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Texas Ring Fence

TXU’s buyout structure creates a potential model for utility M&A and refinancing deals

Fortnightly Magazine - January 2008

Texas PUC’s concerns for ratepayers. These structural features should help Oncor maintain a moderately leveraged capital structure and limit its distributions to the equity owners, which helps support overall financial strength — features the Montana PUC initially found lacking in the NorthWestern deal. The structural features also limit Oncor’s exposure to EFH creditworthiness and potential bankruptcy events.

Bankruptcy Remote

Foremost, the structural features sought to reduce Oncor’s exposure to EFH’s credit risk and help it maintain an investment-grade rating. When the buyout was announced, Standard & Poor’s concluded EFH’s rating would fall from BBB- to the single-B category based on the proposed capital plan, which included a large amount of new debt. To separate Oncor’s credit risk from EFH’s, the sponsors decided to ring-fence it from EFH — that is, to make Oncor bankruptcy-remote from EFH.

The credit issue is one of preventing substantive consolidation — i.e., if EFH goes bankrupt, it could pull Oncor into its bankruptcy proceeding.

Legal ring-fencing is a common practice when a parent tries to achieve a rating on a subsidiary higher than its own. The parent attempts to create a separate identity for the subsidiary — a different board of directors, management, business plan, accounts, records, liquidity facilities, corporate name and so on. But this is not enough. Additionally, the subsidiary directors will include at least one who is independent, that is, one who has not had a material commercial or ownership relations to the subsidiary or its parent for a long time — usually five years. This independent director has a fiduciary responsibility to the company and also its lenders. That director’s approval is required to make material changes to the subsidiary, such as a change in business plan, material agreements, liquidity facilities, and, most importantly, for filing the subsidiary into bankruptcy or agreeing to such a filing by another entity. Therefore, without the independent director’s approval, the subsidiary cannot file for bankruptcy.

Another requirement of separateness is that the parent must be able to secure a non-consolidation opinion from legal counsel, which concludes that if the parent did file for bankruptcy, the court would view the subsidiary as a separate entity and not consolidate it into the parent’s bankruptcy. Of course, nothing is foolproof, so this is why people talk about being bankruptcy-remote but not bankruptcy-proof.

S&P analysts view Oncor’s structure as bankruptcy-remote from the parent company. The company will have nine directors, six of which will be independent by rules established under the New York Stock Exchange. Two of these six will be independent under the more stringent criteria S&P has established for such directors in relation to legal ring-fencing structures. Analysts also reviewed the non-consolidation opinion regarding Oncor and EFH and found it acceptable.

Financial Commitments

In addition to the ring-fencing structure, Oncor and its holding company will be bound by a number of financial commitments to help support their financial integrity and at least maintain the current regulatory construct. Oncor has a good arrangement, with an ROE of 10.75 percent and efficient capital recovery features that support stable cash flow