Commission Watch

Deck: 
The developing jurisdictional battle over authorizing rejection of wholesale power supply agreements is getting white-hot, pitting creditors against ratepayers.
Fortnightly Magazine - September 1 2003

Commission Watch

The developing jurisdictional battle over authorizing rejection of wholesale power supply agreements is getting white-hot, pitting creditors against ratepayers.

 

Does the Federal Energy Regulatory Commission (FERC) or the federal bankruptcy courts decide whether a bankrupt energy marketer can get out of a wholesale power contract that the marketer says isn't profitable enough? A high-stakes turf battle between FERC and the federal bankruptcy courts is being waged over just this question, and the resolution of the case is anything but clear.

At stake is whether the interests of creditors or the interests of ratepayers will win out in the end. In an industry littered with bankrupt and troubled energy marketers, it's more than an academic question being batted around by teams of lawyers.

The battle has been most dramatically illustrated in the case of NRG Power Marketing Inc. (NRG-PMI), where the variety and pace of legal proceedings involving the company, the Connecticut attorney general, and Connecticut Department of Public Utility Control resembles a complex legal chess match.

Unfortunately, the battle so far between creditors and ratepayers appears to be taking place in two parallel universes, the bankruptcy court and FERC. Because it's not clear which, if either of these arbiters has authority over the other, there's a real danger that NRG-PMI may be faced with conflicting, all-or-nothing results. It's a fight that could ultimately end up in the U.S. Supreme Court.

The Roots of the Conflict

In the bankruptcy court, protection of creditor interests is paramount. Ratepayers are unlikely to have meaningful direct participation in a merchant company case. Bankruptcy courts apply the business judgment test to assess what contracts, if any, of the bankrupt entity will be honored. The key to the business judgment test is whether it makes financial sense to continue an agreement, in light of the bankrupt business' status. Consequently, a debtor would likely be permitted to reject a below-market contract even if that contract was profitable-if the debtor could utilize its same resources to enter into a new contract on more profitable terms. The standard unquestionably permits a debtor to reject an unprofitable contract. Thus bankruptcy courts will favor rejection of any below-market power supply agreement, and they will place the entire financial burden of that rejection upon ratepayers.

Conversely, ratepayer interests are paramount under the public interest standard at FERC; the interests of creditors of the merchant power supplier are likely to be considered tangentially, if at all. Only in the event that the debtor's creditor problems are so severe that continued performance of an unprofitable contract would cause disruption or termination of service to customers would FERC consider canceling or modifying the contract -and then just to the extent necessary to ensure continued service. The Mobile-Sierra standard therefore generally serves to place the economic burden of an unprofitable contract substantially, if not exclusively, upon the creditors of the merchant company rather than upon ratepayers.

It remains to be seen whether appellate courts will attempt to develop and apply principles that reconcile and accommodate these competing bankruptcy and FERC standards to avoid the current all-or-nothing approach. Alternatively, it is possible that legislation could be enacted that attempts some reconciliation of the two conflicting doctrines .

The NRG-PMI facts give a nice example of how contract rejection operates in the bankruptcy context. There, NRG-PMI alleges that the "costs" to perform the standard offer supply agreement, or SOSA, are $500,000 per day, totaling approximately $70 million if the contract is performed through the end of the term on Dec. 31, 2003.

Thus, if NRG-PMI were permitted to reject the SOSA, it would "save" $70 million. If NRG were allowed out of the contract, Connecticut Light & Power Co. (CL&P), in turn, would be entitled to assert a general creditor damage claim against the NRG-PMI bankruptcy estate in the amount of $70 million.

To assess the impact of rejection versus performance of the SOSA upon creditors of NRG, including CL&P, consider this hypothetical example, in which we assume that: (1) total assets available in the NRG bankruptcy estate are $100 million in cash; and (2) there are $300 million of general creditor claims against NRG, before considering any claims of CL&P.

If NRG were required to perform the SOSA through the end of its term, $70 million of its cash reserves would be required for this purpose, and its remaining cash assets would be reduced to $30 million ($100 million cash minus $70 million for the SOSA). CL&P would have no claim against NRG-PMI, because its contract would be fully performed.

The other creditors of NRG-PMI would receive a 10 percent dividend in relation to their $300 million of aggregate claims (the remaining $30 million constitutes 10 percent of the $300 million in claims, which would be allocated equally among creditors).

