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GT Alert

Rejecting Executory Power Contracts in Bankruptcy Cases: Jurisdictional Authority, But Has the Standard Changed?

October 2004
By Bryan L. Elwood, Greenberg Traurig, Dallas Office

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On August 4, 2004, a three-judge panel of the Fifth Circuit Court of Appeals issued an opinion1 in the Mirant Corporation bankruptcy case reversing a federal district court (the “District Court”) decision holding that it was powerless to approve Mirant’s proposed rejection of a wholesale contract for the interstate sale of electricity. The Fifth Circuit ruled that the District Court could authorize Mirant’s rejection of the executory power contract regardless of the Federal Energy Regulatory Commission’s (“FERC”) otherwise exclusive jurisdiction over the rates charged in the contract.2

Bryan L. Elwood
"Overruling a district court decision, the Fifth Circuit opinion issued in Mirant holds that a Chapter 11 debtor can reject an executory power contract even if the rates charged in the contract are subject to FERC approval."

The Fifth Circuit remanded the case to the District Court to rule on the merits of Mirant’s rejection motion. However, in doing so, the District Court was instructed to seriously consider applying a more stringent standard than the traditional business judgment test typically used to evaluate a debtor’s rejection of an executory contract or unexpired lease. Thus, while the Fifth Circuit made it clear that an executory power contract can be rejected in a bankruptcy proceeding, one must wonder whether the Fifth Circuit Court of Appeals has changed the standard for rejecting power contracts?

Background Facts

Mirant Corporation and a number of its affiliates (collectively, “Mirant”) filed Chapter 11 bankruptcy petitions in July 2003, with the United States Bankruptcy Court for the Northern District of Texas. One of the largest public utilities in America, Mirant, in addition to generating electricity, buys and sells power for use across the United States.

In June 2000, Mirant entered into an asset purchase agreement (the “APA”) with Potomac Electric Power Company (“PEPCO”) to purchase most of PEPCO’s electric generation plants and to take assignment of PEPCO’s power purchase contracts. However, two of these power contracts were not assigned to Mirant due to the inability to obtain supplier consent. Instead, PEPCO and Mirant agreed, pursuant to a schedule attached to the APA (the “Back-to-Back Agreement”), that PEPCO would comply with its obligations under these unassigned contracts and that Mirant would then purchase, at the rates charged therein, an amount of electricity from PEPCO equivalent to PEPCO’s obligations under these contracts. Upon submission, FERC then approved the rates charged in the Back-to-Back Agreement. These rates are higher than the current market rate for electricity.

After filing bankruptcy, and due to its continuing losses under the Back-to-Back Agreement, Mirant filed a motion to reject the Back-to-Back Agreement, but not the APA itself, as an executory contract. Following a hearing, the bankruptcy court held that it had the power to authorize the rejection of the Back-to-Back Agreement.

However, before a final ruling could be made on the merits of whether Mirant had grounds to actually reject the Back-to-Back Agreement, the District Court withdrew the case from the bankruptcy court and held a new hearing on the matter. The District Court then held that FERC has “exclusive” authority to determine whether wholesale rates charged for electricity sold in interstate commerce are reasonable and that any challenge to approved rates must be pursued in a FERC proceeding. As a result, the District Court found that Mirant could not reject the Back-to-Back Agreement because doing so was an improper attempt to avoid its contractual obligations at the rates FERC had previously approved. Finding no exceptions under the Bankruptcy Code, the District Court stated that Mirant was required to first seek relief from the rates charged in the Back-to-Back Agreement in a FERC proceeding. Mirant thereafter appealed this decision to the Fifth Circuit.

Legal Analysis

The Federal Power Act gives FERC the exclusive responsibility of approving rates charged in wholesale contracts for the interstate sale of electricity as being “just and reasonable.” In acknowledging this fact, the Fifth Circuit noted that the United States Supreme Court previously determined that FERC “has the ‘exclusive authority to determine the reasonableness of wholesale [electricity] rates’ under the Federal Power Act.” Mississippi Power & Light Co. v. Mississippi, 487 U.S. 354, 371 (1988).

"Unfortunately, the Fifth Circuit was not entirely clear whether a debtor’s intentions in seeking to reject a power contract must be for reasons other than due to the rates charged."

In bringing its motion to reject the Back-to-Back Agreement, Mirant claimed that it had the right to reject, subject to the bankruptcy court’s approval, “any” of its executory contracts. FERC countered that its authority under the Federal Power Act over wholesale rates preempted the District Court’s jurisdiction to approve the rejection of the Back-to-Back Agreement. Agreeing with Mirant, the Fifth Circuit concluded that the District Court’s power to approve the rejection of the Back-to-Back Agreement did not conflict with FERC’s authority to regulate rates for the interstate sale of wholesale electricity.

