From time to time, issues arise before the US bankruptcy court that cause jurists to consider the interplay between the Bankruptcy Code and another Federal statute. The latest of these is the Federal Power Act. The Federal Power Act, among other things, grants the Federal Energy Regulatory Commission (Ferc) the exclusive jurisdiction to regulate the transmission and sale of electric energy in interstate commerce. Ferc is also responsible for regulating prices and the terms and conditions for the sale of energy between states and regions.
US courts have been trying to strike a balance between the fundamental principles of the US Bankruptcy Code, which favours reorganization, and the public policy under the Federal Power Act to ensure nationwide availability of reliable and economical power and protect consumers from excessive rates. These independent goals have collided when bankrupt generators have sought to return to profitability by using the Bankruptcy Code to terminate burdensome power purchase agreements, leaving utilities to scramble for replacement power, often at much higher cost.
Efforts to terminate these contracts have been challenged and courts have reached different conclusions about whether it is up to the bankruptcy judge or Ferc to decide whether a power contract can be cancelled in a bankruptcy proceeding. Also at issue is the standard bankruptcy judges must use in their decisions. The outcome of these issues is of interest to the lending community because institutions that finance power projects and utilities wonder about the security of the long-term power purchase agreements (PPAs) that they lend against.
On balance, the bankruptcy court, sitting as a court of equity, is well suited to determine the terms under which a power generator in financial distress can reorganize in an effort to maximize value for its creditors. Rather than place a veto power over a project's survival in the hands of Ferc, the bankruptcy court should, as it always does, consider whether approval of a debtor's business judgment to terminate a PPA would so endanger the power purchaser and its retail consumers as to violate public policy.
Volatility
Given the recent volatility in energy prices and the liquidity crisis facing the energy industry, power generators and purchasers have found themselves before the bankruptcy court in recent years seeking to restructure their finances. As a result, bankruptcy courts have been faced with debtors' requests to exercise their rights under the Bankruptcy Code to reject or disavow long-term PPAs. In two recent situations arising in the Chapter 11 cases of NRG Energy Inc, Mirant Corporation and their respective subsidiaries, the contract counterparties, both regulated utilities, asserted that only Ferc, and not the bankruptcy court, had jurisdiction over the ultimate disposition of the PPAs. The debtors countered that rejection of contracts is clearly within the exclusive jurisdiction of the bankruptcy courts. Ferc, protective of its mandate, played active roles in these disputes.
For power generators and their lenders and other creditors, this developing law could greatly affect creditor recoveries and limit restructuring alternatives.
Rejection of contracts
Restructuring a business successfully in Chapter 11 often requires not only reducing its indebtedness but also refocusing its business operations to more profitable pursuits. This operational assessment process must include a review of all contractual relationships to determine whether the debtor could improve its future operating margins and profitability by rejecting certain contracts that are no longer in its best interests.
The ability to reject burdensome executory contracts pursuant to section 365 of the Bankruptcy Code is one of the most valuable debtor benefits. It permits a debtor to pick and choose among its unexpired leases and executory contracts. The term executory contract is not defined in the Bankruptcy Code but is generally accepted to mean any contract where both parties have material ongoing obligations. Except for leases of non-residential real property, which are subject to a 60-day deadline (which can be extended by the bankruptcy court), the decision to assume or reject does not have to be made by a debtor until confirmation of a plan of reorganization, unless the bankruptcy court orders otherwise. However, the debtor often seeks to reject unfavourable contracts early on in the bankruptcy case if doing so could result in immediate savings.
A debtor may assume an executory contract (other than an agreement to provide a loan or other financial accommodation) only if, at the time of assumption, two things occur. The company must cure past defaults and show its financial capability to perform the contract fully in the future. Section 365 of the Bankruptcy Code provides a further benefit in that it permits a debtor as part of the assumption process to assign a contract to a third party notwithstanding a prohibition within the contract. Personal service contracts and certain intellectual property licences cannot be assigned without consent.
A bankrupt company alternatively has the power to reject an executory contract if it is burdensome to the estate and if, in the debtor's business judgment, rejection is appropriate. If a contract is rejected, it is not terminated but rather the debtor is deemed to have breached the contract as of a point in time immediately before the bankruptcy filing. This excuses the company from further performance, but also exposes it to a claim for damages by the contract counterparty. This damage claim is treated as a pre-petition general unsecured claim, which could be compromised under a plan of reorganization for cents on the dollar. In contrast, the breach of a previously assumed contract gives rise to an administrative priority claim for damages that is not limited by the Bankruptcy Code. It is the relegation of rejection damage claims to pre-petition general unsecured status that allows a debtor to opt for rejection if a voluntary breach of the contract outside of bankruptcy would not have been considered.
