Chapter 11: Life After Death by Chris Trayhorn, Publisher of mThink Blue Book, April 1, 2003 It is a fundamental tenet of economics that life in a competitive marketplace comes with both risks and rewards. Partial deregulation of the utility industries has proven no exception. Utilities are now facing, in some cases for the first time, the reality that bad things sometimes happen even to good companies. In particular, utilities operating in competitive energy markets have found themselves vulnerable to the possibility of purchasing commodities at higher prices than they are allowed to pass on to consumers, as the California energy crisis dramatically illustrated. When a utility finds itself in a bad situation, where can it turn for help? One important option is Chapter 11 protection under the United States Bankruptcy Code. Although bankruptcy is always risky, a Chapter 11 reorganization can, and often does, bring troubled companies back from the brink of extinction. Chapter 11, however, is not a panacea for every ill. Some situations, including some commonly encountered by struggling utility companies, are not easily remedied even with the strong medicine that reorganization can provide. Chapter 11 provides a process whereby a business may attempt to reorganize itself by restructuring its debt, business, and assets or by liquidating its assets in an orderly fashion. It also provides debtors with powerful tools to cure the underlying causes of its financial problems. Of course, these benefits come with certain drawbacks, even apart from the stigma that bankruptcy bears. For instance, Chapter 11 fundamentally changes the dynamics of operating a company. Public Process Bankruptcy is a very public process. It can be very distressing for a company’s officers to know that a small army of creditors, attorneys, and other interested parties will publicly debate the company’s past decisions, present proposed actions and future viability. Even more disturbing is the realization that the company’s future is almost entirely dependent on the approval of its creditors. In fact, a company that has filed for Chapter 11 protection is normally operated by its officers as a “debtor-in-possession,” which has the primary duty not of maximizing profits for shareholders, but of maximizing the company’s assets for the benefit of its creditors — and only then for the benefit of its shareholders if any value remains. As an additional challenge to this often-daunting process, industries that operate under public scrutiny, most notably the utility industries, may find their attempts to take full advantage of the benefits of Chapter 11 frustrated by the actions of regulators, state legislatures, and other public actors. On the other hand, bankruptcy can provide a fresh forum to work out a utility’s tensions with the public actors who may have become intractable in traditional regulatory environments. With all of this in mind, it is useful to review the major lessons learned from several of the leading utility bankruptcies of the last few years. Recent utility bankruptcies provide a valuable backdrop against which to evaluate bankruptcy’s usefulness in new situations. Of course, bankruptcy (like most forms of litigation) can be unpredictable. As in the stock market, past performance does not necessarily predict future results. Nonetheless, the questions and answers below provide utility companies with valuable insight into life after death. Will state and federal regulatory bodies be allowed to intervene in the bankruptcy proceeding? Generally, bankruptcy courts have allowed state public utility commissions or similar regulatory bodies to participate in utility bankruptcy proceedings. This means that regulatory agencies will generally be allowed to be heard on issues that arise during the bankruptcy, as would any other party in interest. They may even propose a plan of reorganization, as the California Public Utilities Commission (CPUC) has in the Pacific Gas and Electric (PG&E) bankruptcy, if the court in its discretion allows. The regulators will generally not, however, be allowed to vote on a plan of reorganization since they usually are not creditors. In addition to PG&E, state agencies have been granted party in interest status in In re Public Service Company of New Hampshire (PSNH), In re Cajun Electric Power Cooperative Inc. (Cajun), and In re Columbia Gas Systems, Inc (Columbia). The rationale for including the regulatory entities in the proceedings is well-summarized by the bankruptcy court in PSNH, which stated that “rather than burdening the reorganization process of a regulated electric utility, the granting of such status and rights to the State of New Hampshire should expedite the progress of this reorganization process.” Thus, it is very likely that interested regulatory bodies will be heard in utility bankruptcy cases. By contrast, a utility’s ratepayers themselves will likely not be allowed to participate directly in the bankruptcy proceedings. For example, the bankruptcy court overseeing the PG&E bankruptcy ruled early in that proceeding that adequate representation of creditors did not require the formation of a ratepayer committee. The court noted that “ratepayers have other means and other fora to protect their interests,” namely the state regulators. Can a regulatory body change rates during the pendency of bankruptcy? Regulators who have power to set utility rates can be expected to continue “normal rate-making activities” involving the utility, even after the utility has filed for Chapter 11 protection. The bankruptcy “automatic stay” that generally stays all actions against a debtor to recover on pre-petition financial obligations does not generally apply to regulatory rate-making actions. Thus, filing for bankruptcy most likely does not prevent a regulator from increasing or decreasing the debtor utility’s rates based on the effects of normal external forces. On the other hand, bankruptcy courts have been known to enjoin regulators as in Cajun Electric, where rate cases were seen as oppressive and disruptive to the reorganization. However, recent United States Supreme Court opinions, which have expanded traditional notions of state sovereign immunity under the 11th Amendment, suggest that such injunctions, unless very carefully crafted, may be beyond the power of the federal courts. Who will make daily business decisions during the pendency of the bankruptcy? The Bankruptcy Code generally allows a company operating under Chapter 11 to make so-called “ordinary course of business” operational decisions without court approval. In contrast, decisions not in the ordinary course of business (such as the sale of major assets, re-financing and substantial changes in operations) cannot be taken without court approval unless no party in interest objects