Smackdown! Round Three - The Bankruptcy Court vs. FERC

Deck: 

The jurisdictional battle over authorizing rejection of wholesale power contracts continues.

Fortnightly Magazine - April 2006

The high stakes turf battle over whether the Federal Energy Regulatory Commission (FERC) or the federal bankruptcy courts have jurisdiction over rejecting wholesale power contracts is now in its third round. Round one was fought in 2003 in the NRG bankruptcy case and ended in a settlement among the parties. Round two followed with the Mirant Chapter 11 case. Now punches and counterpunches are flying in round three: the Calpine bankruptcy.

Notwithstanding the volume and intensity of the litigation and the number of decisions rendered over the past three years, resolution of the battle remains anything but clear. In fact, when comparing the Jan. 27, 2006, district court ruling in Calpine to the most recent prior ruling in Mirant, FERC Chairman Joseph T. Kelliher observed that “they came up with the exact opposite answer as a legal matter. … I have to admit that there is some confusion.”1 A summary of the three rounds of battle to date demonstrates why such confusion prevails.

NRG Case

In the NRG Chapter 11 case, NRG Power Marketing Inc. (NRG-PMI) had entered into a pre-bankruptcy power supply agreement (PSA) with the Connecticut Light & Power Co. (CL&P), which NRG-PMI sought to reject as being out of the money. Under generally applicable bankruptcy law, contract rejection is governed by a liberal business judgment standard, so, not surprisingly, NRG-PMI quickly obtained an order from the bankruptcy court authorizing rejection of the PSA under that test.

On a parallel path, however, the Connecticut attorney general and the Connecticut Department of Public Utility Control initiated proceedings at FERC in which they obtained an emergency order directing that NRG-PMI continue to honor the PSA while further FERC proceedings were carried out. FERC also ruled that it would utilize a stricter standard than the business judgment standard. The United States District Court for the Southern District of New York then issued an order deferring to FERC on any further PSA rejection proceedings.

A complicating factor in the NRG case arose from the procedural requirement that FERC orders generally are subject to appellate review only in the United States Court of Appeals for the District of Columbia Circuit. Thus, arguably, neither the New York District Court nor the 2nd Circuit Court of Appeals could review the FERC order once it had been issued. Parallel appeals soon were filed by NRG in the D.C. Court of Appeals and in the 2nd Circuit Court of Appeals.

Before those appeals could be processed, however, NRG emerged from bankruptcy and the term of the PSA expired in December 2003. NRG-PMI and CL&P thus called off the fight and entered into a settlement that ultimately was approved by FERC in its Mirant case order issued Dec. 18, 2003.2

Round two followed almost immediately, however, with the Mirant Chapter 11 filing. Mirant’s primary power contract rejection dispute was with Potomac Electric Power Co. (PEPCO) in relation to several so-called back-to-back power-supply contracts Mirant asserted were out of the money. Seeking to avoid the prospect of a parallel FERC proceeding and potentially conflicting FERC order as had occurred in NRG, Mirant obtained from the Texas bankruptcy court an injunctive order prohibiting any such parallel proceeding. Mirant then sought contract rejection in the bankruptcy court. PEPCO and FERC immediately responded by seeking and obtaining a withdrawal of reference of the contract rejection case from the bankruptcy court to the United States District Court for the Northern District of Texas, which ruled that FERC had exclusive jurisdiction over the matter. That decision was appealed to the United States Court of Appeals for the 5th Circuit, which issued a decision later in 2004 reversing the District Court, in part, and remanding the case for further proceedings.3

In reversing the District Court, the 5th Circuit held that the bankruptcy court, rather than FERC, has jurisdiction to determine whether a debtor party to a power contract should be permitted to reject that contract. However, the 5th Circuit also held that a stricter standard than the business judgment standard should govern such a rejection by the bankruptcy court:

Clearly the business judgment standard normally applicable to rejection motions is more deferential than the public interest standard applicable in FERC proceedings to alter the terms of a contract within its jurisdiction. Use of the business judgment standard would be inappropriate in this case because it would not account for the public interest inherent in the transmission and sale of electricity.

