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The Constellation Experience

Ring-fencing after the subprime meltdown.

Fortnightly Magazine - August 2010

is deemed a default of all of the parent and/or subsidiary lender agreements reflecting a recognition that the lender is essentially lending to one combined entity). The cross-default issue can be remedied by requiring the elimination of all cross-default provisions from such financing arrangements. More broadly, however, another routine ring-fencing requirement, and one ordered by the MDPSC in the Constellation-EDF case, is that the utility obtain a non-consolidation opinion from independent bankruptcy counsel that the required ring-fencing measures will achieve and maintain the necessary separation of subsidiary and parent such that a bankruptcy court will not apply the doctrine of consolidation to consolidate the assets and liabilities of the subsidiary with the assets and liabilities of a bankrupt parent or affiliate. 24

More extreme measures of protection are, perhaps, conceivable. A utility commission could condition regulatory approval ( i.e, relating to some acquisition or merger) on the provision of a parent holding company and subsidiary guarantee that the subsidiary not voluntarily file a petition for bankruptcy in the event of a parent filing. However, serious questions of public policy would surround the legality and enforceability of such a provision.

Credit Rating Separation

Absent ring-fencing measures, the rating agencies fear that the parent corporation will draw the subsidiary into a parent bankruptcy or otherwise adversely affect its financial health when the parent is experiencing financial crisis. 25 “[R]ating agencies, particularly Standard & Poor’s, typically accord a subsidiary the same credit rating as its parent, even if the subsidiary’s financial condition on a stand-alone basis appears to be stronger.”  26 However, where strong ring-fencing measures are in place, the rating agencies may accord substantial credit rating differentials between the parent and subsidiary.

This outcome is not assured. On occasion, rating agencies have downplayed the likelihood of such benefits. In 2002, Standard & Poor’s stated that “[i]n general, ring-fencing will only create a marginal rating differential between subsidiary and its parent entity.”  27 Based upon his experience and the rating agencies’ published criteria, witness Atkins testified in the BGE case that his proposed ring-fencing measures (which, with certain significant modifications and strengthening served as the core of the MDPSC’s ring-fencing of BGE) would result in a three-notch credit rating separation between Constellation and BGE. 28 His prediction turned out to be partially correct. Following the MDPSC’s Phase II order, on Nov. 2, 2009, Standard & Poor’s revised its credit ratings for Constellation and BGE and rated BGE two notches higher than Constellation ( i.e, a rating of BBB+ for BGE and BBB- for Constellation).

The subject of ratings separation, similar to the issue of bankruptcy remoteness, is replete with uncertainty and each case might well turn on its own particular facts. Consistent with the Delphic pronouncements of the rating agencies, in general, Standard and Poor’s offers the vague caution that “each ring-fencing exercise must be viewed on its own merits.” 29 However, there is a clear distinction between circumstances where robust ring-fencing measures are in place and where they are absent. In the absence of ring-fencing measures sufficient to establish bankruptcy remoteness, rating