How To Construct a “Ring Fence”
By Kristin Meikle and Amy Nelson
Many distressed power and telecoms companies are looking for ways to protect their profitable businesses and projects from the reach of creditors of the other parts of the company that are in distress.
One method for doing this is called “ring fencing.” This article explains what ring fencing is, why it is done, how entities have been successfully ring fenced, and what risks and issues should be taken into account when considering whether a subsidiary can or should be ring fenced.
Ring-fencing structures sometimes attract bad press, but appear to be able to sustain judicial scrutiny. For example, a federal appeals court recently brushed aside objections from the state of California and upheld steps that PG&E Corp. — a holding company — took in early 2001 to isolate its regulated utility subsidiary, the Pacific Gas & Electric Company, in order to protect its other subsidiaries. The utility filed for bankruptcy three months after PG&E put the ring fence in place. Such financing structures have also met with some level of approval within the financial community. Standard & Poor’s confirmed the efficacy of one such ring-fencing structure in late 2002 when it reaffirmed a strong credit rating for Portland General Electric Co., notwithstanding that the utility’s parent — Enron Corp. — was in bankruptcy. The credit rating survived because Enron had set up a ring fence around Portland General, and there were powerful financial disincentives for the Enron creditors to force Portland General into bankruptcy.
What is Ring Fencing?
The phrase “ring fencing” refers to steps taken to make a subsidiary “bankruptcy-proof” or “bankruptcy remote.” Ring fencing is supposed to shield the assets of the subsidiary from the bankruptcy of its parent or affiliates and allow the subsidiary to obtain or maintain a “standalone” credit rating substantially higher than the lower credit rating of its parent.
Ring fencing is used in a variety of financing situations, including acquisition financing, monetizing a subsidiary’s dividend distributions, and corporate spin-offs. In the project finance context, ring fencing generally refers to implementation of two types of provisions: the requirement that an independent director or a separate class of stock be established for an entity to vote on voluntary bankruptcy filings, and the requirement that the entity observe “separateness covenants,” such as maintenance of separate bank accounts and no commingling of assets. These types of provisions are implemented in order to guard against certain specific risks in the bankruptcy context, including the following:
- The filing of a voluntary bankruptcy petition by the governing body of the subsidiary.
- Substantive consolidation. Substantive consolidation is an equitable remedy that allows the bankruptcy court to pool the assets and liabilities of two separate but affiliated entities and to treat them as though they are the assets of a single bankrupt debtor. Courts will look at whether there is substantial identity between the entities to be consolidated, meaning whether the affairs of the parent and the subsidiary are so intertwined as to make the two entities essentially indistinguishable. They will also look at whether consolidation is necessary to avoid some harm or realize some benefit.
- The filing of an involuntary bankruptcy petition against the subsidiary by creditors of the parent or its affiliates, by creditors of the subsidiary or by the parent or its affiliates.
- Piercing the corporate veil. The “corporate veil” may be pierced if the subsidiary has acted as the “alter ego” of its parent, if the parent exerts more control over the subsidiary than would be expected of a normal investor, or if the actions of the parent directly caused the subsidiary to incur a liability. Piercing the corporate veil is a risk when the parent so disregards the separate identity of the subsidiary that their enterprises are seen as effectively commingled. Creditors could pursue a form of “reverse” corporate veil piercing when the parent is insolvent and the subsidiary is viewed as a source of funds.
How to Ring Fence
There is no one blueprint that will guarantee that an entity is successfully ring fenced. However, there are at least six factors at which courts and rating agencies look in order to determine whether an entity is sufficiently “standalone” to justify shielding its assets from creditors of its affiliates (or, in the case of rating agencies, to justify a “standalone”, investment grade, rating).
First, the new entity must be a single-purpose entity. Its objects and powers must be restricted as closely as possible to the core activities necessary to effect the structured transaction. This restriction reduces the entity’s risk of voluntary insolvency due to claims or risks associated with activities unrelated to the structured transaction. It also reduces the risk of third parties filing involuntary petitions against the entity. These restrictions should be drafted into the entity’s charter documents for two reasons: the charter documents are publicly available, and therefore serve as public notice of the restrictions, and the entity’s management is more likely to refer to these documents, and therefore be reminded of the restrictions, when conducting its affairs.
Second, the new entity should incur no additional debt beyond what is needed for its routine business purposes. In order to limit the likelihood of an involuntary filing, the entity should covenant not to incur debt except where such action is consistent with its business purpose. This will reduce the likelihood of holders of additional indebtedness pursuing involuntary petitions to gain access to the entity’s assets or cash. The entity’s charter documents may also contain limits on the entity’s ability to incur voluntary liens.
Third, the new entity should covenant not to merge or consolidate with a lower-rated entity. The bankruptcy-remote status of the subsidiary must not be undermined by any merger or consolidation with an entity not adequately protected from bankruptcy or by any reorganization, dissolution, liquidation or asset sale. The new entity should also covenant not to dissolve.