Therefore, upon remand, the District Court should consider applying a more rigorous standard to the rejection of the back-to-back agreement. If the district court decides that a more rigorous standard is required, then it might adopt a standard by which it would authorize rejection of an executory power contract only if the debtor can show that it “burdens the estate, that, after careful scrutiny, the equities balance in favor of rejecting” that power contract, and that rejection of the contract would further the Chapter 11 goal of permitting the successful rehabilitation of debtors.

Following remand, the District Court refused to authorize rejection of the back-to-back power contracts. However, that decision was based primarily on certain factors unique to the Mirant-PEPCO case that limit its precedential value in other power- contract rejection matters.4

Calpine Case

Having observed the formidable battles in rounds one and two, the Calpine combatants exchanged a dizzying flurry of blows to start round three. As was the case with NRG and Mirant before it, Calpine was party to a number of substantial wholesale power contracts with load-serving entity (LSE) counterparties. Sensing that Calpine’s bankruptcy was imminent, the California Electricity Oversight Board, the California attorney general, and the California Department of Water Resources (the California parties) filed an emergency petition with FERC on Dec. 19, 2005, seeking a pre-emptive order prohibiting Calpine from rejecting various power contracts. Two days later, and before FERC had acted on the emergency petition, Calpine commenced Chapter 11 proceedings in the bankruptcy court for the Southern District of New York. As part of that bankruptcy filing, Calpine sought and obtained from the bankruptcy court a temporary restraining order that prohibited FERC from taking any action to require continued performance of its power contracts. Calpine then proceeded to seek bankruptcy court authorization to reject a number of power contracts including those that impacted the California parties.

On Jan. 3, 2006, in rapid response to developing events, FERC issued its Order Providing Interim Guidance, in which it referred extensively to the 5th Circuit Mirant decision and concluded:

Although the commission reached a different result in NRG, a federal Court of Appeals has now spoken to the issue addressed in NRG and we intend to follow that authority. Under that authority, the commission is precluded from taking action under the FPA that impacts a debtor’s ability to reject an executory contract.

While thus recognizing that the bankruptcy court would have jurisdiction over power contract rejection, FERC further concluded in its Jan. 3, 2006, order that the 5th Circuit decision in Mirant required that a bankruptcy court could not base rejection of a power contract on the business judgment standard, but must apply an enhanced standard that took into account the public interest. The FERC order thus goes on to establish procedures for seeking comments from parties in interest as to whether rejection of the Calpine contracts would impact the public interest.

FERC made clear its purpose in seeking such comments as follows:

By seeking comment on this issue, the commission does not intend to supplant the role of the Bankruptcy Court in considering whether to reject the Calpine II contract. Rather, the purpose of our inquiry is to develop a record on which the commission can, as necessary, make a determination, and then inform the Bankruptcy Court, of its views regarding potential rejection of the Calpine II contract by the Bankruptcy Court.

Meanwhile, the California parties, taking a page from the PEPCO playbook in round two, sought and obtained an order withdrawing the reference over the contract rejection case from the bankruptcy court to the United States District Court for the Southern District of New York. On Jan. 27, 2006, the District Court issued its order holding that FERC had exclusive jurisdiction over Calpine power-contract rejection and that neither the Bankruptcy Court nor the District Court had further jurisdiction to consider the matter. In its order, the District Court expressly noted that it “is aware that its holding here is in obvious conflict with the holding of the 5th Circuit in Mirant and the conclusions of the FERC [Jan. 3, 2006] order.”

The District Court went on to observe that 5th Circuit precedent was not binding on courts in the 2nd Circuit and that factual distinctions between the Calpine contracts and the Mirant contracts were sufficient to justify a different result in any event. With regard to the Jan. 3, 2006, FERC order that had adopted the 5th Circuit Mirant ruling, the District Court held that “FERC does not have the authority to determine the court’s jurisdiction.”

The District Court order in Calpine is now on appeal to the United States Court of Appeals for the 2nd Circuit. No further actions have been taken by FERC, and Calpine is continuing to perform the power contracts at issue while the appeal is pending.