to the proposed action. Will regulatory approval be required for the company to exercise powers granted under the bankruptcy code, such as rejecting contracts? The Bankruptcy Code grants significant powers to debtor companies that have filed for protection under Chapter 11 of the Bankruptcy Code. These powers include the power to avoid and recover “preferential” or “fraudulent” transfers, as well as the power to assume or reject executory contracts entered into before bankruptcy. These powers allow companies in Chapter 11 to revisit previous decisions, effectively allowing them a second chance to make certain critical decisions. Before exercising these powers bankruptcy court approval is required. But regulatory approval is not normally required before exercising rights arising under the Bankruptcy Code. This issue arose during the course of the Cajun proceedings. An open administrative docket was sought by the state public service commission to consider whether Cajun had prudently exercised its contract rejection right, one of the Company’s core bankruptcy powers, in refusing, for the time being, to reject Cajun’s fuel supply and fuel transportation contracts. In response, the bankruptcy court ruled that the commission was enjoined from making such an inquiry. The approval of the bankruptcy court would be required before the utility could exercise such a right; however, the approval of the regulatory agency, to its consternation, would not be required. Will regulatory approval be required to confirm a plan of reorganization? Confirmation and consummation of a plan of reorganization are the principal objectives of a Chapter 11 reorganization case. A plan of reorganization restructures the company and sets forth the means for satisfying claims against the company. Confirmation of a plan of reorganization by the bankruptcy court makes the plan binding, so far as possible, on the world. A requirement of regulatory approval of part of the plan gives substantial power over the debtor utility’s future to a regulatory agency. Here the law differentiates between decisions regarding rate-making itself and decisions regarding the restructuring of the utility under Chapter 11. The law requires that any rate changes proposed in a plan of reorganization be approved by the regulator before they can be implemented. On the other hand, the law and court decisions suggest that, even though regulatory agencies will be allowed to participate and be heard in the bankruptcy process, their authority to approve the restructuring (aside from rate changes) proposed in a plan is severely limited. It appears that core bankruptcy restructuring actions (such as transfers of assets, merger, disaggregation of component entities, and the like), may be approved by the bankruptcy court irrespective of non-bankruptcy law. At least this is the current teaching from PG&E. (Nonetheless, PG&E has agreed to comply with federal, but not state, regulatory approval requirements.) In December 2001, PG&E presented a plan of reorganization that would disaggregate the current company into three limited liability companies pursuing four lines of business: retail gas and electric distribution, electric transmission, interstate gas transmission, and electric generation. State law prohibited key aspects of this disaggregation and required the approval of the CPUC prior to any sale, lease, or spin-off of any of the company’s utility facilities. Based on these state law requirements, CPUC objected to the proposed reorganization. In early 2002, the bankruptcy court overseeing the PG&E case issued a decision rejecting PG&E’s claim that federal bankruptcy law preempts non-bankruptcy laws otherwise applicable to the proposed restructuring transactions. This decision was reversed by an order of U.S. District Court for the Northern District of California, which held: “The preemption issues raised by reorganization are particularly acute in the case of a public utility in bankruptcy, as perhaps no other debtor is subject to as much state regulation as the public utility. But the removal of the statutory right of approval by state commissions of the restructuring of public utilities by the 1978 Bankruptcy Reform Act is powerful evidence that Congress concluded that public utilities should no longer be subject to the costs, delays and uncertainty accompanying such a requirement. “The bankruptcy code at one time permitted state regulatory commissions to wield considerable power over the reorganization of public utilities. But now — with the exception of the right to approve rate changes — it does not. Non-bankruptcy laws otherwise applicable to the ‘restructuring transactions necessary to an effective and feasible reorganization’ are expressly preempted by the bankruptcy code.” After the District Court issued its decision, CPUC requested that the decision be stayed pending an appeal of the decision to the 9th U.S. Circuit Court of Appeals. The District Court denied CPUC’s request. As of the date of this article, the decision has not been appealed, although because the decision is interlocutory, it may be appealed later. Is Chapter 11 available to help restructure foreign power projects? Chapter 11 is powerful medicine for the restructuring of financially troubled power projects. As a result, both lenders and energy companies have looked toward U.S. bankruptcy law for assistance with the restructuring of troubled foreign power projects. The doors of the U.S. Bankruptcy Court are open for the filing of Chapter 11 by companies which have any assets in the United States (even if simply a bank account), some operations in the United States, or were incorporated in the United States. Moreover, projects which are in bankruptcy, receivership, or liquidation overseas, and which do not seek to file Chapter 11, may still obtain the assistance of the U.S. Bankruptcy Courts in support of the foreign proceeding — such as by enjoining creditors in the United States from going after assets within the United States. While the theoretical possibilities for restructuring foreign power projects under Chapter 11 are broad, there are many practical impediments. Chief among these is the difficulty of a United States court effectively protecting or otherwise asserting jurisdiction over those assets not located here. Conclusion At the writing of this article, the bankruptcy court presiding over the PG&E case had not ruled as to whether the company’s or the CPUC’s plan of reorganization would be confirmed. This ruling, together with decisions that will be made on appeal, will cast substantially more light on a Chapter 11 utility’s life after death. In the meantime, except for rate-making, creditors and courts have the upper hand over a Chapter 11 utility’s life support. n Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.