Fallout From Enron
Chadbourne asked many thoughtful people in the project finance community in the few days before and after Enron filed for bankruptcy what effect they foresee from Enron’s struggles on the independent power industry. Here are the main points that came out of the survey.
Tighter Debt Market
Project developers expect to have to pay more to borrow money at least for the next six to 12 months. One senior banker summed up the situation as “delays, higher costs and more scrutiny.” The head of structured finance at a large energy company said, “We will all pay a direct price for Enron’s failure.”
One investment banker predicted that energy companies will have to pay 10 to 35 basis points more to borrow money in the future as an Enron premium. Another investment banker trying to place a Rule 144A debt offering in early December called that “a modest assessment.” At least one debt private placement risked a delay in closing because the road trip had to be extended to call on more potential buyers for the debt issue.
Lenders are reassessing how much leverage projects can support. Watching the seventh largest corporation in the United States in terms of sales collapse in the space of just a few weeks makes lenders worry that the worst-case scenario in their deals could be worse than they imagined before. A consequence of making the downside case more severe is it will not support as much leverage. This has a ripple effect through the power business. It changes the calculus for smaller developers who lack their own equity to put into deals. They may be unable to hold on to as large an ownership share in their projects as before. The higher cost of capital means some projects will be deferred. Turbine prices will continue to decline.
Closer attention will be focused than before on who is the offtaker for a project. The head of project finance lending for a bank that has been in the lead on many recent merchant plant financings in the US market said he expects to face a lot tougher questions from his credit committee about the strength behind the offtake contracts, but that “in speaking to other bankers, it seems that they are already recognizing the difference between Enron and other power marketers who have physical assets to back their trades.”
“This is probably not the moment to run a new name past the guys in risk management,” said another senior banker. “Every marketer will be getting a new level of scrutiny on existing exposure as will any new requests if the originator has the guts to ask.” This banker sees an “opportunity” for power marketers to provide more capital — equity, mezzanine — to projects under development. He suggested that power marketers try to use the next few months to firm up trading activities with more physical assets.
Another factor that may lead to longer lead time to close deals is the market is not as confident as before about investment grade ratings. Just six weeks before the bankruptcy filings, Enron put out an earnings release projecting strong pro forma profits. Two of the three big rating agencies reaffirmed Enron’s rating of triple-B plus. Moody’s remained skeptical. It put the rating under review, but hinted that the danger was a downgrade of one notch. Ratings are a timesaver for lenders, but only if they are credible. However, it is not clear that banks gain any better insight into credit risk by spending more time on due diligence themselves. They may have no realistic alternative other than to continue with the existing system but charge a higher risk premium.
One banker predicted some smaller banks that merely tag along in lending syndicates would withdraw from the market for a while.
Financial officers at project developers echoed the bankers. The chief financial officer of a large independent power company said, “The ashes are still falling from the volcano, but clearly given all the shocks to the industry this year, bank financing will become more difficult as those bankers who were already worrying about the merchant business may use this as another excuse to reduce commitments or exit the market altogether. Ditto for bond buyers who will likely take enormous losses on the Enron structured and supposedly secured off-balance sheet financings.”
How long will these effects last? A leading banker with many years of experience in the market said, “Liquidity in the marketplace will be affected, but I think this is a short run issue, as these markets are very deep, broad and resilient.” At the end of the day, the more significant issue is the demand and supply for power — how long it will take the economy to pull out of recession and whether there was already an oversupply of merchant plants headed for construction even before the Enron collapse.
The market adjusted surprisingly smoothly to the Enron collapse for traders, but perhaps more unevenly for others.
Enron had a very broad reach in the economy. The company accounted for 14.7% of electricity trades, much of it on its own electronic trading floor, EnronOnline, according to the last trade figures in early October. Enron owns 7.5% of total capacity on gas pipelines in the United States. About 25% of its income came from overseas assets.
One trader said after the bankruptcy filing, “The jury is still out on the effects, but at this point, it doesn’t appear that there will be as large a domino effect as may have been expected. We are watching two companies closely to see if we need to restrict trading with them due to Enron exposure. All of the large trading firms seem to have exposures within the $100 million range, which is manageable. I’m not sure yet if we will see smaller firms go down as a result. The banks seem to be the worst hit.”
Perhaps consistently with this view, one banker complained, “How can Enron have been the number one trader and almost no one — with the sad exception of us banks — has any exposure to them?” Traders had three to four weeks after the first signs of trouble to reduce their exposure. One banker spoke of a ripple effect among banks. The banks are “scrambling to review their exposure and to make sure we are taking the necessary appropriate steps to protect our positions.” An analysis by Lehman Brothers published soon after the merger talks with Dynegy collapsed predicted that the ultimate recovery on senior unsecured notes, bonds and debentures would be in the range of 25¢ to 35¢ on the dollar. Lehman Brothers advised Dynegy on the merger.
The collapse left many project developers in a bind. At least 17 projects have contracts with the Enron affiliate, NEPCO, to build gas- or waste-fired power plants both in the US and abroad for completion in 2002 or 2003. Projects that are already under construction are in a different position than ones that have not yet gotten financing. One senior banker said, “Certainly we see NEPCO EPC contracts that we were going to take earlier stopping deals.” Another said, “The biggest issue I have seen thus far related to NEPCO, which is building several power plants for clients and whose balance sheet, when revealed for the first time a few weeks ago to one who insisted on seeing it after Enron’s problems grew greater revealed — surprise — NOTHING! No real assets, no liabilities, just a shell company to take orders. This may be a bit of overstatement, but not much.”
One harried general counsel at a developer, when asked about the effects of the Enron collapse, responded: “Up to my eyes dealing with the problems being created with lenders, EPC contracts, and other interested parties.” He said he would say more when he could find “a few spare moments to collect my thoughts.”
