The reorganization of a wholesale energy supply company under Chapter 11 of the United States Bankruptcy Code presents daunting challenges due to the typical financing structure in place at the inception of the bankruptcy case. The wholesale energy supplier (then known in bankruptcy as the “debtor-in-possession”) is immediately caught in the middle between its own financing company and its clients—the energy supply companies, known as ESCOs, who provide physical energy supply to end-user customers. The ESCOs depend upon the continued financing from the debtor-in-possession and the release of funds from the debtor-in-possession’s lender to pay for its energy purchases, related taxes, and fees so it can satisfy its own operating expenses. In the bankruptcy context, the lender may not be inclined to permit these transfers, leaving the ESCOs in an extremely precarious, if not insolvent, position. The lender only possesses this ability because, when the lender originally granted financing to the wholesale energy supply company, the ESCOs simultaneously consented to a lockbox arrangement with the lender. Theoretically, at least, this vulnerability may have been avoided if the ESCOs had preserved some right to payment as part of the lockbox agreement entered into with the lender rather than subjecting funds it expects to be paid to the first priority lien and security interest of the lender.
All of this played out recently in the Chapter 11 bankruptcy cases involving Big Apple Energy, LLC and Clear Choice Energy, LLC (the Debtors), filed on August 27, 2018, in the United States Bankruptcy Court for the Eastern District of New York, Case Nos. 18-75807(AST), and 18-75808(AST), respectively. The “Debtors” were represented by Jonathan I. Rabinowitz, of the firm Rabinowitz, Lubetkin, & Tully, LLC, Livingston, New Jersey. They had been financed by Macquarie Investment US Inc. Prior to the bankruptcy filing, the Debtors had been negotiating with Macquarie on the terms of a restructure when, on the evening of August 22, 2018, Macquarie terminated these discussions, declared a default, accelerated the debt owed to it, and terminated its financing. This compelled the Debtors to file bankruptcy under Chapter 11 in the hopes of immediately forcing their ability to use funds so they could operate and thereafter reorganize under the Bankruptcy Code.
In response, throughout the bankruptcy cases, Macquarie continued to attempt to compel the immediate liquidation of the Debtors’ assets to pay down the approximately $21 million that it was owed, rather than cooperating with the reorganization of the Debtors’ businesses or a more orderly liquidation. The Debtors’ assets consisted primarily of amounts due from utilities on behalf of energy provided by the Debtors through the ESCOs to the ESCOs’ customers. The ESCOs had, as part of the pre-bankruptcy lockbox arrangement, provided the utilities with payment direction letters instructing them to make all payments to the lockbox controlled by Macquarie. From Macquarie’s perspective, it could sit back and let the utilities pay amounts due to the lockbox and simultaneously preclude the Debtors from remitting any funds to or on behalf of the ESCOs. This would, of course, impose a significant financial hardship, to say the least, upon the ESCOs.
The ESCOs did not just sit back and take this “lose-lose” situation that jeopardized their own businesses. The ESCOs—initially, Ameristar Energy, LLC; Allied Consolidated Energy; High Rise Energy, LLC; United Energy Supply Corp.; Global Energy, LLC; All American Power & Gas, LLC; Flanders Energy, LLC, and Pure Energy USA, LLC—immediately sought to compel the release of the amounts necessary to pay for the energy that they had provided, the associated sales and other taxes imposed, and the fees charged by the ESCOs that they depend upon to operate their businesses. The fundamental problem they faced was that if Macquarie held a lien and security interest against these monies the Debtors could not use them under the Bankruptcy Code as requested by the ESCOs unless such diminishment in Macquarie’s “cash collateral” resulted in a corresponding enhancement or unless Macquarie was otherwise fully secured. In bankruptcy parlance, Macquarie was statutorily entitled to “adequate protection” in exchange for the use of its cash collateral.