Fourth, the new entity should observe various “separateness covenants” in order to avoid being substantively consolidated with its parent. It should maintain separate offices from its parent, separate financial records and financial statements, its own corporate books and records, and separate bank accounts. There should be no commingling of assets with its parent or any of the parent’s affiliates. It should pay its own liabilities and expenses. It should have adequate capitalization, given the nature of its business. Entities may also want to consider implementing restrictions on asset transfers and dividend declarations.
Fifth, the company should obtain a “non-consolidation opinion” from its counsel. A non-consolidation opinion addresses the likelihood that a court will grant substantive consolidation based on the observance by a parent and its subsidiary of the various “separateness covenants” referenced above.
Finally, the new entity should in its charter documents provide for either an independent director or a special class of stock (or “golden share”). The independent director or the owner of such class of shares should be an independent entity with no tie or relationship to the parent, its affiliates or any lender to the parent or affiliates. The charter documents of the subsidiary should require the affirmative vote of the independent director or the holder of the golden share before any voluntary filing into bankruptcy. It should also require the independent director or the holder of the golden share consider the interest of the subsidiary’s creditors, in addition to the interests of the shareholding parent, when deciding whether to file. This factor is often viewed as critical by the rating agencies in order to insure that a standalone rating for the subsidiary is justified. Different entities have taken different approaches to this factor. For example, the California utilities have adopted the independent director approach. Under the corporate documents of these entities, a unanimous vote of the board of directors is required for certain major corporate actions, including the institution of bankruptcy proceedings, dissolution, liquidation, and the payment of dividends in excess of certain tests. Portland General instead established a special class of junior preferred stock that is held by an entity independent of Portland General and its affiliates and that requires the vote of the junior preferred holder before Portland General can voluntarily file for bankruptcy.
These factors are not in and of themselves bullet-proof. For example, courts will generally not compel compliance with the various covenant requirements. “Nonpetition” covenants — under which a parent agrees not to file a bankruptcy petition against the subsidiary — are typically not enforceable, as waivers or prohibitions on bankruptcy petitions are void as a matter of public policy. Non-consolidation opinions are fact specific, limited in scope and highly qualified; they also do not address the likelihood of the parent independently filing the subsidiary into bankruptcy. The “golden share” or independent director mechanism only addresses a voluntary bankruptcy situation. While the independent director or golden shareholder may prevent a voluntary petition, the risk that creditors will pursue an involuntary filing still exists. In addition, although it is accepted practice that once an entity is in the “vicinity of insolvency,” the director’s duties extend beyond the entity and its shareholders to include its creditors, the use of an independent director whose position is created specifically to look beyond the interests of the shareholders has seldom been tested in court. Some courts have indicated a willingness to ignore the independent director arrangement. At least one Delaware court permitted a corporation to file a voluntary petition in 1992 without the unanimous vote of the directors, contrary to the requirements of the charter documents. However, this holding appears to be the exception rather than the rule.
As a result, an entity should consider incorporating as many of the elements listed in this article as possible when contemplating a restructuring with the intent of ring fencing. (It should probably also opt for the golden share approach rather than the independent director approach.)
Other Issues to Consider
Although courts appear to be willing to uphold the ring-fencing structures established to date, and rating agencies have provided significantly higher ratings to ring-fenced entities than to their parent companies, because of the highly publicized nature of the Enron bankruptcy and other recent high-profile bankruptcies, ring fencing is subject to a high level of public scrutiny and is liable to be challenged again in the courts.
Because of this, there are a number of non-legal considerations to factor in to the decision of whether and when to ring fence.
Ring fencing is often perceived by the public as an attempt to hide assets that would otherwise be available to creditors. However, the companies doing the ring fencing suggest that they are restructuring their assets to maintain the viability of the company. The difference between hiding and restructuring may depend in part on timing — for example, whether the new entity was in place before or after the liabilities were incurred. PG&E Corp.’s timing was potentially more of a problem given that the restructuring occurred just three months prior to when its affiliate, Pacific Gas & Electric Company, filed for chapter 11 bankruptcy protection. Although this element has not yet appeared as a factor in the court’s decision-making process, companies would be wise to begin the restructuring and ring-fencing process as soon as practicable, before their financial problems become dire.
The restructuring effort may also benefit from how one “spins” the restructuring. For example, Edison Mission Energy received FERC approval for the restructuring of subsidiaries of Edison International over the objections of Exelon and others, in part because it stressed that the restructuring was necessitated by its need to meet certain financial commitments to the state of California. In its approval, FERC indicated that it was relying on fulfillment by Edison International of financial commitments it had made to the California Department of Water Resources and that the additional financing to be obtained would serve the public good. Consequently, when contemplating a restructuring to effectuate a ring fencing, companies should consider not only the implementation of various legal factors and the timing of the transaction, but also how they will tell their stories to the public.