But if rejection of the SOSA was permitted, NRG-PMI would retain its entire $100 million cash reserve, because it would not be required to pay $70 million toward performance of the SOSA. In that instance, CL&P would be entitled to assert a damage claim of $70 million. Thus, the pool of NRG-PMI creditors would increase from $300 million to $370 million. Each of these general creditors would receive a dividend of approximately 27 percent on their aggregate claims of $370 million from the $100 million of available funds. Thus, the bankruptcy law principle of equal creditor treatment would be promoted by increasing the payout to creditors overall, rather than permitting a single creditor to retain the full advantage of a favorable contract and thereby causing a lesser distribution (10 percent) to all other creditors.1

Public Interest

In contrast to the bankruptcy business judgment test, longstanding FERC precedent requires satisfaction of the so-called public interest test to abrogate2 a jurisdictional power supply contract.3 FERC succinctly de-scribed this standard in connection with its direction to NRG-PMI. In its June 25, 2003 order the commission said: "We direct NRG-PMI, on behalf of itself and its affiliates, to provide evidence sufficient to demonstrate that continued performance under the contract will impair its financial ability or the ability of its public utility affiliates to continue service, cast upon other customers an excessive burden, or be unduly discriminatory."

It is precisely the issue of whether NRG-PMI can satisfy this test that is the subject of the ongoing FERC proceeding, in which a final decision is expected shortly.

The goal here is to utilize several hypothetical scenarios to illustrate the distinction between the public interest test and the bankruptcy court business judgment test.

Fundamental to this distinction is the substantial concern with ratepayer impact that is present in the FERC standard, which is not encompassed in the bankruptcy court standard. This focus on public interest and ratepayer impact is at the heart of the strategy of the Connecticut attorney general and the Connecticut Department of Public Utility Control in pursuing the FERC challenge to bankruptcy court jurisdiction. As will be discussed in further detail below, Connecticut ratepayers would otherwise have no "seat at the table" in the NRG bankruptcy case.

Why Now?

The conflicting bankruptcy business judgment test and FERC public interest test have co-existed for decades, so why are we seeing a clash of these different standards now? Quite simply, deregulation created the right circumstances. Before deregulation, bankruptcies of regulated, vertically integrated public utilities were quite rare, and the nature of the regulated industry made it unlikely that a contract party other than a regulated utility would be involved in such a dispute.

The conflict has recently taken center stage due to two primary factors: (1) the deteriorating credit condition of many of the merchant power companies and the resulting bankruptcies within this sector; and (2) the disconnect of ratepayer interests from any direct linkage to the merchant power company bankruptcy proceedings.

In determining whether to reject the SOSA in the NRG bankruptcy case, for example, the only adverse party before the bankruptcy court was CL&P, a single potential creditor of NRG. CL&P's ratepayers, the parties ultimately most affected by the contract rejection, have no status as creditors in the bankruptcy proceedings of an unregulated merchant company such as NRG. In legal terms, ratepayers lack standing in the case, and so cannot appear in the case. That is because the regulated utility, in this case CL&P, stands between the ratepayers and the merchant generator. Prior to electric industry restructuring, the entity before the bankruptcy court in similar circumstances would likely have been a regulated public utility, with a direct relationship to ratepayers, and bankruptcy law would have recognized the need to incorporate applicable ratepayer interests in the context of any such bankruptcy case. In contrast, resorting to FERC jurisdiction appears to represent one of the few available means under current law to raise and seek to protect ratepayer interests in a merchant company bankruptcy.

Turning to the specific elements of the test, one key determinant is whether performance of the SOSA would threaten continued service to customers. In the hypothetical, where NRG's cash reserves would be reduced from $100 million to $30 million as a result of continued performance of the SOSA, no interruption of customer service can be reasonably foreseen; NRG at all times retains sufficient funds to perform the contract. Thus, the same hypothetical fact pattern that easily justifies bankruptcy court rejection of the SOSA rather clearly fails to meet the .