Scorecard So Far

A review of the litigation scorecard to date, and a prognostication of the battles to come, indicate that market participants are in for continued uncertainty. The round one NRG fight, due primarily to its short duration, provided no meaningful appellate-level guidance on the jurisdictional turf battle. The Mirant case in round two resulted in an appellate decision that clearly established, at least in regard to the specific type of power contracts at issue there, that the bankruptcy court, rather than FERC, had jurisdiction over power contract rejection. The 5th Circuit provided additional guidance concerning the need for a bankruptcy court to use an enhanced standard for power-contract rejection decisions. While it suggested some general guidelines, the 5th Circuit did not attempt to provide a comprehensive definition or manner for application of such an enhanced standard.

Because the District Court decision following remand in Mirant relied primarily on other grounds in denying contract rejection, round two ended without a court decision that comprehensively applied an enhanced rejection standard to specific power contracts under specific economic and public policy circumstances.

As has been made clear in round three action to date in the Calpine case, and whatever guidance may be obtained from the 5th Circuit Mirant decision, that decision is controlling only within the 5th Circuit. Clearly, the District Court in Calpine was not constrained by the 5th Circuit in reaching what it admitted to be a contrary decision.

Attention is focused now on the United States Court of Appeals for the 2nd Circuit, which soon will weigh in on the questions posed to it in the Calpine appeal. The 2nd Circuit certainly will address the issue of whether FERC or the bankruptcy court has jurisdiction over power-contract rejection and also may enunciate its views on what standards should govern any such rejection determination. Because this litigation is playing out at such an early stage of the Calpine bankruptcy and because the power contracts at issue are sufficiently long term, round three represents the best opportunity so far to achieve a final decision that not only answers the jurisdictional question but defines and applies a rejection standard.

With all the above being said, however, it is important to recognize that the most that will result from round three is the establishment of jurisdictional rules and rejection guidelines that will be controlling in regard to bankruptcy cases filed within the 2nd Circuit. Of the 11 judicial circuits in the United States where bankruptcy cases can be filed, only the 5th and 2nd Circuits will have provided guidance on the relevant issues in the foreseeable future.

Continued case-by-case handling of power contract rejection in bankruptcy cases that may be filed in other jurisdictions thus portends years of uncertainty and potentially conflicting results. The fate of power-contract rejections could well depend on which jurisdiction a power marketer chooses for a bankruptcy filing—a matter subject to some discretion and not necessarily bearing any relation to the jurisdiction where customers who may be affected by a contract rejection are located. For example, the Mirant case was filed in the Northern District of Texas with PEPCO and its customers based in the District of Columbia area. The Calpine case is pending in New York, and the customers primarily affected are located in California. The only potential for bringing earlier clarity and uniformity to the matter is through either a United States Supreme Court decision or federal legislation that addresses the relevant issues.

Up to now, LSE counterparties and their customers have dodged the bullet in three rounds of intense bankruptcy-related power-contract litigation. Because a bankrupt power marketer cannot reject a power contract without first obtaining court approval to do so, the litigation delays inherent in processing appeals have worked to the advantage of the LSEs and their customers as a result of favorable early round court decisions prohibiting contract rejection. Had the District Court decided differently at the initial stage of any one of the cases in rounds 1, 2, and 3, contract rejection would have occurred immediately and the affected LSE and its customers would have had to address the consequences while time-consuming appeals were processed. Obviously, if a marketer obtains authority to reject a power contract in any future bankruptcy case, the rejection likewise would become effective while an appeal played out.

It also is significant to recognize that power-contract rejection is not a risk limited solely to large merchant power company bankruptcies such as NRG, Mirant, and Calpine. Such risks are equally present in any power-supply contract entered into by an electric utility with an unregulated wholesale supplier. To the extent that more and more electric utility LSEs enter into medium- and long-term wholesale power contracts (whether through state regulatory supervised auctions or otherwise) as a means to stabilize supply costs, the bankruptcy of a wholesale supply counterparty that resulted in contract rejection would be disruptive to that price stability.

