Court Ruling Backs Regulators by Chris Trayhorn, Publisher of mThink Blue Book, March 11, 2004 In November 2003, the 9th US Circuit Court of Appeals issued a decision in the Pacific Gas and Electric bankruptcy case that has potential ramifications for public utilities and other regulated entities. In contemplating reorganization under the US Bankruptcy Code, the court held the code does not expressly pre-empt non-bankruptcy laws, such as state public utility or environmental regulation, except to the extent such laws relate to financial condition. PG&E, the large vertically-integrated California public utility, filed a voluntary petition under Chapter 11 of the Bankruptcy Code on April 6, 2001. The San Francisco-based company subsequently filed a reorganization plan that proposed disaggregating the company into four new corporations that would own its generation assets, electric transmission assets, gas transmission assets, and retail distribution operations. Under the reorganization plan, only the retail distribution corporation would continue to be subject to the jurisdiction of the California Public Utilities Commission (CPUC). Certain material aspects of the reorganization plan, including the transfer of utility assets, issuance of utility securities, and assignments of permits and licenses to the newly created entities, would normally require approvals from various state and local authorities, including the CPUC. Further, the transfer of generation assets would have been unlawful under Section 377 of the California Public Utilities Code, which provides that “no facility for the generation of electricity owned by a public utility may be disposed of prior to Jan. 1, 2006.” PG&E sought to carry out the proposed reorganization without obtaining approvals from state and local regulators and despite the explicit prohibition. In the disclosure statement accompanying its reorganization plan, PG&E took the position that all laws that may affect implementation of its reorganization plan are categorically pre-empted by Section 1123(a)(5) of the Bankruptcy Code, which states: “notwithstanding any otherwise applicable nonbankruptcy law, a [reorganization] plan shall … provide adequate means for the plan’s implementation … .” In essence, PG&E sought an order from the Bankruptcy Court that the reorganization plan would pre-empt jurisdiction of the CPUC and other regulatory agencies, as well as any law, rule, or regulation that would otherwise apply to the proposed restructuring transactions. As characterized by the Bankruptcy Court, PG&E was pursuing an “across-the-board, take-no-prisoners pre-emption strategy.” Various California agencies and municipalities challenged the reorganization plan. PG&E’s broad reading of the law was initially rejected by the Bankruptcy Court. On appeal, a federal judge reversed and adopted PG&E’s position. On further appeal, the 9th Circuit reversed and held that “the express pre-emption of Section 1123(a)(5) is limited to otherwise applicable nonbankruptcy laws ‘relating to financial condition,’ as specified in §1142(a) [of the Bankruptcy Code].” 9th Circuit’s Legal Analysis The appellate decision is based entirely on principles of statutory interpretation. The court agreed with PG&E that a reorganization plan pre-empts otherwise applicable nonbankruptcy laws. The phrase “notwithstanding any other applicable nonbankruptcy law” is typical language used by Congress in the Bankruptcy Code to effectuate pre-emption of other laws. However, the court disagreed with the scope of pre-emption, concluding that Section 1123(a)(5) should be read in conjunction with Section 1142(a) of the Bankruptcy Code that also addresses the issue of pre-emption. That section provides that a reorganization plan shall be implemented: “notwithstanding any otherwise applicable nonbankruptcy law, rule, or regulation relating to financial condition.” (Emphasis added.) Basically, the court held that the pre-emptive “notwithstanding” clause in Section 1123(a)(5), which was added in 1984, was intended to be co-extensive in scope with the pre-emption clause in Section1142(a), and not to create a broader, independent basis for pre-emption. The court did note that at least one lower court had interpreted the pre-emptive effect of Section 1123(a)(5) in a broader manner. In that case, Public Service Co. of New Hampshire v. New Hampshire (108 B.R. 854, 891 Bankr.D.N.H.1989), the court found pre-emption was allowed to the extent necessary to effectuate a feasible reorganization. However, the court assumes without stating that its decision was one of first impression among the federal courts of appeal. The court’s analysis begins with the legislative history of the US Bankruptcy Code. Sections 1123 and 1142 were both enacted as part of the Bankruptcy Reform Act of 1978, legislation that forms the basis of the present-day code. However, as enacted in 1978, Section 1123(a)(5) did not contain a “notwithstanding” pre-emption clause. By contrast, the 1978 version of Section 1142(a) contained the same pre-emption clause found in the current version, which pre-empts nonbankruptcy laws related to “financial condition.” The pre-emption clause in Section 1123(a)(5) was added as part of a set of 1984 amendments to the Bankruptcy Code. Legislative history suggests that the amendments were intended to be of a technical rather than substantive nature. Legislative history also suggests that, as enacted in 1978, Congress intended there to be a linkage between Section 1123, which describes the content of a confirmable reorganization plan, and Section 1142, which describes the effect of the plan. In addition to the legislative history, the court was guided by two maxims of statutory interpretation. The first, a general maxim established in a long line of US Supreme Court cases, holds that Congress does not intend to pre-empt state law lightly, particularly laws pertaining to traditional state police powers. Unless Congress expressly provides otherwise, grants of federal pre-emption are to be narrowly construed to avoid pre-empting areas that the states have regulated traditionally. Public