Power Contracts and Bankrupt Generators

Power Contracts and Bankrupt Generators

October 01, 2004

By Joseph Smolinsky

US courts in different parts of the country have reached different conclusions about whether it is up to the bankruptcy judge or the Federal Energy Regulatory Commission to decide when a power contract with unfavorable terms can be canceled in a bankruptcy proceeding.

Also at issue is what standard a bankruptcy judge must use if it is his or her decision.

The cases are important because banks financing power projects wonder how secure are the long-term power purchase agreements, or “PPAs,” against which they lend.

The NRG Energy and Mirant bankruptcies provided an opportunity recently to settle these questions.  A federal district court in New York said it is up to FERC to decide when a power contract can be canceled.  A US appeals court in the south central United States told Mirant that the decision should rest with the bankruptcy judge, but suggested he should use a stricter standard than is usual for bankruptcy proceedings when deciding whether to let such a contract be canceled.

The cases call into question the interplay between the US bankruptcy code and the Federal Power Act.  The Federal Energy Regulatory Commission has exclusive jurisdiction under the Federal Power Act to regulate the transmission and sale of electricity in interstate commerce.  FERC is also responsible for regulating prices, terms and conditions for the sale of electricity between states and regions.

A company in bankruptcy can sometimes reject or disavow contracts as part of a plan to restructure its finances.

Starting with the Enron bankruptcy filing in late 2001, four merchant power companies have been in bankruptcy.  Two merchant generators — NRG Energy, Inc. and Mirant Corporation — tried to reject long-term power purchase agreements, but their requests to the bankruptcy judge for approval were opposed by the contract counterparties, both regulated utilities.  The utilities in both cases argued that only FERC, and not the bankruptcy court, has jurisdiction over the ultimate disposition of PPAs.  The merchant generators countered that rejection of contracts is clearly within the exclusive jurisdiction of the bankruptcy courts.  FERC, protective of its mandate, played active roles in both these disputes.

This article discusses the rights of a bankrupt company to terminate contracts generally and how the NRG and Mirant courts have reconciled these broad debtor rights to disavow contracts with FERC’s need to ensure that consumers are supplied with stable and economical electricity.  For independent generators and their lenders and other creditors, this developing law could greatly affect creditor recoveries and limit restructuring alternatives.

In General

Restructuring a business successfully in chapter 11 often requires not only a reduction in debts, but also a refocusing of business operations to more profitable pursuits.  This operational assessment process necessarily includes a review of all outstanding contracts to determine whether the bankrupt company could become profitable again by rejecting certain of its contracts.

The ability to reject burdensome “executory” contracts under section 365 of the US bankruptcy code is one of the most valuable benefits from filing for bankruptcy.  It permits a bankrupt company to pick and choose among its various leases and executory contracts.  The term “executory contract” is not defined in the Bankruptcy Code, but the term is generally accepted to mean any contract where there are material ongoing obligations remaining by both parties.  The decision whether to assume or reject leases of office space and other nonresidential real property must be made within 60 days, unless the court allows more time.  The decision to assume or reject other contracts does not usually have to be made by the bankrupt company until it presents a plan of reorganization.  However, many companies try to reject burdensome contracts early in the bankruptcy process because doing so brings immediate savings. 

The bankruptcy code lets a bankrupt company assume an executory contract (other than an agreement to provide a loan or other financial accommodation) only if, at the time of assumption, two things occur.  The company must cure past defaults and demonstrate its financial capability to perform the contract fully in the future.  Section 365 of the US bankruptcy code provides a further benefit in that it permits a bankrupt company, as part of the assumption process, to assign a contract to a third party notwithstanding a prohibition against such assignments in the contract.  Notwithstanding this, personal service contracts and certain intellectual property licenses cannot be assigned without consent.

A bankrupt company has the power to reject an executory contract if the contract is burdensome and, in the company’s business judgment, rejection is appropriate.  If a contract is rejected, then it is not terminated but rather the bankrupt company is considered to have breached its obligations under the contract as of the bankruptcy filing.  This excuses the company from any further performance, but also exposes it to a claim for damages from the counterparty to the contract.  The counterparty’s damage claim is treated in bankruptcy as a “pre-petition general unsecured claim” for damages.  This establishes its priority for payment.  In contrast, if a contract is assumed by the company and then later breached, the counterparty has an “administrative priority claim” for damages.  Such claims are ahead of general unsecured claims in line.

The standard a bankruptcy court applies in deciding whether to let a bankrupt company assume or reject a contract is the “business judgment” test.  In general, a company’s decision to reject an executory contract in its business judgment must be upheld, unless it is the product of bad faith, or of whim or caprice.  Most courts disregard as irrelevant the harm caused to other parties to the contract as a result of a rejection.  There are some courts that have modified the business judgment test to consider a balancing of the harms, but courts have only denied rejection in situations where general creditors of the bankrupt company would not be aided significantly by rejection and the rejection would result in substantially more harm to the contract counterparty than it would benefit for the bankrupt company.

Rejection of PPAs

Contracts in the project finance arena such as PPAs are unusual because of their long terms of 20 years or more.  Contract pricing is based on long-term commodity market projections that could be extremely volatile and greatly affected by external forces.  As such, these contracts are more susceptible than most to rejection by independent generators in chapter 11 proceedings.

