Project Sales: Overlooked Issues
By Stefan Unna
Events over the past year — including the PG&E and Enron bankruptcies, the downturns in US and foreign securities exchanges and the continuing volatility in California and emerging markets — have placed enormous pressure on generators and power marketers to increase cash reserves and shore up their balance sheets. Many power projects are currently for sale.
Many sales transactions are structured as mergers or acquisitions of whole companies. The targets themselves or target subsidiaries are often special-purpose entities with a single power project and outstanding debt structured on a project finance basis. These types of transactions call for familiarity both with practice in the M&A market and with project finance.
The overlap between M&A and project finance can lead to unique issues that would not normally arise in a transaction that is purely one or the other. Here are a few such issues.
Projects sold together as a group are usually tied together in a holding structure in which a holding company owns several special-purpose companies, each of which owns a distinct project. This is done to prevent liabilities linked to one project from infecting the others. The officers and directors are often the same for the special-purpose company as for its intermediate parent and even the holding company.
Such a situation is ripe for a claim based on “piercing the corporate veil” that the cash flows of all the projects owned by special-purpose companies with common directors should be available to satisfy the debts of any other special-purpose company in the ownership chain — exactly the opposite of such a structure’s intended purpose. The essence of such a claim is that the separate legal entity of two or more different companies should be ignored because those companies have been managed as one entity; their existence as separate entities is a sham.
Claims to pierce a corporate veil are not lightly granted. Courts are reluctant to disregard the distinct legal identity that is the essence of what a company is. Companies can protect themselves by doing the following. Make sure that each company with large debts or potential liabilities is adequately capitalized in relation to its activities. Try to stagger officers and directors to limit overlap across companies. Take care to ensure that separate meetings are held and other corporate formalities are maintained for each company. Make sure that each company has its own bank account and that there is no co-mingling of funds.
For anyone familiar with how project companies and their holding companies are often governed, this list of suggestions may set off alarm bells. Although the likelihood of a successful piercing claim may be remote, just the possibility that such a claim could be raised can have an unsettling effect on a project acquisition.
Assume a scenario in which one project company has been overcome by a large liability or potential liability that exceeds its assets, but its sister companies remain healthy. An acquirer may still be willing to acquire the holding company for the entire group even if it assigns no value to the sick project company on the assumption that the liabilities of the sick project company are entirely contained within it. A claim to pierce the corporate veil could cause the liabilities of the sick project company to infect its holding company and thus reach the cash flows from all other healthy projects owned by that holding company.
A successful claim to pierce the corporate veil transforms a liability that might be large or unquantifiable and that one normally hopes would be limited to the assets of a particular company into one that encumbers cash flow from all of its sister project entities under the same holding company.
Older power purchase agreements raise concerns about the ability of the project owner to draw dividends from the project because the dividend may be considered a “fraudulent transfer” in some parts of the United States.
Most US states have some form of fraudulent transfer statute. Approximately 40 states have adopted the “Uniform Fraudulent Transfer Act,” with one or more variations. The statutes in the other states vary widely.
The concern with power purchase agreements and dividends arises in a common scenario where electricity from an older power plant is sold under contract at a negotiated fixed price but the price will switch in the near future to a market price, either because the power contract will expire shortly or because it provides for such a switch. Assume further that the financial models for the project predict that the project will be insolvent if its output must be sold at current market prices. Under this scenario, the dividends that an owner may otherwise expect to be able to withdraw from the project before the pricing switch may be put in jeopardy.
The term “fraudulent transfer” is misleading to many non-lawyers because it does not require any act that fits the standard understanding of what constitutes fraud. These laws are meant to bar transfers of money or assets by an entity while that entity was insolvent. An insolvent company can usually not pay money or transfer assets unless it receives “reasonably equivalent value,” or else the payment or asset transfer risks being unwound.
Although the specifics vary, almost all states that have adopted the Uniform Fraudulent Transfer Act also have statutes that provide that a transfer made or obligation incurred by a debtor is deemed fraudulent as to creditors if two things are true. First, the debtor must have made the transfer or taken on the new debt without receiving reasonably equivalent value in exchange. Second, the debtor must be engaged in a business for which its remaining assets are unreasonably small in relation to the business or else it must be a situation where a reasonable man would have worried that the debtor would be in the position — as a result of the transfer — of having to incur debts beyond its ability to pay as they became due. It does not matter that the creditor’s claim arose after the transfer was made or the new debt incurred. The transfer can still be unwound or the new debt declared void.
Most states have statutes providing that a transfer by a debtor is fraudulent as to creditors whose claims arise before the transfer if the debtor makes the transfer without reasonably equivalent value and the debtor was insolvent. Insolvency is usually defined to exist if the sum of the debtor’s debts is greater than all of its assets at a fair valuation, and it is presumed to exist if the debtor is generally not paying its debts as they become due.
A dividend or other distribution is by definition not in exchange for reasonably equivalent value, but it is a matter of proof whether a reasonable man would have worried that the distribution would cause the company to have to incur debts beyond its ability to pay or become insolvent. In the case where it is clear that a project’s revenues will drop due to a switch to market pricing under the power contract, such proof may not be difficult to find.