Apparently understanding this full well, the ESCOs’ counsel argued that amounts paid by the utilities on their behalf were subject to a “trust” while in the possession of the Debtors and Macquarie, for the ESCOs’ benefit. Returning or using such trust funds—“earmarked” for the ESCOs, as their counsel argued—did not then diminish Macquarie’s collateral base. The premise was quite a stretch under commercial law, and bankruptcy law in particular, because a trust would essentially constitute an undisclosed secret lien abhorrent to the existence and priority of the liens and security interest system upon which lenders, borrowers, and others depend to establish financing. There also did not appear to be any documentary support for the existence of such a trust.
But the ESCOs had a sympathetic presiding judge, the Honorable Alan S. Trust, who initially resisted Macquarie’s liquidation strategy. Judge Trust recognized the ESCOs’ predicament—desperately needing the release of funds from the lockbox to pay for the energy they had supplied and the associated taxes they had incurred, and to receive funds they needed to survive. In fact, two of the Debtors’ ESCO clients had, during the Debtors’ bankruptcy cases, filed their own Chapter 11 bankruptcy cases in the Eastern District of New York—North Energy Power, LLC on September 17, 2018, and City Power and Gas, LLC on November 17, 2018. Over Macquarie’s objection, Judge Trust authorized the limited release of funds for the benefit of, with limited exceptions, the ESCOs.
The ESCOs also sought to protect their rights and force their issues by compelling the Debtors’ assumption or, in the alternative, rejection of their supply contracts. Assumption would have meant the Debtors would be required to continue financing and permit the release of all appropriate funds paid to the lockbox by the utilities as required by the supply contracts. Rejection would have relieved the ESCOs of their payment direction letters provided to utilities.
The untenable situation was quite apparent to Judge Trust who, as early as September 27, 2018, during a preliminary hearing on a motion to convert the case to Chapter 7, stated that, after providing an opportunity for the Debtors to execute the orderly liquidation of its assets until the end of October, 2018, the Court would “enter an order converting the … cases to Chapter 7, unless there’s a substantial change in the current economics as presented by the estate.” Under Chapter 7, a trustee is appointed to liquidate the debtor’s assets for the benefit of creditors. If a debtor operates a business, the trustee typically terminates such operations immediately under Chapter 7.
The economics did not improve, and on December 3, 2018, Judge Trust granted (from the bench and subject to the submission of written orders) multiple motions for assumption or rejection of the supply contracts, motions for relief from the automatic stay, and the motion to convert the cases to Chapter 7. The actual order converting the cases to Chapter 7 did not enter until December 11, 2018.
Given the legal entanglements among the three competing parties, this result was likely inevitable. Macquarie was never going to agree to the erosion of its collateral base, and such release of funds was essential to the ESCOs’ survival. While it would have helped if the Debtors’ financial picture looked more promising, the real answer, if at all possible, lay in the ESCOs having preserved their rights to receive certain minimal amounts from Macquarie’s lockbox regardless of the Debtors’ default. This needed to have been negotiated at the beginning of the financing relationship as part of the lockbox arrangement. It almost certainly wasn’t going to happen after the bankruptcy filing.
Wholesale and retail energy suppliers would be best served if they:
- Contemplate the prospect of default or insolvency by another participant prior to entering into their financing arrangement, and then protect themselves against those possibilities when documenting their agreement;
- Fully evaluate each party’s respective rights and corresponding room for negotiation before engaging in a workout or Chapter 11 bankruptcy filing, so they are prepared for each reasonably possible outcome; and
- Once involved in a workout or a Chapter 11 bankruptcy, dedicate themselves to developing and accomplishing an “out of the box” solution that balances each party’s competing interests while still maintaining the entire enterprise for everyone’s mutual best interest.
When suppliers can take steps to ensure their own financial security in the case of default or insolvency by other participants, they put themselves in a position to weather unexpected bankruptcy issues such as those presented by Big Apple and Clear Choice. Since no one can fully predict when such issues will arise, taking proactive steps to protect themselves is both wise and necessary.
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