Specifically, the Fifth Circuit panel determined that because Mirant’s proposed rejection of the Back-to-Back Agreement would be considered a breach of contract, the question then became whether the Federal Power Act granted FERC exclusive authority over breaches of FERC-approved contracts. The Fifth Circuit held that the Federal Power Act does not give FERC exclusive jurisdiction over breach of contract claims where the alleged breaches are unrelated to an approved rate. As a result, the Fifth Circuit found that the rejection of the Back-to-Back Agreement would only have an “indirect” impact on the rates charged therein as the amount of damages PEPCO would have as an unsecured claim for Mirant’s breach would be calculated using the FERC-approved contractual rate. In this regard, the Fifth Circuit specifically stated:

The [Federal Power Act] does not preempt a district court’s jurisdiction to authorize the rejection of an executory contract subject to FERC regulation as part of a bankruptcy proceeding. A motion to reject an executory power contract is not a collateral attack upon that contract’s filed rate because that rate is given full effect when determining the breach of contract damages resulting from the rejection. Further, there is nothing within the Bankruptcy Code itself that limits a public utility’s ability to choose to reject an executory contract subject to FERC regulation as part of its reorganization process.

Unfortunately, the Fifth Circuit was not entirely clear whether a debtor’s intentions in seeking to reject a power contract must be for reasons other than due to the rates charged. Specifically, FERC asserted, and the District Court held, that Mirant’s reason for seeking to reject the Back-to-Back Agreement was because the rate was higher than the current market rate. However, Mirant countered by stating that it did not need the electricity provided under the Back-to-Back Agreement to meet its supply requirements. In addressing this issue, the Fifth Circuit stated:

A debtor’s use of the filed rate as a criteria to select for rejection under § 365(a) those contracts which impose the greatest burden upon the bankruptcy estate does not convert that rejection decision into a prohibited collateral attack on the filed rate when the electricity purchased under the rejected contract is not necessary to fulfill a debtor’s supply obligations.

As such, it is unclear from the Fifth Circuit’s comments whether the District Court has jurisdiction to authorize the rejection of the Back-to-Back Agreement if Mirant’s sole reason for wanting to reject was due only to the above-market rates being charged.

Finally, in remanding the case to the District Court for determination of whether grounds actually exist for rejecting the Back-to-Back Agreement, the Fifth Circuit noted that the bankruptcy court had previously indicated that it might choose to apply a more “rigorous” standard in evaluating Mirant’s rejection motion than the business judgment standard typically used. Agreeing, the Fifth Circuit noted that because FERC can only approve a rate change if it is in the public’s interest, the District Court, on remand, “should” therefore consider applying more stringent standards to Mirant’s motion to reject than the typical business judgment test. Specifically, the Fifth Circuit stated:

Clearly the business judgment standard normally applicable to rejection motions is more deferential than the public interest standard applicable in FERC proceedings to alter the terms of a contract within its jurisdiction. Use of the business judgment standard would be inappropriate in this case because it would not account for public interest inherent in the transmission and sale of electricity.

Accordingly, the Fifth Circuit suggested that the District Court adopt a standard whereby Mirant bore the burden of showing that the Back-to-Back Agreement “burdens the estate,” that the “equities” are in favor of rejecting the contract, and that rejection would further Mirant’s reorganization. In doing so, the Fifth Circuit instructed the District Court to “carefully scrutinize the impact upon the public interest” and to “ensure that rejection does not cause any disruption in the supply of electricity to other public utilities or to consumers.”

While couched as “suggestions,” the Fifth Circuit appears to have made clear its expectation that the District Court apply more stringent standards to the rejection of executory power contracts such as the Back-to-Back Agreement. Although the Fifth Circuit panel did not specifically state what these higher standards are to entail, “public interest” is to be factored into whether a debtor is authorized to reject an executory power contract.

Conclusion

Overruling a district court decision, the Fifth Circuit opinion issued in Mirant holds that a Chapter 11 debtor can reject an executory power contract even if the rates charged in the contract are subject to FERC approval. As a result of this opinion, debtors in the Fifth Circuit are not required to initiate a FERC proceeding to attempt to rid itself of a burdensome power contract. Instead, these debtors can seek relief before the bankruptcy court administering their bankruptcy cases, which, in turn, gives them a powerful tool to assist in their reorganization efforts.

However, in holding that executory power contracts containing rates subject to FERC approval can be rejected in bankruptcy proceedings, the Fifth Circuit indicated that a more rigorous standard should be applied than the traditional business judgment test used in evaluating whether rejection is appropriate. Instead, the Court stated, without being specific, that the “public interest” should be considered when a debtor seeks to reject an executory contract that includes rates approved by FERC.

 


Footnotes

1  See 378 F.3d 511 (5th Cir. 2004). As of September 24, 2004, the Fifth Circuit had not issued a final mandate reversing and remanding the District Court opinion.

2 While this Fifth Circuit opinion appears to be the first Circuit Court of Appeal's decision directly addressing this issue, a similar situation arose recently in the NRG Energy, Inc. bankruptcy case. In that case, and although the United States Bankruptcy Court for the Southern District of New York determined that the business judgment standard had been satisfied, it refused to vacate an existing FERC order requiring NRG to continue providing energy under the contract. In re NRG Energy, Inc., 2003 WL 21507685, *2 (S.D.N.Y. 2003). NRG then filed a motion with the United States District Court for the Southern District of New York requesting authority to cease performance under the contract and for injunctive relief. That court, much like the District Court in this case, held that it did not have subject matter jurisdiction to make a decision on these issues. See id., at 4. This issue was subsequently settled prior to a ruling by the Second Circuit.

 

© 2004 Greenberg Traurig


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This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.