Bankruptcy Courts May Authorize Rejection of FERC-Regulated Contracts

Conflicts arising from the seeming incongruity between the Bankruptcy Code and other federal statutes governing the way that companies in various industry sectors are regulated have figured prominently in recent headlines involving companies such as PG&E, Enron and a number of telecoms. Bankruptcy and appellate courts are increasingly called upon to resolve these conflicts in a way that harmonizes as nearly as possible the competing policy concerns involved. One such dispute was the subject of a ruling recently handed down by the United States Court of Appeals for the Fifth Circuit in connection with the chapter 11 cases of Mirant Corporation and its affiliates. The decision contains both good and bad news for energy companies facing bankruptcy. The good news is that FERC-regulated contracts may be rejected as part of a reorganization proceeding. The bad news is that the decision to reject may be subject to heightened scrutiny.

By statute, U.S. district courts are given original, but not exclusive, jurisdiction over "all civil proceedings arising under" the Bankruptcy Code as well as those "arising in or related to cases under" the Code. In addition, district courts are granted exclusive jurisdiction over all the property of a debtor's estate, including, as relevant here, contracts, leases and other agreements that are still in force when a debtor files for bankruptcy protection. That jurisdiction devolves automatically upon the bankruptcy courts, each of which is a unit of a district court, by standing court order.

A bankruptcy court's exclusive jurisdiction over unexpired ― or "executory" ― contracts and leases empowers it to authorize a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to either "assume" (reaffirm) or "reject" (breach) almost any executory contract during the course of a bankruptcy case in accordance with the strictures of Bankruptcy Code section 365. Assumption allows the DIP to continue performing under the agreement, after curing outstanding defaults, or to assign the agreement to a third party as means of generating value for the bankruptcy estate. Rejection frees the DIP from rendering performance under unfavorable contracts. Rejection constitutes a breach of the contract, and the resulting claim for damages is deemed to be a pre-petition claim against the estate on a par with other general unsecured claims. Accordingly, the power granted by Congress under section 365 is viewed as vital to the reorganization process because it can relieve the debtor's estate from burdensome obligations that can impede a successful reorganization. The court will authorize assumption or rejection if it is demonstrated that either course of action represents an exercise of sound business judgment. This is a highly deferential standard akin in many respects to the business judgment rule applied to corporate fiduciaries.

Public and privately operated utilities providing interstate utility service within the U.S. are regulated by the Federal Power Act ("FPA") under the supervision of the Federal Energy Regulatory Commission ("FERC"). Under the FPA, although contract rates for electricity are privately negotiated, "those rates must be filed with FERC and certified as 'just and reasonable' to be lawful." FERC has "exclusive authority" to determine the reasonableness of the rates.

Based on this statutory mandate, courts have developed the "filed-rate doctrine," which provides that a utility's "right to a reasonable rate [under the FPA] is the right to the rate [that FERC] files or fixes, and, . . . except for review of [FERC's] orders, [a] court can assume no right to a different one on the ground that, in its opinion, it is the only or the more reasonable one." Under the filed rate doctrine, the reasonableness of rates and agreements regulated by FERC "may not be collaterally attacked in state or federal courts. The only appropriate forum for such a challenge is before [FERC] or a court reviewing [FERC's] order."

If a utility files for bankruptcy, FERC's exclusive discretion in this realm could be interpreted to run afoul of the bankruptcy court's exclusive jurisdiction to authorize the rejection of an electricity supply agreement based on the debtor's business judgment that the rates charged under the agreement are unreasonable. This was the thorny issue addressed by the Fifth Circuit Court of Appeals in Mirant.

Mirant Corporation and 82 of its subsidiaries (collectively, "Mirant") filed voluntary chapter 11 petitions in 2003. Prior to filing for bankruptcy, Mirant, one of the largest regulated public utilities in the U.S., agreed to purchase certain electric generation facilities from Potomac Electric Power Company ("PEPCO"). In connection with the sale, PEPCO was to assign to Mirant several purchase power agreements (each, a "PPA"), which are long-term fixed-rate contracts pursuant to which PEPCO agreed to purchase electricity from outside suppliers. Because certain of the PPAs required PEPCO to obtain the PPA supplier's consent to assignment, the purchase agreement provided that, if PEPCO could not obtain such consent, the unassigned PPAs would be subject to a "back-to-back" agreement.

Under a back-to-back agreement, PEPCO would continue to comply with the terms of any unassigned PPAs, and Mirant would agree to purchase an amount of electricity from PEPCO equal to PEPCO's obligations under the unassigned PPAs at the rate set forth in the applicable PPA. After PEPCO was unable to obtain the required consent to assign two of the PPAs, Mirant and PEPCO entered into such an agreement, which the parties filed with FERC. FERC subsequently approved the wholesale electricity rates set forth in the agreement.

