-11445 (MFW) (Bankr. D. Del. Dec. 13, 2021), Judge Walrath found that an attempted exercise of a blocking right was invalid under the circumstances and denied a motion to dismiss the chapter 11 cases. Importantly, the court found the creditor in question’s equity investment, although substantial, was structured in such a way that made it more akin to debt – the preferred equity security contained a mandatory redemption obligation, a fixed return on investment, no rights to share in the profits of the debtor, and forced sale and foreclosure rights. The court likened the case to Intervention Energy and the similar “blurring of the interests of the entity between its shareholder and creditor rights.” Accordingly, the court found that the quasi-creditor could not block the bankruptcy filing.
Section III: Action steps and best practices
As illustrated above, despite a growing body of case law on the subject matter, the case law interpreting permissible versus impermissible blocking rights is still relatively unclear. Wind power generation entities and their stakeholders should proactively address possible conflicts and impediments.
First, wind power generation entities should closely review their articles of incorporation and operating agreements. The focus should be on provisions regarding the requisite percentage of votes needed to commence a bankruptcy filing or act upon other restructuring alternatives and whether there are any provisions limiting fiduciary duties. Consider these questions, among others:
- Do such actions require a simple majority, supermajority, or unanimity?
- Are votes allocated on a 1:1 basis or is voting power based upon ownership percentage?
- Does the operating agreement require that only independent or disinterested members or board members vote on the proposed action, or can conflicted members vote on the proposed action?
- Does the operating agreement limit or restrict directors’, controlling shareholders’, or members’ fiduciary duties or does the agreement remove fiduciary duties entirely?
If the answer to these questions leads to a scenario where the exercise of a single shareholder’s, single member’s, or one party’s voting rights could prevent a proposed bankruptcy filing, the wind power generation entity should consider whether amending its operating agreement would be in its and its stakeholders’ best interests. This process would likely require obtaining the consent of all or a supermajority of shareholders or members, depending on the terms of the operating agreement.
Further, if the wind power generation entity is considering restructuring alternatives, evaluate whether establishing an independent or special committee is permissible under the operating agreement and whether such committee would assuage any potential conflicts of interest among the wind power generation entity, its hedge provider, its lender, and other equity holders.
Lastly, wind power generation entities should evaluate potential chapter 11 filing jurisdictions. Selecting the right venue may make the difference between a successful restructuring and dismissal of the case for failure to obtain requisite filing authority.
From a lender or hedge provider perspective, evaluate any potential equity purchases in the face of already existing security interests or unsecured claims against the company. Based on Franchise Services, the timing and value of such investment could come into play in determining whether the creditor’s actions are those of a “bona fide” equity holder. Consider whether the exercise of a blocking right could be seen as an end-around to prevent the company from filing bankruptcy so that the creditor may foreclose on the underlying assets. In general, avoid “golden share” scenarios where consideration for forbearance is the extension of equity, especially if the equity afforded is insignificant in monetary value but significant in voting rights.
Next, evaluate whether the parties entitled to vote on a proposed bankruptcy filing have any direct or indirect conflicts of interest. As discussed, it is not uncommon in the industry for different bank affiliates to wear different hats with respect to the same project (i.e., act as a lender/hedge provider and equity holder, for example).
In that case, consider creating conflicts walls between the hedge provider side and the equity holder side of the involvement with the company. Such conflicts walls should not only prevent business personnel from coordinating strategy but should also wall off attorneys and other professionals involved. Even if no conflict of interest is present, avoiding the appearance of a conflict of interest may help avoid unnecessary legal fights down the road.
Finally, as discussed above, if any entity in the Project’s organizational structure proposes the installation of an independent director or special manager or committee to evaluate restructuring alternatives, take steps to ensure that the creditor is involved in such strategic discussions.
“Winter is here”
The risk that a major weather event could again impact energy production and distribution in Texas and throughout the country is significant. Document review and contingency planning now will be vital to safeguard against future obstacles in considering restructuring alternatives. Entities involved in Projects should take a hard look at how entities in their capital and debt structure may seek to exercise blocking rights. Hedge providers, lenders, and equity holders should understand the landscape and how public policy and fiduciary duty considerations may factor into bankruptcy filing decisions.
To learn more about these issues and their impact on your business, please email DLAPiperCommodities@us.dlapiper.com or any of the authors of this article.
An earlier version of this article appeared on Law360 on February 1, 2022.