Given the potential impact on ratepayers from power-contract rejection and the prospect of sustained periods of uncertainty in case-by-case litigation, serious attention should be given to enacting federal legislation to address both the relevant jurisdictional issue and the rejection standards pertinent to power contracts in the event of a marketer bankruptcy. At the same time, all affected LSEs, state public utility commissions, and ratepayer advocates carefully should oversee the terms of competitive wholesale power supply arrangements to ensure maximum protection from potential bankruptcy risks. As FERC has noted,5 it is not automatically the case that LSEs will be able to pass along bankruptcy rejection damages to ratepayers. Thus, scrupulous business judgment and prudence in structuring all aspects of power-supply agreements is particularly critical for the LSE.

While nothing can guarantee the elimination of litigation risk over power contracts in bankruptcy, concerted action and diligence of the type described above would do much to bring greater predictability to power-contract rejection. Otherwise, a number of future smackdown rounds are likely in a continuing see-saw battle.

 

Endnotes:

1. Dow Jones Newswires, Feb. 2, 2006.

2. Blumenthal v. NRG Power Marketing Inc., 105 FERC ¶ 61,292. While no appellate court guidance resulted from round one, the following excerpts from the concurring opinion of Commissioners Brownell and Kelliher to the December 2003 FERC order approving the settlement are noteworthy:

We support the proposed settlement of the contract dispute relating to NRG-PMI’s provision of wholesale service to CL&P. We are writing separately to express our view that the commission should not have involved itself in this dispute in the first place…. It is unusual for the commission to involve itself in contract disputes when the parties can avail themselves of any breach of contract claims they might have in court.

The original FERC order that took jurisdiction over the NRG matter away from the bankruptcy court and mandated continued NRG-PMI contract performance was issued over the dissent of Commissioner Brownell and prior to the time of Commissioner Kelliher’s and Commissioner Kelly’s appointments to the FERC.

3. Mirant v. Potomac Electric Power Co., 378 F.3d 511.

4. The back-to-back contracts at issue in Mirant were entered into as part of a larger asset purchase agreement. PEPCO asserted, and the district court agreed, as the primary basis for its decision on remand, that the back-to-back contracts were not severable from the overall purchase transaction and thus could not be rejected separately when the remainder of the transaction had been performed. While the district court decision following remand was the subject of another appeal, Mirant emerged from Chapter 11 in January 2006. Interestingly, Mirant’s Chapter 11 plan provided securities to Mirant creditors equivalent to the full value of their claims. Thus, even if rejection of the PEPCO back-to-back power contracts had been authorized, it is likely that any PEPCO damage claim would have been fully compensated.

5. When FERC considered the application for approval of the indirect transfer of jurisdictional facilities in Mirant Corp., 111 FERC ¶ 61,425 (June 17, 2005), several protests were raised concerning the potential impact on Pepco ratepayers arising from the then pending back-to-back contract rejection. FERC responded to those protests as follows:

  38. The decision of Pepco to enter into the back-to-back agreement is best viewed as a matter of business judgment where the risk of non-performance was a factor to be considered, among many other factors, in deciding whether to sell facilities at certain prices. Pepco could have negotiated for greater security of its revenues, but did not, and now finds itself an unsecured creditor under an executory contract with a bankrupt estate. The protestors are, in essence, asking us to do indirectly what we could not do directly, namely, to assure that Pepco obtains full recovery of its contract revenues at the expense of other creditors and, perhaps, the successful emergence of a reorganized company from bankruptcy. In these circumstances, the commission is not convinced that such action is consistent with the public interest.

  39. We are not persuaded that the local regulatory agencies have no practical choice but to allow Pepco to recover any lost revenues through higher rates. As explained above, the potential effects on retail rates and Pepco’s financial condition have not been substantiated as to relative significance. More significantly, while protestors have argued that the local regulatory agencies would be likely to approve rate increases, such a decision is not a certainty. The chairman of the Maryland commission indicated that while the Maryland commission would strongly consider any request by Pepco to recover unpaid purchased power costs from its customers, it would have to hold a formal proceeding to address many factors before acting on Pepco’s request, if one is made.