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Fifth Circuit Reverses Sanchez Lien Ruling, Finds DIP Lenders Entitled to 100% of Reorganized Equity

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Relevant Document:
Opinion

A three-judge panel of the Fifth Circuit issued an opinion this afternoon vacating and remanding U.S. Bankruptcy Judge Marvin Isgur’s final order and opinion in the Sanchez Energy, nka Mesquite Energy, lien-related litigation. Judge Isgur’s opinion allocated 69.73% of Mesquite stock to the Sanchez unsecured creditor representative and 30.27% to the DIP lenders. The panel – consisting of Judges Edith H. Jones, Kurt D. Engelhardt and Andrew S. Oldham – took the matter under advisement last September.

The Fifth Circuit concludes: “[T]he bankruptcy court was required to award the DIP Lenders one hundred percent of the equity in Mesquite, because the value of their superpriority liens exceeded the stipulated enterprise value of the reconstituted debtor” (emphasis added).

Judge Isgur’s ruling followed a multiprong, multiyear, post-effective-date trial to resolve the impact of defective prepetition liens on the company’s most valuable hydrocarbon leases, and specifically the impact of the lien defect on the allocation of reorganized equity in Sanchez.

Today’s opinion, authored by Judge Edith Jones, rules that Judge Isgur’s equity allocation contravened section 550 of the Bankruptcy Code, “because it incorrectly approved more than a ‘single satisfaction’ as a remedy for the avoided secured creditors’ liens.” Specifically, because the Sanchez plan returned the actual liens in question to the estate as part of the plan, the court could not then order the recovery of the value of those liens later without running afoul of the single satisfaction rule. “Courts cannot award value under Section 550(a) when the estate has recovered its transferred property in kind,” Judge Jones writes.

The opinion adds: “[O]f course … a court in its discretion [can] select, as alternative preference recoveries, ‘the property transferred’ or ‘the value of such property.’ But a value award cannot lie for avoiding a nonpossessory lien when, as in this case, the liens are returned to the estate.”

The key aspect of the plan that triggered this result is described as follows:
 

“Important for purposes of this dispute, Article VIII.E of the Plan provided that ‘on the Effective Date … all … Liens … against any property of the Estates … shall be fully released and discharged, and all of the right, title, and interest of any holder of such … Lien[s] … shall revert to [Mesquite.]’ The releases of the DIP liens and secured creditors’ liens, even though those liens were then perceived to have no value, allowed Mesquite to be reorganized with a clean balance sheet and no overhanging encumbrances.”

While not directly tied to the holding, the panel adds that Judge Isgur’s allocation “charted its own approach” outside of the approaches taken by the two litigating sides’ dueling experts.

As outlined in the opinion, Sanchez filed for chapter 11 bankruptcy protection in August 2019 as oil prices collapsed. The company carried $500 million in secured notes and $1.75 billion in unsecured notes, with maturity dates ranging from 2021 to 2023.

The secured creditors had obtained liens on virtually all of Sanchez’s assets in April 2018, including valuable oil and gas interests known as the “HHK Leases,” which the Fifth Circuit panel writes “were apparently worth more than all of Sanchez’s other assets combined.” However, realizing their liens on these valuable leases might be unperfected, the secured creditors filed correction affidavits in June and July 2019, the opinion notes.

To prevent the lien corrections from falling outside the 90-day preference period that could render them avoidable, Sanchez rushed to file for bankruptcy protection on Aug. 11, 2019.

As described in the opinion, this timing proved catastrophic. Within months of the bankruptcy filing, the Covid-19 pandemic sent oil and gas prices into negative territory, rendering the HHK leases – once the company’s crown jewels – essentially worthless by April 2020 when the bankruptcy court approved the reorganization plan.

The opinion notes that the plan was unusual in several respects. Rather than liquidating, Sanchez would emerge as a new entity called Mesquite Energy Inc., with an enterprise value of just $85 million. Equity ownership would be determined through a complex three-phase litigation process designed to resolve disputes over lien validity.

Crucially for the Fifth Circuit, the plan provisions returning liens to the estates, including the DIP liens, were what subjected the DIP liens to the post-effective-date trial process (otherwise the DIP lenders would have been able to foreclose given that the stipulated enterprise value at the time was less than their postpetition lending).

Under the plan, secured creditors who provided the DIP financing would receive at least 20% of the equity, assuming the validity of the DIP liens. The remaining 80% would be allocated based on the outcome of what the plan termed “Lien-Related Litigation,” which would proceed in phases as follows:
 

  • Phase 1 would determine whether the DIP liens were valid;
     
  • Phase 2 would assess the validity of the secured creditors’ prepetition liens; and
     
  • Phase 3 would place a hypothetical value on any successful avoidance claims.