The standard a bankruptcy court will apply in considering whether to authorize a debtor to assume or reject a contract is the business judgment test. It is prevailing law that a debtor's decision to reject an executory contract in its business judgment must be upheld, unless it is the product of bad faith, or of whim or caprice. Most courts will disregard as irrelevant the harm caused to other parties to the contract as a result of a rejection. Some courts, however, have modified the business judgment test to consider a balancing of the harms, but courts have only denied rejection in situations where the debtor's estate would not be aided by rejection and the potential damage to the contract counterparty would be disproportionately greater than the estate's expected benefit.
Rejection of PPAs
Contracts in the project finance arena such as PPAs are unique because of their longevity: often 20 years or longer. Also, contract pricing is based on long-term commodity market projections of future prices, which could turn out to be extremely volatile and greatly affected by external forces. As such, these contracts are more susceptible than most to rejection by independent generators in Chapter 11 proceedings.
Mirant and NRG both found their way into Chapter 11 during 2003. Each was a party to one or more PPAs with a regulated utility that each could no longer economically perform under. Both companies recognized that, as part of their overall restructuring efforts, they should take advantage of the Chapter 11 filing to reject certain PPAs. Mirant stated that rejection of its PPA with Potomac Electric Power Co (Pepco) was one of the primary objectives it needed to achieve for a successful reorganization. As described below, Mirant and NRG faced legal snags in implementing these restructuring initiatives as the courts struggled to reconcile the competing interests of the Bankruptcy Code and the Federal Power Act.
NRG
NRG Energy was party through a subsidiary to a four-year PPA with Connecticut Light & Power Company (CL&P), which required NRG to provide a fixed amount of energy to CL&P at a set price from January 1 2000 until December 31 2003. Immediately before filing for Chapter 11 relief on May 14 2003 in the US Bankruptcy Court for the Southern District of New York, NRG provided notice to CL&P that it intended to terminate the PPA. Later that day, NRG commenced its Chapter 11 case and filed a motion to reject the PPA. The next day, in furtherance of their purported regulatory authority, the Connecticut Public Utility Control and the Connecticut attorney-general filed a petition with Ferc to stay the termination, citing harm to CL&P's customers. Ferc issued an order staying the termination on May 16 2003. CL&P thereafter obtained approval of the NRG Court to intervene in the Ferc proceedings.
On June 2 2003, the Bankruptcy Court authorized the rejection under the business judgment standard but, in doing so, refused to overrule the Ferc stay of contract termination. It further informed NRG that it would have to take steps in another forum to vacate the Ferc stay order, which required continued performance. CL&P appealed the decision and NRG moved in the District Court for declaratory and injunctive relief against Ferc. Ferc responded by issuing a second order requiring NRG to comply with the rates, terms and conditions of the contract pending a Ferc determination of whether NRG's proposed termination was consistent with the public interest.
In addressing NRG's request to enjoin Ferc from conducting further proceedings to enforce the PPA, the District Court held that the issues that were pending before Ferc (whether NRG could cease performance notwithstanding the Federal Power Act guidelines) fell squarely within Ferc's regulatory responsibility. Moreover, the District Court noted that section 8251 of the Federal Power Act provides that orders issued by Ferc are to be reviewed only by the US Court of Appeals. Accordingly, the District Court dismissed the declaratory judgment action and motion for injunctive relief for lack of subject matter jurisdiction. NRG went on to settle its differences with CL&P by stipulation and NRG was able to emerge from Chapter 11 a short time later.
Mirant
In 2000, Pepco, a regulated utility serving the District of Columbia and Maryland, agreed to sell its power plants to Mirant. Mirant also agreed to replace Pepco as the purchaser under a number of long-term power contracts that Pepco had entered into with other electricity suppliers. Pepco had difficulties assigning to Mirant two of the contracts under which it was an electricity purchaser, so Mirant agreed to enter into a new contract (referred to as a back-to-back agreement) under which it promised to buy electricity from Pepco at the same price that Pepco had to pay under the two agreements it was unable to assign. At the time, the rates under the new contract were reviewed and approved by Ferc. The rates under the back-to-back agreement ultimately proved higher than market rates and Mirant was suffering substantial losses. At the time of the bankruptcy filing, the back-to-back agreement had a remaining term of more than 18 years.
In July 2003, Mirant filed for relief under Chapter 11 in the US Bankruptcy Court for the Northern District of Texas. Mirant had seen the trouble that NRG had caused itself by providing notice of termination to CL&P of its agreement and allowing it to take preemptive action before Ferc by securing orders against NRG directing performance. To avoid the same fate, Mirant filed two motions in an adversary proceeding against Pepco and Ferc: a motion seeking authorization to reject the back-to-back agreement and one asking the Bankruptcy Court to enjoin Ferc or Pepco from taking any action to require Mirant to comply with the back-to-back agreement. The Court granted preliminary injunctive relief against Ferc and Pepco in September 2003.