Because of the significant financial losses experienced by Mirant under the back-to-back agreement, Mirant sought court authorization to reject the agreement after it filed for bankruptcy. It also sought an injunction preventing FERC or PEPCO from taking any actions to require Mirant to abide by the terms of the agreement. The bankruptcy court granted Mirant's request for injunctive relief, but did not rule on Mirant's motion to reject the back-to-back agreement.

Instead, the litigation continued in the district court, which withdrew the reference of the proceeding to resolve the potential conflict between the FPA and the Bankruptcy Code. The court ultimately ruled that FERC has exclusive authority under the FPA to determine the reasonableness of wholesale rates charged for electric energy sold in interstate commerce, and those rates can be challenged only in a FERC proceeding, not through a collateral attack in state or federal court. According to the district court, the Bankruptcy Code does not provide an exception to FERC's authority under the FPA, and therefore, Mirant had to seek relief from the filed rate in the back-to-back agreement in a FERC proceeding. The court accordingly denied Mirant's motion to reject the agreement and vacated the injunction issued below. Mirant appealed to the Fifth Circuit.

The Court of Appeals reversed. Initially, it determined that although the filed-rate doctrine prevents a district court from hearing breach of contract claims that challenge a filed rate, a court is permitted to grant relief in situations where the claim is based upon another rationale. Thus, the Fifth Circuit explained, the FPA does not prevent a court from ruling on a motion to reject a FERC approved rate setting agreement so long as the proposed rejection does not represent a challenge to the agreement's filed rate. PEPCO's claim arising from rejection of the agreement, the Court of Appeals emphasized, would be calculated based on the filed rate. Moreover, the Fifth Circuit emphasized, even though Mirant's desire to reject the agreement was motivated in part by the lower prevailing market rate, its business justification was also premised on the existence of excess supply and the consequent lack of any need for the energy covered by the contract. The Court of Appeals accordingly concluded that rejection of the agreement was not a challenge to the filed rate, and that the FPA did not preempt a ruling on Mirant's motion.

The Fifth Circuit rejected FERC's argument that anything less than full payment would constitute a challenge to the filed rate, observing that "any effect on the filed rates from a motion to reject would result not from the rejection itself, but from the application of the terms of a confirmed reorganization plan to the unsecured breach of contract claims." It went on to note that, although the Bankruptcy Code contains numerous limitations on a debtor's right to reject contracts, "including exceptions prohibiting rejection of certain obligations imposed by regulatory authorities," there is no exception that prohibits a debtor's rejection of wholesale electricity contracts that are subject to FERC's jurisdiction. Concluding that "Congress intended § 365(a) to apply to contracts subject to FERC regulation," the Fifth Circuit held that the court's power to authorize rejection of the back-to-back agreement does not conflict with the authority conferred upon FERC to regulate rates for the interstate sale of electricity. It accordingly reversed the decision below.

Mirant is emblematic of the way that the majority of courts approach a potentially irreconcilable conflict between two federal statutes. Wherever possible, most courts attempt to resolve such conflicts in a way that gives due consideration to the important policy considerations associated with both statutes. In Mirant, that resolution was reached by means of a determination that the rejection of an executory agreement establishing presumptively reasonable utility rates is not tantamount to a collateral attack on the reasonableness of the rates ― provided rejection is not motivated solely by a desire to take advantage of lower market rates. Stated differently, the Fifth Circuit found that there was no conflict between the statutes.

Still, certain aspects of the Fifth Circuit's ruling are troubling. Even though the Court of Appeals acknowledged that the Bankruptcy Code does not on its face contain any special restrictions on the ability of a trustee or DIP to reject a FERC regulated rate agreement, its ruling suggests that a different standard should apply to these kinds of contracts. In connection with its decision to reverse the district court ruling and remand the case for further consideration of Mirant's motion to reject, the Fifth Circuit stated that "[u]se of the business judgment standard would be inappropriate in this case because it would not account for the public interest inherent in the transmission and sale of electricity."

Instead, the Court of Appeals suggested, rejection of an executory power contract should be permitted only upon a showing that: (a) the contract is burdensome to the estate; (b) the equities favor rejection; and (c) the rejection "would further the Chapter 11 goal of permitting the successful rehabilitation of debtors." In applying this test, the Fifth Circuit observed, courts should give particular consideration to the public interest and should ensure that the rejection will not disrupt power delivered "to other public utilities or to consumers." Such a heightened standard for the rejection of FERC regulated rate agreements, however, is found nowhere in the Bankruptcy Code. Congress has clearly delineated restrictions on the ability to reject other kinds of agreements (e.g., collective bargaining agreements) where it saw fit to provide special consideration to the non-debtor parties to the agreement. The absence of any such express limitations with respect to FERC regulated rate agreements suggests that the Fifth Circuit's approach may be open to challenge.

Mirant Corp. v. Potomac Electric Power Co. (In re Mirant Corp.), 378 F.3d 511 (5th Cir. 2004).

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