Examiner: Dynegy asset transfers 'ill-conceived,' harmful to creditors

By Jim Witters

Wilmington, Del., March 9 - A court-appointed examiner called some asset transfers made by Dynegy Holdings, LLC during the spring and summer of 2011 "ill-conceived" and harmful to creditors in favor of stockholders, according to a report filed Friday with the U.S. Bankruptcy Court for the Southern District of New York.

Examiner Susheel Kirpalani said Dynegy Holdings' reduction of indebtedness in connection with the CoalCo transaction should have inured to the benefit of Dynegy Holdings and not Dynegy Inc.

"Reduced to its essence, the transaction transferred hundred of millions of dollars away from Dynegy's creditors in favor of its stockholders," Kirpalani wrote.

"The examiner concludes that the conveyance of CoalCo to Dynegy Inc. was an actual fraudulent transfer and, assuming that Dynegy Holdings was insolvent on the date of the transfer (approximately two months before the bankruptcy filing), a constructive fraudulent transfer, and a breach of fiduciary duty by the board of directors of Dynegy Holdings," Kirpalani wrote.

Dynegy issued a press release March 9 stating that it had received an executive summary of the examiner's report.

"The board of directors of Dynegy and the board of managers of DH (Dynegy Holdings) take the examiner's findings seriously and intend to review the full report, once it is made available, to determine its impact on DH's chapter 11 proceedings, if any," the press release stated.

Background of the case

In the three months before filing its bankruptcy petition, Dynegy Holdings transferred or authorized the transfer of billions of dollars in assets as part of its plan to reorganize the business and restructure its debt, the examiner's report states.

The first phase of the restructuring involved refinancing Dynegy's secured back debt, which was in danger of a covenant breach.

Once the potential bank default was averted, Dynegy tried to reduce the amount of unsecured debt while increasing value for stockholders.

"To those familiar with the basic tenets of corporate finance, this may seem paradoxical, as it is a bedrock principle that a company's creditors must be paid in full before its stockholders can receive or retain any value ― unless, of course, creditors agree otherwise," the examiner wrote.

During the spring and summer of 2011, Dynegy Inc. moved assets away from the reach of Dynegy Holding's unsecured creditors in an attempt to encourage those creditors to accept less than full payment, while permitting a recovery for stockholders, the examiner wrote.

Kirpalani was to decide if those actions were legal.

"Dynegy expected that creditors would challenge this strategy and, to maximize its defenses, Dynegy tried to structure its transfers of assets away from Dynegy Holdings in a manner that it could claim were transfers in exchange for fair value. Put simply, Dynegy believed that, even if Dynegy Holdings was insolvent, as long as it transferred assets in exchange for what the law considers 'reasonably equivalent value,' then creditors would have no legitimate cause to complain," Kirpalani wrote.

Examiner's findings

Kirpalani found that Dynegy's strategy was permissible with respect to the first phase of restructuring - the two silos of assets CoalCo and GasCo - because those transfers did not injure creditors and were not intended to do so.

Dynegy's strategy was ill-conceived, however, with respect to the second phase of the restructuring, which included the transfer of CoalCo by Dynegy Holdings to Dynegy Inc. "in exchange for a piece of paper that Dynegy actively avoided valuing," the report states.

"This transfer of CoalCo, which the board of Dynegy Inc. then valued at $1.25 billion, was made in exchange for an illiquid, unsecured, highly unusual financial instrument called an 'undertaking,'" Kirpalani wrote.

The undertaking contained no covenants to protect the holder's value against other actions that might be taken by Dynegy Inc., the report stated.

Kirpalani valued the transaction's midpoint at $860 million.

Immediately after the transaction, Dynegy Inc. and Dynegy Holdings agreed to amend the undertaking to allow Dynegy Inc. to reduce its payment obligations by about $1.678 over the course of the payment stream for each dollar face amount of Dynegy Holdings bonds acquired or retired by Dynegy Inc., even if the bonds were acquired or retired at less than face value, the report states.

The result of the transaction was the transfer to Dynegy Inc. of CoalCo and also the corporate opportunity to use CoalCo as a vehicle for exchanging its outstanding bonds for structurally senior bonds at a discount, Kirpalani wrote.

"The addition of the payment reduction mechanism into the amended undertaking rendered the undertaking unsalable to third-parties, and thereby further eroded the value of the undertaking to Dynegy Holdings."

"The boards of Dynegy Holdings and Dynegy Gas Investments, LLC did not appreciate that what may be good for Dynegy's ultimate parent, Dynegy Inc., may not be good for Dynegy Inc.'s insolvent subsidiary, Dynegy Holdings," the examiner concluded.

"Indeed, when authorizing the transfer of CoalCo away from Dynegy Holdings, they believed they were attempting to obtain creditor concessions for the benefit of the 'company' or 'enterprise' as a whole," he wrote.

The board members of Dynegy Inc. did not understand that the transfer was being made or why the CoalCo transfer was prudent or appropriate, Kirpalani concluded. Others on the board did not even know whether there was a separate Dynegy Holdings board.

"But other members knew exactly what was happening, and why the CoalCo transfer was being made," the report states.

Members of the Dynegy Inc. financing and restructuring committee understood that the goal was to "capture any value attainable by acquiring Dynegy Holdings's bonds at a discount for the benefit of Dynegy Inc.," Kirpalani wrote.

"They did not believe this was inappropriate so long as it did not violate the contractual restrictions in Dynegy Holdings's debt agreements," the examiner's report states.

"Throughout the planning and execution of the prepetition restructuring, the Dynegy Inc. board favored paths that benefited Dynegy Inc. and its stockholders to the detriment of Dynegy Holdings and its creditors," according to the report.

Examiner's conclusions

"Dynegy Holdings would have a claim against Dynegy Inc. for the fraudulent transfer of CoalCo. Alternatively, to remedy the injustice occasioned upon Dynegy Holdings and, derivatively, its creditors, CoalCo should be deemed property of Dynegy Holdings's bankruptcy estate. Finally, the breach of fiduciary duty by the board of directors of Dynegy Holdings should be equally attributed to the board of directors of Dynegy Inc.," Kirpalani wrote in his report.

The examiner concluded that the bankruptcy court could confirm a Chapter 11 plan for Dynegy Holdings, "but, in light of the conduct of all but one of the members of the board of Dynegy Inc. as of Sept. 1, 2011, four of whom now constitute the majority of the board of Dynegy Holdings, any plan that provides for these individuals to continue as directors would not be consistent with the interests of creditors and with public policy."

Kirpalani said he does not believe that "the continued service by senior management of Dynegy Inc., even in director or officer capacities, would be contrary to creditor interests or public policy."

Dynegy is a Houston-based producer and seller of electric energy, capacity and ancillary services. The company and four subsidiaries filed for bankruptcy on Nov. 7. The Chapter 11 case number is 11-38111.

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