Flood of Questions
The collapse led to a flood of questions.
Chadbourne quickly put up an internal distribution list on e-mail to keep project finance and bankruptcy lawyers who were fielding questions about the situation better informed about what issues the firm was being asked to address. The list grew quickly to 50 people.
Chadbourne lawyers reported fielding three main types of questions from clients.
One set of questions had to do with the options for developers who are saddled with Enron contracts. This is an especially difficult problem for developers whose projects are not yet financed and may never be unless they can break free of the contracts. Unfortunately, once a company has filed for bankruptcy, the law does not let the other party to the contract simply walk away from the contract for a “status default”— a clause that says the Enron contractor has defaulted on the contract if it goes bankrupt. The developer’s only remedy in such a case would be to persuade the bankruptcy court that there was a true substantial performance default. The bankruptcy judge is unlikely to allow the contract to be cancelled at such an early stage in the proceedings, according to David LeMay, a bankruptcy partner in the New York office. However, LeMay said “one of the chinks in the armor that Enron created by filing for only  companies is they left themselves open to cancellations involving nonfiled entities.”
Another set of questions revolved around projects where other companies have minority interests and in which Enron is either the majority or managing partner. Neil Golden, a project finance partner in the Washington office, advised looking first at the shareholders or partnership agreement. “Sometimes if a shareholder goes into bankruptcy, he loses the right to vote or other shareholders may have a right to buy him out.” (Provisions like those are sometimes invalidated by bankruptcy courts, LeMay noted.)
Golden said there are two potential problems created by Enron’s troubles. One is the bankruptcy filing may be a default under the project financing agreements or may trigger an obligation on the part of other partners to post guarantees. This may not be a problem if the Enron partner was not included in the bankruptcy filing. There is also the issue whether the project company can be run efficiently if Enron personnel lose their jobs or their attention is diverted or if decisions involving the project must be run by a bankruptcy judge. Golden said that, in such situations, the other partners may have few real options.
Questions also came from companies that want to buy Enron assets. Enron reported receiving three to four calls a day from interested purchasers in some of its assets. At least in the case of assets belonging to “filed entities,” David LeMay said, the debtor usually signs an agreement with a “stalking horse bidder” to sell it the assets subject to overbids and then takes the agreement to bankruptcy court for approval. Bidding procedures are set by the court and a breakup fee is approved for the stalking horse if it loses ultimately to another bidder. An auction is then held and the winning bid is presented to the court for approval.
An interesting question is whether many Enron assets may be harder than appears at first glance to sell. One banker cautioned, “They haven’t been doing much project financing. They often put their guarantee on risks, and they took cash from projects in return . . . Now they will have difficulty selling some of those assets.”
Enron Europe Limited and six affiliates filed separately for “administration” in London, the UK equivalent of chapter 11 bankruptcy. Denis Petkovic, a partner in the London office, said the filing “operates to stop secured and other creditors from trying to liquidate or take other proceedings against the company.” Petkovic said the action will also lead to scrutiny of past transactions and their possible vulnerability to court orders, effectively cancelling some contracts entered into up to two years before the onset of insolvency. This could happen if the administrator can prove that a contract was “at undervalue,” meaning the company received significantly less value from the contract than it had given. Also, payments to affiliates and other creditors will be scrutinized and will be at risk if they are “preferences,” meaning that the payor was influenced, when making the payment, to put the recipient in a better position than other creditors in the event of insolvent liquidation.
Estimates are for the bankruptcy proceedings ultimately to take six years. Enron has a sprawling corporate structure. A large part of the complication will be sorting out the priority of creditors of its 3,500 subsidiaries and among any litigants who win suits against the company or managers whom the company may be required to indemnify.
Many people speculate that the Enron collapse might lead to a regulatory backlash. A lot will depend on how the story ultimately plays in the press.
The New York Times said in an editorial, “There is a certain irony that Enron, a champion of deregulation, now becomes a poster child for the need for strong regulation on Wall Street.” Both houses in the US Congress announced hearings to look into the financial collapse. A banker said, “I am a bit fearful that the politicians will read more into this than there really is, and try to do something.” The Senate has put energy policy on the agenda for debate starting in January. However, the Bush administration has no interest in rolling back deregulation, and an omnibus energy policy bill that the opposition party introduced in early December in the Senate made no move in that direction, either.
The main effect is likely to be more subtle. Enron had probably the largest and most effective lobbying staff working for open markets — not only at the federal level, but also in state capitals. It will take a while before other companies can fill the gap. “Enron was the pied piper of restructuring: its loudest, boldest and often most eloquent champion,” said one veteran of Capitol Hill. The head of the Washington office of one of the largest US independent power companies said, “Enron’s legislative staff are smart, aggressive and hard working . . . I think we all relied on their ability to cover a lot of members when contact had to be made. The other independent power companies are growing their legislative capacities, but it will take a while to make up the difference.”
On Tuesday, December 4, perhaps to provide some sense of perspective, the following e-mail arrived from someone in an office building across the street from Enron headquarters in Houston:
I’ve been looking out of my 7th floor office window at a very dismal day. Dismal, not just due to the weather, but dismal also because since 10 a.m., I have been watching 4,000 dedicated and loyal Enron employees stream out of the buildings with boxes, bags and briefcases in tow, in some cases maybe their life’s work.
These are hardworking Houstonians, our neighbors, our fellow bus riders, our children’s Sunday school teachers, piano teachers, coaches, etc. Today, they not only lost their jobs and some, if not all, of their retirement money, they don’t even know if they have medical insurance. Until the bankruptcy hearing at 4 p.m. today, there’s no word even on any severance pay.