Before the Bankruptcy Court heard the rejection motion, Pepco sought relief in the District Court, which decided to take jurisdiction away from the Bankruptcy Court and to use its own jurisdiction not only to rehear the motions requesting injunctive relief but also for the rejection motion as well. After extensive hearings and intervention by Ferc, the District Court found in December 2003 that Ferc had exclusive authority to authorize Mirant to stop performing the back-to-back agreement, because Ferc has exclusive jurisdiction over wholesale electricity sales in interstate commerce, and Ferc's exclusive authority may not be undermined through a collateral attack in another forum, such as the Bankruptcy Court.
The District Court further found that the only business justification supporting Mirant's motion to reject the back-to-back agreement was the losses it suffered because the rate approved by Ferc exceeded the market rate - matters directly within the purview of Ferc authority. Based on this analysis, the District Court denied the motion to reject for lack of jurisdiction and overturned the Bankruptcy Court's granting of injunctive relief. Mirant appealed the rulings to the Fifth Circuit Court of Appeals.
The Court of Appeals overturned the District Court's ruling and sided with Mirant. It said in August 2004 that a bankruptcy court's power to authorize the rejection of a PPA, such as the back-to-back agreement, "does not conflict with the authority given to Ferc to regulate rates for the interstate sale of electricity at wholesale".
It found that a rejection of a PPA is a breach of the contract and that the Federal Power Act does not provide Ferc with exclusive authority over the remedies for breach of a Ferc-approved contract. It also noted that elsewhere in the Bankruptcy Code there are express prohibitions or limitations against rejection of government-regulated contracts but that no such exception existed for Ferc. Accordingly, the Court of Appeals reversed the District Court and authorized and directed the District Court (or the Bankruptcy Court to the extent its jurisdiction is reinstated) to consider the rejection motion.
Notwithstanding the finding by the Court of Appeals that the bankruptcy court has exclusive jurisdiction over rejection of the back-to-back agreement, the Court of Appeals recognized the strong public interest in protecting the nation's supply of electricity and directed that the court overseeing the rejection motion impose a more stringent test than the business judgment rule. It instructed the lower court to scrutinize the impact of rejection upon the public interest, as well as ensure that the rejection would not cause any disruption in the supply of electricity to other public utilities or to consumers.
Mirant considered the Court of Appeals decision to be a big victory. However, it remains possible that the court deciding the rejection motion will determine that, to further public interest considerations under the Federal Power Act, the court will apply a stringent Ferc public interest test and only permit rejection if it is in the public interest of both parties.
For example, in the case of NRG, Ferc suggested that, to satisfy the public interest test, CL&P would need to realize full payment for each dollar of damages caused by terminating the contract. If that were the standard applied, it would be difficult for Mirant to show that consumers in Pepco's territory would not be harmed. It is more likely that the court will simply seek comfort that Pepco has access to other sources of electricity, even if this results in a rate increase to Pepco's customers, and otherwise defer to Mirant's business judgment.
In other words, only if rejecting the contract will result in an actual shortage or unavailability of power will the public interest standard supersede the business judgment standard. Also, although not noted by the court or by the parties, Section 202(c) of the Federal Power Act authorizes the US Department of Energy to compel a supplier to provide power in the event of an emergency or a shortage of power and to establish reasonable compensation to the supplier. The court might find that the existence of this remedy can protect the public and allow the business judgment standard to be applied without satisfying additional public interest standards.
Since the Fifth Circuit's decision in August 2004, the District Court has proceeded with the limited issue of whether the District Court should retain jurisdiction to hear all matters with respect to the Pepco dispute and what standard the court should use in approving the request for rejection. At the time of writing, the court has not yet considered the underlying rejection motion or the appropriate standard for review. Given the 18-year remaining term on the back-to-back agreement, the final outcome could be significant for Mirant creditors.
Disagreement
Both the NRG and Mirant cases suggest that there is no judicial agreement on a bankruptcy court's jurisdiction over the treatment of a PPA. Clearly, the Mirant approach is less rigid, more pragmatic and more oriented toward preserving the going concern value of bankrupt generators. The Mirant approach nevertheless accepts the notion that some safeguards are perhaps necessary to protect a national interest.
We are likely to see other situations in which the jurisdiction of the bankruptcy court is challenged by regulated utilities and Ferc. For debtors who are not as well financed as NRG and Mirant, it might prove difficult to sustain a lengthy campaign against Ferc through the appellate courts to achieve a final order approving rejection. This in itself could jeopardize a project's restructuring efforts. In the near term, these decisions might lead to forum shopping by prospective debtors in the power sector. Ultimately, as with certain other areas where the Bankruptcy Code conflicts with Federal statutory law, there might be legislation or Supreme Court consideration to address the interplay between the Federal Power Act and the Bankruptcy Code. But for now, the power struggle continues.
Joseph Smolinsky is a partner at Chadbourne & Parke LLP in New York.