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Dynegy, after devastating report, rallies to defense of its directors and their actions

Dynegy last week launched a full-throated attack on the report filed last week in its Chapter 11 case by court-appointed examiner Susheel Kirpalani, with company president and CEO Robert Flexon saying in a press release that the company was “both troubled and disappointed” by the report.

Meanwhile, according to a preliminary response to the report filed in bankruptcy court in Poughkeepsie, N.Y., the company charged that Kirpalani’s report was “based on numerous misstatements or incomplete statements of fact, the misapplication of blackletter law and the inexplicable omission of certain material facts and governing law relevant to its conclusions.”

What’s more, the company said, with respect to allegations leveled against certain of the company’s managers and directors, the report “attacks and impugns the integrity of numerous individuals who have careers and reputations – all of which have been inappropriately put at jeopardy – on the basis of key assumptions made by the examiner that conflict directly with the facts known to the [directors]…at the relevant time.”

As reported, Kirpalani filed a devastating report on March 9 concluding, among other things, that a series of transactions by the company in the summer of 2011 that, in effect, transferred ownership of the company’s coal-based power-generation assets from Dynegy Holdings to its publicly traded corporate parent, Dynegy Inc., constituted both actual and constructive fraudulent conveyances. The transactions had the effect of benefiting the parent company’s public shareholders at the expense of its subsidiary’s creditors, culminating in a Chapter 11 filing last November that left shareholders unimpaired despite creditors taking a significant haircut.

Kirpalani also found that the company’s board of directors, in engineering and implementing these transactions, breached its fiduciary duties to creditors.

Kirpalani’s finding of an actual fraudulent conveyance was based on his determination finding that the purpose behind the transactions was to “hinder and delay” recoveries by the company’s creditors, although Kirpalani specifically also said he did not find evidence of an intent to defraud creditors, inasmuch as the company was upfront about disclosing the transactions.

Evidence ignored

One argument central to the company’s defense against Kirpalani is undercutting his conclusion that Dynegy Holdings was insolvent at the time of the transaction. “The conclusions reached by the examiner are dependent on a determination that DH was insolvent at the time of the transactions,” the company said in its press release this morning.

“Notably, however, the examiner did not actually determine whether Dynegy Holdings was insolvent,” the company said. “Instead, the report assumed insolvency and ignored critical evidence to the contrary.”

According to the company, its directors believed that Dynegy Holdings was solvent at the time of the transfer of the assets, inasmuch as “the consolidated company at that time had over $1 billion in liquidity, approximately $570 million in equity market capitalization, financial forecasts demonstrating the company’s ability to meet its liabilities for the foreseeable future, the ability to raise additional capital through new credit lines and asset sales, and no significant debt maturities until 2015.”

In light of that belief on the part of its directors, the company also challenges Kirpalani’s conclusion that the transfer of the coal assets to Dynegy Inc. could constitute an actual fraudulent transfer that was intended to “hinder and delay” creditors.

According to the court filing, the first step of the transfer, in which ownership of the coal assets were transferred from Dynegy Holdings to a bankruptcy-remote entity known as Dynegy Gas Investments, was a necessary step for the company to obtain new secured financing to provide needed liquidity – a move that clearly benefited Dynegy Holdings’ creditors by helping the company avoid default.

The company further argued that the second step of the transaction, in which the coal assets were transferred from DGI to Dynegy Inc., was a necessary step to use those same assets to delever Dynegy Holdings’ balance sheet – again, a transaction intended to benefit creditors, not “hinder or delay” them.

“The transaction was done in support of an exchange offer intended to reduce Dynegy Holdings’ debt for the benefit of Dynegy Holdings’ creditors,” the company explained in its press release, “while offering a more secured investment for those creditors who participated in the exchange.” Further, the company said, once that exchange offer fizzled, the company entered into a restructuring support agreement with Dynegy Holdings’ creditors – the pact that the company took into bankruptcy court – “that effectively would unwind the CoalCo transfer and provide Dynegy Holdings creditors a more secured interest.”

Thoughtful and immediate action

While defending its transaction, the company also rallied to the defense of its managers and directors, who came under harsh criticism in Kirpalani’s report for alleged violations of fiduciary duties owed to creditors.

“The report’s conclusions regarding fiduciary duties are incorrect and contrary to precedent,” the company said, citing, among other things, the directors’ belief that the company was solvent and they, therefore, were acting for the benefit of shareholders and not creditors. What matters, according to the company, is not whether the directors’ judgments ultimately prove to have been correct, but rather their subjective perception at the time they took action. “A fundamental principle of Delaware corporate law is that a board of directors cannot be second-guessed on the conduct of corporate affairs if they exercised proper business judgment.”

According to Dynegy, the business judgments reached by its board in mid-2011 were justified by the facts that the company was faced with a looming debt default, excessive leverage, significant turnover of officers and directors, and adverse swings in energy prices, “all of which required thoughtful and immediate action which the Board carried out.” According to the company, “The directors used their best business judgment and retained internationally recognized advisers…to determine the right course of action that preserved value for the company’s stakeholders and ensured it was done in the proper manner.”

Given this, the company argues, there is no basis to Kirpalani’s finding that directors breached fiduciary duties to creditors, and thus no legal basis for his finding that the corporate veil should be pierced in evaluating the restructuring transaction.

An opportunity at vindication

As reported, the company is entering a critical three-week period in the wake of the filing of Kirpalani’s report.

The company has already filed a reorganization plan and disclosure statement incorporating the terms of the aforementioned restructuring support agreement. A hearing on the disclosure statement was scheduled for March 12, but that was cancelled in light of Kirpalani’s report.

That plan is now up in the air. Among other things, Kirpalani recommended in his report that exclusivity in the case be terminated so that creditors have the ability to vote on competing proposals.

On March 12, the bankruptcy court ordered the parties into mediation to be led by Kirpalani, with a status update slated for April 4. Also pending before the court is a motion from the U.S. Trustee to appoint a trustee in the case to oversee the company, a hearing on which is also scheduled for April 4.

Notwithstanding that compressed time frame, the company urged a go-slow approach.

“The company is concerned that the parties and the court not form conclusions about the company and its personnel before they have had the opportunity to vindicate their actions from what is as an unfair attack,” Dynegy said in the response filed with the bankruptcy court.

Further, the company noted, “Before the court and the parties in interest move straight to the question of how the conclusions expressed in the report should or will affect the path of these cases, it is critical to understand that the report is not evidence, nor is it admissible,” adding, “This is not a mere technicality, but rather a Constitutional acknowledgment that a court should never be denied both sides of the story.”

Still, whatever the relative merits of Kirpalani’s or the company’s legal arguments, there is no denying that Kirpalani’s report has opened up a can of worms that will, from this point forward, have to be responded to in one of two ways: through a new consensus among the parties, or litigation.

Dynegy appears to recognize this reality, and is keeping its options open. Even as it pressed its strong defense of itself and its directors in the court filing and its public statement, the company said in the press release that it “remains committed to working with all creditor groups to reach a consensual restructuring agreement that is beneficial to all stakeholders. – Alan Zimmerman

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