Court Rejects Attempt to Cancel Contract in Bankruptcy

Court Rejects Attempt to Cancel Contract in Bankruptcy

September 01, 2006

A US appeals court appears in a strongly-worded opinion in July to have definitively closed the door on efforts by Mirant, a US independent power company, to use its bankruptcy as justification to walk away from commitments it made to the Potomac Electric Power Company, a utility, when Mirant bought the utility’s power plants.

The case is important because it sheds light on how great a risk a seller faces that a buyer who later goes bankrupt might be able to walk away from part of the business deal.

At issue in the case was the fate of a “back-to-back agreement” under which Mirant promised to assume obligations that Pepco made to other independent generators to buy their electricity under long-term contracts.

The fight between Mirant and the utility has a long and tortured history that the judge in the case summarized as “Mirant’s unrelenting and unjustified effort to avoid a legitimate contractual obligation it now views as a bad deal.”

The decision is moot. The parties settled the case before the decision was rendered. The motion to approve the settlement was still pending before the bankruptcy court when the NewsWire went to press. The appeals court issued its order after already receiving lengthy submissions from the parties and hearing oral arguments on the issues before the settlement. The court appeared to acknowledge the settlement by requiring that its order should not be published and limiting any precedental value strictly to the facts of this individual case.

Background

Mirant signed a contract in December 2000 to buy a group of power plants from Pepco. As part of the deal, Mirant also agreed to assume Pepco’s obligations under several power purchase agreements that committed Pepco to buy electricity from third parties. At the time of the negotiations, both Mirant and Pepco acknowledged that the purchase price for the power under these power purchase agreements was above market and the contracts in question had an agreed “negative value” of approximately $500 million. Consequently, the purchase price for the power plants was reduced from $3.2 billion to $2.65 billion.

Pepco notified Mirant at the closing that some of the power purchase agreements were unassignable; therefore, the parties entered into a back-to-back agreement that committed Mirant to purchase from Pepco, at Pepco’s cost, all capacity, energy, ancillary services and other benefits that Pepco was obligated to purchase from the third parties under the unassignable power contracts. The back-to-back agreement is expected to cost Mirant approximately $10 to $15 million a month until the purchase obligation expires.

Mirant filed for bankruptcy protection on July 14, 2003. Within two months of filing for bankruptcy, Mirant filed a motion with the bankruptcy court to reject the back-to-back agreement. Mirant wanted to limit the rejection to only the back-to-back agreement while keeping the Pepco power plants and while preserving a right it had to connect the plants to the Pepco grid.

Mirant’s motion to reject the back-to-back Agreement started a chain of intense litigation that spanned three years and several courts. The rejection motion was first moved from the bankruptcy court to a federal district court, which denied the motion on grounds that a bankruptcy court cannot affect a matter that the Federal Power Act assigns to the Federal Energy Regulatory Commission. Mirant appealed the district court order to the US appeals court for the fifth circuit, which reversed the order and held that a bankruptcy court (or district court) does in fact have the authority to allow a power contract that is subject to FERC regulation to be rejected. The appeals court said the Bankruptcy Code trumps FERC when it comes to assumption and rejection of energy contracts and remanded the proceeding to the district court for a decision on the rejection. However, the appeals court suggested that the district court should use a more rigorous standard before rejecting the back-to-back agreement than the usual “business judgment standard” that usually applies in bankruptcy proceedings when debtors wants to reject contracts. The more rigorous standard would take into account the public interest in the transmission and sale of electricity.

When the case came back to it, the district court held that the back-to-back agreement could not be separated from the broader purchase of the Pepco power plants and, thus, was not eligible for rejection under the Bankruptcy Code. The Bankruptcy Code requires that an executory contract must be assumed or rejected in its entirety to prevent a debtor from keeping the benefits of a contract while rejecting the burdens to the detriment of the other party to the agreement. Mirant again appealed to the US appeals court for the fifth circuit.

While awaiting the results of the appeal, Mirant filed a second rejection motion. This time it said it wanted to reject the power plant purchase and the back-to-back agreement together. However, Mirant excluded from the rejection “ancillary agreements,” including a right to connect to the Pepco grid and certain lease assignments and easements. The issue of whether or not these “ancillary agreements” meant Mirant was not rejecting the contract in the entirety was argued before the district court, but the case was suspended while Mirant continued to pursue other aspects of the case before the appeals court. However, the district court ordered Mirant to continue to perform under the back-to-back agreement in the meantime. Mirant then appealed this order to the appeals court as well.

In June 2006, while the several appeals were pending, Pepco and Mirant reached a settlement. Notwithstanding the settlement, the appeals court issued its order on both appeals on July 19, 2006.

Appeals Court Order

The appeals court worked through a thicket of issues. One was whether the back-to-back agreement could be rejected without also rescinding the power plant purchase. The court said whether two agreements are “severable” is a matter of state law. The documents in this case said District of Columbia law would control. Analyzing DC law, the court determined that the parties assented to “all of the promises,” including the back-to-back agreement, the sale of the power plants, the interconnection agreements and the lease agreements, as a “single whole.” There were no separate contracts or transactions and everything was included in the overall deal and executed on the same day as one package. Further, there was a single consideration for the total agreement as evidenced by the purchase price (which was reduced by the cost of the back-to-back agreement). The court asked rhetorically why Mirant would enter into a legal obligation to purchase power at an above-market rate unless it was in exchange for something Mirant considered valuable, which in this case was the power plants and associated agreements. Next, the appeals court determined that the district court applied the proper standard for rejection in this case because the purpose of allowing a debtor to reject a contract is to free the debtor from agreements that would hinder or disable its reorganization. The court noted that Mirant has already successfully emerged from bankruptcy and the unsecured creditors in the case received payment in full on their claims. Therefore, it cannot be argued that the back-to-back agreement is causing any hindrance to a successful reorganization because the reorganization is already successful and complete.

Finally, the court held that the district court correctly required Mirant to continue to perform under the back-to- back agreement pending the appeal. The court reiterated that a debtor is not entitled to reap the benefits of a contract without suffering the burdens as well and found that Mirant continued to benefit from ownership of the power plants. Therefore, the district court was right to force Mirant to continue to pay for them.

Conclusion

The judge in the case concluded his decision with a strongly worded admonition against any further appeals by Mirant. Specifically, the court said “any future appeals that continue the pattern of attempts to reject the [back-to-back agreement] or efforts to refuse payment pending rejection may well invite the most severe sanctions available to this court.”

Even though the decision does not have official precedential value beyond the scope of the Mirant case, it provides useful insight by its forcefulness into how a court is likely to view an integrated asset purchase and sale agreement that includes provisions for out-of-market power purchases as part of the consideration. When negotiating or entering into these arrangements, it is important to create and emphasize as much as possible the indicia of separate agreements and consideration for each part of the transaction if the buyer wants to preserve the right to discharge these obligations in bankruptcy. This can perhaps be done by express language in the documents evidencing this intention or by entering into complete and separate agreements with respect to each segment of the transaction.