utility regulation is generally considered an exercise of police power and is a traditional area of state regulation. The second presumption is that, absent clear indications to the contrary, Congress does not legislate on a clean slate in the bankruptcy arena. In other words, congressional enactments such as the 1978 Bankruptcy Code and 1984 amendments are presumed to codify, not modify, pre-existing bankruptcy laws and practice. Armed with these maxims of statutory interpretation and its reading of the legislative history, the court concluded that the 1984 amendment, which added the pre-emption clause in Section 1123(a)(5), was intended merely to clarify the scope of pre-emption allowable under Section 1142(a). The court found no indication in the statutory language or legislative history that Congress intended to displace traditional state police powers in the context of Chapter 11 reorganizations. As held by the court: “It is thus clear that the addition of the ‘notwithstanding’ clause by amendment in 1984 was not intended by Congress to make any substantial change to the 1978 code. In particular, it is clear that the ‘notwithstanding’ clause of §1123(a) was not intended to change the express pre-emptive effect of a confirmable reorganization plan. The 1978 Code had already indicated in §1142(a) the express pre-emptive effect of a confirmed reorganization plan: The plan is to be implemented ‘notwithstanding any otherwise applicable nonbankruptcy law, rule, or regulation relating to financial condition.’ As we read the 1984 amendment to §1123(a), the newly added ‘notwithstanding’ clause was intended to be coextensive with the already-existing ‘notwithstanding’ clause of §1142(a)” (2003 WL 22718162 at *12).” Interestingly, the predecessor statute to Section 1142 contained a provision expressly requiring public utilities seeking reorganization to procure the approval of any state regulatory commission with jurisdiction over the utility. That language was not included in the 1978 enactment of the Bankruptcy Code. PG&E argued that the failure to include that language indicated that Congress intended specifically to pre-empt state utility regulations. The Court rejected this argument, concluding that the failure to include that language meant that Congress intended to treat utilities the same as other companies (i.e., only allowing pre-emption of nonbankruptcy laws relating to financial condition). Based on its interpretation that the code only pre-empts laws related to financial condition, the 9th Circuit remanded the case to the Bankruptcy Court for a determination of whether PG&E’s reorganization plan was permissible under that standard. The 9th Circuit also left open on remand the issue of whether PG&E’s plan was permissible under an implied pre-emption theory. Courts have generally recognized that the Bankruptcy Code implicitly pre-empts state laws that impose such onerous obstacles as to interfere with the implementation of the bankruptcy process itself. Ramifications for Utilities To the extent it applies or is adopted in a particular jurisdiction, the 9th Circuit’s decision has significant ramifications for utilities and regulated entities seeking to reorganize under Chapter 11 of the Bankruptcy Code. Debtors may not assume that the Bankruptcy Code automatically pre-empts otherwise applicable nonbankruptcy laws, rules, and regulations. Certain regulations will be deemed pre-empted, consistent with the PG&E decision, to the extent they relate to financial condition. The scope of pre-emption relating to financial condition under Section 1142(a) is undefined by statute or case law, leaving open the possibility that certain of the laws that PG&E sought to avoid – such as those restricting transfer of assets and issuance of securities – may be deemed pre-empted as relating to financial condition. Otherwise, the debtor is left to argue that the regulations are subject to implied pre-emption because they are so restrictive as to interfere with the bankruptcy process itself. Implied pre-emption necessarily entails a case-by-case analysis of a particular reorganization plan, the otherwise applicable regulations, and the associated burdens on the reorganization process. Accordingly, it provides less certainty to the participants in the bankruptcy process than the bright-line rule PG&E sought to apply in its reorganization plan. Given the judicial reluctance to pre-empt the exercise of state police powers, it is unlikely that courts will approve utility reorganization plans that seek to categorically avoid jurisdiction by state utility commissions. The result is to allow other stakeholders, such as state and local regulators, more say in the bankruptcy reorganization process. PG&E’s own experience is instructive. Initially, PG&E sought a broad exemption that would have effectively removed its generation and transmission assets, including nuclear and hydroelectric facilities, from state regulation. Further, PG&E’s plan would have prevented regulators from attaching conditions (e.g., for public safety or to benefit ratepayers) to the restructuring transactions. The 9th Circuit affirmed that the process must take into account state regulatory concerns, in addition to the economic interests of creditors, when a utility or other regulated entity seeks to reorganize. Although this outcome may upset commonly held assumptions concerning the broad pre-emptive effect of the Bankruptcy Code, it comports with the traditional reluctance of the federal government to pre-empt state police powers. Prior to the 9th Circuit decision in this case, PG&E abandoned its disaggregation plan in favor of a settlement with the CPUC that would keep the company’s assets under CPUC jurisdiction. The settlement was tentatively approved by the Bankruptcy Court about a month after the 9th Circuit’s ruling, subject, in part, to the approval of the CPUC. The commission added its approval on a 3-2 vote the following week. Citation 1 Pacific Gas & Electric Co. v. State of California, – F.3d -, 2003 WL 22718162 (9th Cir 2003). 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.