Initially, in Phase 1, the bankruptcy court held that the DIP liens were unenforceable, but two years later reversed course and found them valid, entitling the DIP lenders to their minimum 20% equity stake as DIP lenders.

In Phase 2, the court determined that while the secured creditors’ liens were valid under Texas law, the correction affidavits failed to perfect the liens within the required time frame, making them avoidable preferential transfers under federal bankruptcy law.

Phase 3 is the grounds for the Fifth Circuit’s reversal. Despite the liens being returned to the debtor’s estate as part of the reorganization plan, the bankruptcy court decided to place a hypothetical $200 million value on the avoided liens to determine equity allocation. The bankruptcy court reasoned that the $85 million enterprise value, plus the $200 million hypothetical value of the preference claims, plus $2 million recovered from company insiders, created an “augmented estate” worth $287 million. Based on this calculation, unsecured creditors received 69.73% of the equity, while secured creditors received only 30.27%.

The panel finds this allocation violates the “single satisfaction” rule in Bankruptcy Code section 550, which limits the recovery on an avoidable preferential transfer to “only a single satisfaction.” From this, the opinion distills the following two questions: “(1) whether the Plan eschewed Section 550 by requiring a hypothetical valuation of the preserved avoidance actions; and (2) how the limitations embodied in Section 550 affected the preserved avoidance actions once the secured creditors returned their liens to the estate.”

On the first question, the opinion finds that for several reasons including the structure of the plan and Texas law on contract interpretation, the plan did not supersede or override the secured creditors’ ability to use the “single satisfaction” rule as a limitation on the unsecured creditors’ recovery:
 

“Read in totality, as they must be, the Plan’s provisions evince the strong disagreement among the parties as to the enforceability of the secured creditors’ liens, and they specifically preserve whatever rights, claims or defenses the secured lenders might assert. To the extent that the Plan’s release of the DIP and secured liens bore legal consequences favorable to the secured creditors, those consequences must be respected. Thus, the Creditor Representative – and the bankruptcy court – err in contending that a proper application of Section 550 would be a ‘self-defeating’ threat to dismantle the Plan and to render the ‘valuation’ process superfluous or meaningless. As has been demonstrated, any ‘valuation’ of alleged preference claims was contingent on substantiating the claims. In sum, if adjudication proved the unsecured creditors’ claims worthless under a proper application of Sections 547 and 550, that result did not frustrate, but implemented the terms of the Plan.”

The panel then evaluates the crucial question of how this impacts the equity allocation:
 

“Another necessary consequence of the Plan is that, when the bankruptcy court reversed course and upheld the DIP liens, not only were the Ad Hoc Secured Creditors entitled to twenty percent of the equity (the minimum specified by the Plan), but they should have been entitled to one hundred percent according to their superpriority liens that covered all of Sanchez’s assets. This was ordained by the facts and the Plan. The facts were that DIP Lenders had injected over $100 million in new money to the company post-petition, while the value of the debtors’ assets slid to $85 million. The Plan provided an opportunity for the unsecured creditors to recover some equity only if they were able to defeat the DIP liens, followed by the HHK leases’ liens. The parties crafted Phase One Lien-Related Litigation precisely to adjudicate first the preeminent claim of the DIP Lenders to the debtors’ assets, and thus, its equity. And the Plan in no way limited the lenders’ ability to mount defenses consistent with Section 550 and other applicable law” (emphasis added).

On the second question of whether the plan somehow trumps application of the “single satisfaction” rule, the decision observes that section 550 says that the estate may “recover … the property transferred, or … the value of such property,” but also “that recovery must be limited to ‘only a single satisfaction.’”

As a matter of statutory interpretation, the panel rejects the unsecured creditors’ contention that “or” in the first part of the provision could be read to allow recovery of the transferred property “and” its value. The opinion also rejects as “unapologetically purposive” and “mischievous” the unsecured creditor’s position that “[a]ccepting the simple release of the worthless … HHK Liens as a recovery … [did] nothing to return the estate to its pre-transfer position.” The opinion adds that regret over “years of litigation” might have been wasted is not valid legal reasoning.

The opinion concludes:
 

“As a result of the foregoing discussion, the bankruptcy court was required to award the DIP Lenders one hundred percent of the equity in Mesquite, because the value of their superpriority liens exceeded the stipulated enterprise value of the reconstituted debtor. The bankruptcy court’s initial wrong turn, avoiding the DIP liens, propelled the parties into subsequent stages of litigation that were unnecessary. But in any event, considering the Phases Two and Three litigation (and still assuming arguendo that the pre-petition liens were avoidable preferential transfers), the court also erred in authorizing recovery of the ‘value’ of the pre-petition liens in addition to the return of the liens to the debtors’ estate pursuant to the Plan.

“Accordingly, we VACATE the judgment of the bankruptcy court and REMAND for further proceedings consistent with this opinion.”