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).