Mirant and NRG both found their way into chapter 11 during 2003.  Each was a party to one or more PPAs with regulated utilities, and each could no longer economically perform its contracts.  Both companies recognized that as part of their overall restructuring efforts, they should take advantage of the chapter 11 filing to reject certain PPAs.  In fact, for Mirant, rejection of its PPA with Potomac Electric Power Co. was said by the debtor to be one of the primary things it had to achieve for a successful reorganization.  Mirant and NRG faced legal snags in implementing these restructuring initiatives as the courts struggled to reconcile the competing interests of the bankruptcy code and the Federal Power Act.

NRG

NRG Energy was party through a subsidiary to a 4-year PPA with the Connecticut Light & Power Company that required NRG to provide a fixed amount of energy to CL&P at a set price from January 1, 2000 through December 31, 2003.  Immediately before filing for chapter 11 relief in a New York bankruptcy court on May 14, 2003, NRG gave notice to CL&P that it intended to terminate the PPA.  Later that day, NRG formally filed for bankruptcy and filed a motion to reject the PPA.  The next day, the Connecticut Department of Public Utility Control and the Connecticut attorney general asked FERC to “stay” the termination, citing harm to CL&P’s customers.  FERC issued an order staying the termination on May 16, 2003.  On June 2, 2003, the bankruptcy court let NRG reject the contract under the business judgment standard, but said it would not overrule the FERC “stay” of the contract rejection.  Thus, NRG had to continue performing the contract.  The court told NRG that it would have to persuade FERC to drop the stay.  NRG promptly asked a federal district court in New York to bar FERC from enforcing its stay.  FERC responded by issuing a second order requiring NRG to comply with the rates, terms and conditions in the contract pending a FERC determination of whether NRG’s proposed termination was consistent with the public interest.

The federal district court ruled that the issues that were pending before FERC — whether NRG could cease performance notwithstanding the Federal Power Act guidelines — fell squarely within FERC’s regulatory responsibility.  Moreover, the district court noted that section 8251 of the Federal Power Act provides that orders issued by FERC are to be reviewed only by a US court of appeals.  Accordingly, the district court dismissed NRG’s complaint.  NRG then went on to settle its differences with CL&P, and the company emerged from chapter 11 a short time later.

Mirant

In 2000, PEPCO, a regulated utility serving the District of Columbia and Maryland, agreed to sell its power plants to Mirant.  Mirant also agreed to replace PEPCO as the purchaser under a number of long-term power contracts that PEPCO had entered into with other electricity suppliers.  PEPCO had trouble assigning two of the contracts under which it was an electricity purchaser to Mirant so Mirant agreed to enter into a new contract — called a back-to-back agreement — with PEPCO under which it promised to buy electricity from PEPCO at the same price that PEPCO had to pay under the two agreements that it was unable to assign.  The rates under the back-to-back contract ultimately proved substantially higher than market rates, and Mirant was suffering substantial losses.  At the time of the bankruptcy filing, the back-to-back agreement had a remaining term of more than 18 years.

In July 2003, Mirant filed for bankruptcy relief under chapter 11 in Texas.  Mirant had seen the trouble that NRG caused itself by providing notice of termination of its PPA to CL&P and allowing CL&P to take preemptive action before FERC by getting orders against NRG directing performance.  In an effort to avoid the same fate, Mirant asked the bankruptcy court in Texas for permission to reject the back-to-back agreement, and it also asked the court to bar FERC from taking any action to require Mirant to comply with the back-to-back agreement.  The bankruptcy court granted a preliminary injunction in favor of Mirant in September 2003.

PEPCO then sought relief in a federal district court after the district court exercised its right to transfer the issue to it from the bankruptcy court.  After extensive hearings and intervention by FERC, the district court found in December 2003 that FERC has exclusive authority to determine the reasonableness of wholesale rates for electricity sold in interstate commerce and that those rates can only be challenged in a FERC proceeding, not through a collateral attack in another forum.

Mirant appealed the decision to the US appeals court for the 5th circuit.  The appeals court sided with Mirant.  It said in August 2004 that the power of a bankruptcy court to authorize rejection of a PPA such as the back-to-back agreement “does not conflict with the authority given to FERC to regulate rates for the interstate sale of electricity at wholesale.”  The court said rejection of a PPA is a breach of the contract, and the Federal Power Act does not provide FERC with exclusive authority over the remedies for breach of a FERC-approved contract.  The bankruptcy code does not let certain types of obligations be rejected in bankruptcy without approval of the interested regulators, but there is no such special provision for FERC contracts.  However, the appeals court said the strong public interest in the transmission and sale of electricity suggests there should be a more stringent test than business judgment before Mirant can reject the back-to-back agreement.  It directed the lower court to consider the impact of rejection upon the public interest as well as ensure that the rejection will not cause any disruption in the supply of electricity to other public utilities or consumers.

Mirant viewed the appeals court decision as a victory.  The case is back in the district court for further hearings.  It is still possible the district court could apply the same rigid standards FERC would have before allowing Mirant to terminate the contract.  Given the more than 15-year term remaining on the back-to-back agreement, the final outcome could be significant for Mirant creditors.