By Nick Brown and Billy Cheung
NEW YORK (Reuters) - As Energy Future Holdings prepares for what could be one of the largest-ever U.S. bankruptcies, some of its private-equity lenders are pushing a breakup of the company that could reap them more than $1 billion in tax savings, two people close to the matter said this week.
But such an arrangement could provoke a challenge from the U.S. government, since it would result in a multi-billion-dollar capital gains tax bill that the bankrupt entity is unlikely to be able to afford.
Earlier this year, in an unusual move, the company and the lenders reached out to the Internal Revenue Service seeking its blessing on the proposed structure, according to the sources, who refused to be named because talks are private. The agency declined to rule because the plan is not official, they said.
Barring any last-minute deals, which several people close to the matter say is unlikely, the dispute over the tax issue will come to a head in bankruptcy court. Energy Future is expected within weeks to receive an auditor's opinion that it cannot survive as a going concern, which would trigger a default on its loans. The people close to the case expect the company to file for Chapter 11 as soon as this month to avoid the default.
Energy Future, formerly TXU Corp, was created in a 2007 leveraged buyout by a consortium including KKR & Co (KKR), TPG Capital Management (TPG.UL) and Goldman Sachs' (GS) private equity arm. The deal loaded the company with more than $40 billion in debt shortly before low natural gas prices made its coal-fired plants noncompetitive. A breakup would split its unprofitable generating unit from its regulated distribution business.
The lenders, which include Apollo Global Management (AINV), Oaktree Capital Management and Centerbridge Partners, have more bargaining power than any other stakeholder. With more than $20 billion in loan debt at the company's generating unit, they are by far the largest creditor faction.
Under the lenders' vision, Energy Future's subsidiaries would be sold to the highest bidder, with existing creditors having the right to bid using the face value of their debt. Since that value is higher than the tax value of the assets on the company's books, the so-called credit bid would let the buyer revalue the assets' tax basis, a method known as a step-up, and save money on future taxes.
Such a transaction would also leave a massive capital gains tax liability at the Energy Future parent, which is not expected to have the money to pay it.
While most other stakeholders do not favor the proposal, they see it as a possibility given the lenders' bargaining leverage, said several people close to the matter.
The lenders are not the only ones who could benefit from a breakup. Energy Future's regulated power delivery business could also be sold, and its buyer could effect a similar step-up, one of the people said. But, due to their top-priority payback status and relative size of the unregulated business, it is the lenders who have the most to gain from the scenario.
Tax issues arise often in restructurings, but the sheer size of the potential liability at Energy Future - estimated by people close to the case at between $5 billion and $8 billion - makes the issue especially critical. And the nature of the proposed transaction, in which private-equity funds would benefit from a deal that creates a massive and perhaps unpayable debt to the IRS, makes the case particularly sensitive, one of the sources added.
A spokesman for Energy Future declined to comment. A spokesman for the IRS said federal law prohibits the agency from discussing specific taxpayers or cases.
HEAVY HAGGLING AHEAD
The specter of an unpayable tax bill has haunted more than a year of talks between Energy Future and its creditors to restructure debt and head off a lengthy and expensive Chapter 11 battle. Energy Future at one point proposed a tax-free spinoff of its subsidiaries, but the deal would have eliminated the potential for a step-up, two of the people said.
The capital gains tax that would result from the step-up scenario would not affect the lenders or other secured creditors whose debt holds top payback priority. Instead, it would become an unsecured bankruptcy claim held by the IRS, diluting the claims of other junior creditors.
In that sense, the lending group has become the bane of junior bondholders, which mostly include investment funds with debt at Energy Future's regulated and unregulated units.
More importantly from the government's perspective, there is not expected to be enough money to fully repay holders of unsecured claims in bankruptcy, meaning the IRS would recover only a fraction of the multi-billion-dollar tax bill, if anything.
Unsecured creditors have little power in bankruptcy to elevate their claims or demand payback where value does not exist. But the IRS may push hard to salvage some recovery, given the unique size of the potential claim and the desire to avoid the perception of hurting taxpayers, according to two of the people close to the matter.
The private equity firms, moreover, may be wary of upsetting the government and inviting increased IRS scrutiny of their businesses, one creditor source said.
That means Energy Future's eventual bankruptcy is likely to include significant haggling - and maybe litigation - between the government and any party that lends support to a plan that creates a large tax bill.
Perhaps the government's best option for disrupting such a plan, said one person close to the matter, is to argue under bankruptcy law that the plan is invalid because it serves mainly as a tax-avoidance scheme. To approve a bankruptcy exit plan, a judge must conclude among other things that the plan is not designed to dodge taxes.
The government may face an uphill climb. A tax step-up is legal, and it is unclear that any unsecured creditor - even one with the financial resources and political clout of the government - would have the bargaining leverage to work out a deal that avoids a hefty unpaid tax bill.
The IRS could change its own regulations to block the lenders' attempt at the step-up, two of the people said. But others balked at that proposition.
"It's too fundamental a part of the tax code to change," accountant and tax expert Robert Willens, who is not involved in the case, told Reuters. "I don't have any compunction that they would do that, nor could they."
'OLYMPUS HAS FALLEN'
Energy Future last year had hoped to achieve a restructuring that would avoid breaking up the company, dubbing the mission "Project Olympus," according to two of the people close to the matter. The name became a joke to some creditors after Millennium Films released its action blockbuster "Olympus Has Fallen" in March of 2013, they said.
Now, hope of a consensual deal prior to a bankruptcy has all but dried up, and parties are more focused on arranging bankruptcy financing, the sources said. A contentious bankruptcy could mean months or years of negotiations between all stakeholders, including the government, and the tax dispute could eventually be resolved cooperatively.
If it is not, another potential avenue for Uncle Sam is to ask a judge to void Energy Future's corporate structure, making certain "ringfenced" assets - those protected from the reach of creditors - available to creditors, Willens said.
That scenario seems unlikely. People close to the case believe the asset in question - namely Oncor, Energy Future's regulated power delivery business - will remain off-limits to stakeholders.
Dot Matthews, an analyst at CreditSights, wrote in November that the Oncor ringfence was solid. "We have never believed that Oncor would be dragged into an eventual (Energy Future) bankruptcy, and that seems to be the current consensus, as well," Matthews said in a report.
Energy Future could itself change its tax structure so that the tax would fall to its energy-generation subsidiary rather than the Energy Future parent, said one of the people, but that scenario was unlikely because the lenders have enough bargaining leverage to influence the terms of the company's restructuring.
(Reporting by Nick Brown and Billy Cheung; Editing by Amy Stevens and Prudence Crowther)