Alternative hypothetical scenarios that could justify canceling of the SOSA under the standard may include: (1) a scenario by which NRG-PMI did not have sufficient funds to perform the SOSA (e.g., less than $70 million of available funds); (2) a scenario in which NRG-PMI's continued performance would somehow cause the shutdown of generation plants of affiliated entities and thereby jeopardize service to customers; and/or (3) a scenario in which NRG was required to divert resources or generation capacity to service the SOSA and thereby impair service to other electric customers.

The foregoing examples make clear that the determination of which legal standard will govern power contract rejection will have dramatically different impacts upon creditors of merchant companies such as NRG on the one hand, and ratepayers of contract counterparties such as CL&P on the other hand.

Policy and Legal Minefields

The NRG SOSA and similar standard offer service agreements of Mirant and PG&E National Energy Group are among the most compelling cases to invoke the public interest standard. In such instances, a very direct link can be made between the wholesale power supply contract and the impact upon a large group of consumer ratepayers. It remains to be seen whether the case is compelling enough to warrant ending the contracts where no direct linkage between wholesale customers and consumer ratepayers is evident, or where contract rejection affects only a limited number of large, sophisticated customers?

The NRG-PMI case has proceeded on the assumption that if the SOSA is abrogated and CL&P is required to obtain substitute power at a higher price, CL&P will be permitted to pass along this cost to ratepayers. Will it always be the case that the wholesale customer/electric distribution company will/should be able to pass along contract damage costs to ratepayers, which would implicate the public interest standard? If not, should the tests be applied differently?

Another complexity arises from the multiple entity structure present in most merchant power corporate groups. Often, as is the case with NRG-PMI, power contracting and trading is conducted through one entity within the corporate group, while power generation facilities are commonly held by separate affiliated entities. What will be the result if the trading entity by itself lacks the resources to perform a jurisdictional contract under the strictest standard, but an affiliated generation company could provide such service? Is it necessarily the case that the courts can require a generation affiliate, not controlled by the trading entity, to provide service? What if, as is likely to be the case in many merchant power company bankruptcies, the affiliated generation company is sold off during the course of the bankruptcy case to a non-affiliated third party? Is there any means to require the third party to supply service under the original contract terms?4

Many judicial and administrative battles remain to be fought over wholesale power supply agreements of debtor merchant companies, and both creditors and ratepayer advocates will seek to invoke a variety of trumping strategies. In the meantime, the question of who takes the financial hit, the creditors or the ratepayers, hangs in the balance.


  1. There is some dispute on the record in the NRG-PMI proceedings whether continued performance of the SOSA results in an actual loss to NRG in the magnitude of $500,000 per day or whether the SOSA is simply "below market" by that amount without causing actual losses to NRG-PMI. While this latter scenario would change the arithmetic somewhat, the basic principle of equality of creditor treatment would still be served in the same manner by contract rejection. Under this scenario, NRG-PMI would not be required to use any of its $100 million cash reserves to continue to perform the SOSA. However, if it were freed from that SOSA, NRG-PMI could use its resources to enter into an alternative power supply agreement that would produce $70 million more in revenues than the SOSA through Dec. 31, 2003. In that event, total assets within the NRG-PMI estate would presumably increase from $100 million to $170 million as a result of the contract rejection. CL&P would have the same $70 million damage claim as in the original scenario. Total claims would thus increase from $300 million to $370 million. This hypothetical would yield a dividend to creditors of 33-1/3 percent if the contract were not rejected ($300 million of claims against $100 million of available assets) versus a dividend of approximately 47 percent to all creditors in the event of rejection ($370 million of claims against $170 million of assets).
  2. Also disputed on the record in the proceedings is whether a contract "rejection" under the Bankruptcy Code is equivalent to, or should be distinguished from, an "abrogation" under FERC precedent. No effort is made here to parse this distinction. The article assumes the two are functional equivalents. Subsequent appeals may or may not validate this assumption.
  3. Additional debate centers on whether the SOSA is a FERC jurisdictional contract. Again, no effort is made here to resolve that issue.
  4. This multiple entity issue is particularly critical for public utility distribution companies and state utility regulators in structuring fu-ture standard offer supply agreements in various jurisdictions. As a matter of contract, it will certainly be advantageous to bind all affiliated power supply entities to future contract performance and to obtain strong financial guarantees or other assurances of future contract performance. Much can be done through appropriate contract terms and financial assurances to prevent repeat occurrences of the battle in the NRG-PMI matter.