Depending on the laws of the applicable jurisdiction, a creditor (or a trustee in bankruptcy) may be able to sue for the value of dividends paid by an insolvent project company for a period before its insolvency. As a practical matter, bankruptcy trustees generally do not pursue claims based on transfers more than a few years before bankruptcy because of the difficulties of proof as time elapses, although such difficulties may not be insurmountable. The statutes of limitations for raising such a fraudulent transfer claim vary from state to state, but range generally between four and six years. Remedies generally available include avoidance of the transfer, attachment of the asset transferred, and, subject to equitable principles and applicable rules of procedure, injunctive and similar relief.
For a project whose power contract fits this pattern, any dividends that an acquirer maybe expected to receive for the few years prior to the switch to market pricing should be discounted accordingly — entirely in some cases — when assigning a value to such a project.
US project finance developers know how complex US regulation of the electricity sector can be, but they often overlook the need for regulatory reviews and approvals that are required when ownership in an electric generating facility changes hands.
Any direct or indirect change in ownership of any power facility brings into play the Public Utility Holding Company Act — called “PUHCA” — and other related bodies of law. As the name implies, the inquiry under PUHCA is not limited to a look at just the company or group of companies that owns a generating asset; it examines the entire ownership structure and activities, up to the ultimate parent company of the new owner. Its wide scope also reaches any owner, foreign or domestic, of a US generating asset as well as any relevant non-US facility in which there is a US component. Thus, for example, a US-based financial institution that acquires the stock of a company that owns a foreign power plant by way of exercise of lender remedies could find itself subject to PUHCA regulation. Moreover, PUHCA may have unexpected implications for other projects that do not primarily involve the generation of electricity. Even if electricity generation is only a peripheral activity of a target company, the limited generation and sale of power may subject the new owners of the target company to utility regulation under PUHCA.
Briefly stated, PUHCA prohibits the ownership of nonexempt electricity and gas distribution companies as part of a wide-ranging, disparate ownership structure.
Unless one can find an exemption, as a general rule, any company that owns a generating plant will be subject to geographic, functional and structural restraints under PUHCA. Starting with geography, PUHCA requires all nonexempt affiliated companies that own power plants to be part of a single, physically interconnected and integrated system. Turning to functional constraints, PUHCA prohibits a nonexempt parent company from owning businesses that are not functionally related to the power business. The structural constraint that PUHCA imposes on nonexempt or “registered” holding companies is that no more than two intermediate companies may exist between the company that owns the power plant and the ultimate parent.
PUHCA is enforced by the US Securities and Exchange Commission.
There are two major exemptions from PUHCA that are familiar to most people involved in the power industry in the US. Power plants that are “qualifying facilities” under the Public Utility Regulatory Policies Act — called “PURPA”— are exempted from regulation under PUHCA. “Qualifying facilities” are certain power plants that use renewable fuels and cogeneration facilities that generate two useful forms of energy from a single fuel.
The other exemption covers “exempt wholesale generators,” or EWGs. These are the owners of power plants that sell electricity exclusively to wholesale purchasers rather than to end consumers.
Power plants outside the US are often exempted from PUHCA either as EWGs or under a separate exemption for certain entities classified as “foreign utility companies,” or FUCOs.
In any acquisition of a power plant in the US or by a US company outside the US that is not exempted from PUHCA, the Securities and Exchange Commission will require a review of the new owner’s activities and ownership structure.
Even if the power plant qualifies for an exemption from PUHCA, unless it is a “qualifying facility” under PURPA, it will not escape regulation under the Federal Power Act. A facility may be exempted from regulation under PUHCA but still be deemed a “public utility” under the Federal Power Act, meaning that a change in control of the public utility will usually require the pre-approval of FERC. It may also require advance approval from a state utility commission.
If PUHCA or the Federal Power Act applies, it can have an effect on the economics and structure of the resulting deal. Obtaining required regulatory approvals or even exemptions, and structuring a transaction to qualify for those approvals or exemptions, may be time-consuming. Buyers of power assets should focus on the regulatory issues early in the transaction. They are a critical path item with a potentially long lead time.
Anyone buying a power plant must verify that the owner has all the permits needed to operate.
A frequent issue in recent deals is the potential loss of air permitting exemptions because the power contract for a project has either been amended or is about to expire. Another common issue is potential penalties for failing to go through appropriate permitting for upgrades to the power plant.
Many older plants benefited from “grandfather” provisions that exempted them from certain new environmental laws or revisions to existing laws that were enacted after the plants were constructed. Such grandfather provisions often provide that, in order to maintain grandfather status, the power contract under which output from the plant is sold or the equipment in use at the plant must remain substantially unchanged. The US Environmental Protection Agency has been probing recently into possible violations of these rules.
Anyone acquiring an older power plant should pay particular attention to whether the plant went through any upgrades that increased air emissions. He should also be on the lookout for power contract amendments or power contracts that are about to expire. These are things that could trigger changes in the facility’s status under its environmental permits and could lead to permitting violations. A buyer who plans changes to the equipment or the power contract after the acquisition should give careful consideration to the effect these actions will have on the plant’s environmental permits.