Seeds of Discord

A brief summary of the proceedings to date in the NRG-PMI cases.

When NRG-PMI sought bankruptcy court approval to reject an out-of-the-money power supply agreement with Connecticut Light & Power Co. (CL&P), alleging that it cost NRG-PMI $500,000 per day to perform, it came as little surprise to most observers that the bankruptcy court authorized rejection of the contract under the well-settled bankruptcy law "business judgment" doctrine. The contract at issue (a standard offer supply agreement or SOSA) is the source of 45 percent of the power required for CL&P to supply standard offer service to its Connecticut ratepayers. The SOSA provides for a fixed price through Dec. 31, 2003. Rejection of the contract by NRG-PMI would make it necessary for CL&P to obtain alternative, higher-cost power to serve its more than 1 million customers.

Following the bankruptcy court contract rejection order and a subsequent temporary injunction order from the United States District Court for the Southern District of New York, NRG-PMI discontinued providing service under the SOSA. No doubt recognizing an uphill fight in the bankruptcy court, the Connecticut attorney general and the Connecticut Department of Public Utility Control immediately initiated proceedings at the commission. They asserted that FERC jurisdiction superseded bankruptcy court jurisdiction concerning the matter of whether NRG-PMI could discontinue performance of the SOSA. On June 25, 2003, FERC issued its order directing NRG-PMI to recommence supply under the SOSA, holding that any discontinuance of supply under the SOSA would be governed by the Mobile-Sierra public interest standard and establishing procedural protocols and a schedule by which FERC would determine whether termination of service would be permitted. FERC's order explicitly provided that NRG-PMI would be required to continue performing the contract while FERC proceedings remained pending prior to a final decision.

On June 30, 2003, the United States District Court for the Southern District of New York vacated its previous injunction and deferred to FERC jurisdiction, triggering NRG-PMI's emergency appeals for relief from the FERC order with the United States Court of Appeals for the District of Columbia Circuit and the United States Circuit Court of Appeals for the Second Circuit. Given the stakes involved, it is likely that the parties will seek to exhaust all available appellate remedies to obtain final resolution of this matter. It is notable, as well, that NRG-PMI is not alone in confronting these issues. Similar substantial contractual issues exist in the Mirant and PG&E National Energy Group bankruptcy cases that are already pending, and comparable issues are likely to arise in future cases given the current economic climate in the merchant power sector.-H.L.S.

Setting Precedent

How prior clashes between bankruptcy law and federal law have been resolved.

The current jurisdictional battle between FERC and the bankruptcy courts is not the first clash between bankruptcy law and nonbankruptcy federal law or policy. Courts, administrative agencies, and legislators have grappled with such clashes in the past in the areas of federal labor law and federal environmental law. These previous clashes may be instructive as to how the present battle may be resolved.

Federal Labor Law

Significant legal debate existed in the past concerning the ability of a bankruptcy court to authorize rejection of a collective bargaining agreement under the generally applicable business judgment test. The opponents of such rejection argued that the National Labor Relations Act trumped bankruptcy laws in this regard. After a period of court skirmishes over this issue and a significant U.S. Supreme Court decision, Congress passed legislation seeking to rationalize and accommodate the competing standards. Specifically, a separate section of the Bankruptcy Code was enacted to govern rejection of collective bargaining agreements in Chapter 11 cases that established separate protocols and separate standards for these matters. These protocols and standards take into account the interests and collective bargaining rights of employees in a manner that would not have been the case under otherwise applicable executory contract rejection provisions of bankruptcy law.

Federal Environmental Law

An issue that often arises in bankruptcy cases involving a debtor-owner of environmentally contaminated property is whether that debtor will be required to devote its limited resources to environmental clean-up costs, thereby "draining" assets of the bankruptcy estate for that purpose to the detriment of other creditors of the debtor.

In this area, unlike the labor area, no federal legislation has been adopted to date that seeks to reconcile the competing bankruptcy and environmental law policies. The issue has been addressed on a case-by-case basis by court decisions in different jurisdictions that attempt to establish various guidelines for reconciliation of the competing policies. Thus, the ability of creditors, environmental regulators and public advocates to predict the outcome of the policy conflict in a given case will be largely dependent on the specific facts of each case and the controlling law of the jurisdiction in which the debtor is located. -H.L.S.

 

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